MGKS

6530 N. 16th St.

Phoenix, AZ 85016-1306

Telephone: 602-944-1515

Email: info@mgks.com

 

 

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​Employee Stock Ownership Plans (ESOPs) for Closely Held Companies

ESOPs are a type of Qualified Defined Contribution Plan which provides transfer of ownership to participants. ESOPs can accomplish the following goals:

 

  • A way for owners of closely held companies to provide ownership transition in an efficient tax manner.

 

  • Can be used to attract, retain, reward and motivate employees.

 

  • S Corporation companies can avoid taxation on profits attributable to the ESOP’s ownership percentage.

 

ESOPs are company sponsored.  Funding occurs when the sponsoring company makes contributions to an ESOP trust.  Contributions can be in the form of employer stock or cash.  In a leveraged ESOP, the plan can borrow money to buy shares which are held within a suspense account in the ESOP.  Cash contributions to the ESOP are used to repay the loan and take a tax deduction.  Since the loan is repaid through a contribution to the plan, both the principal and interest are deductible.  Generally, the deduction is limited to 25% of eligible compensation.  Shares are released as the loan is paid and are allocated to participant accounts.  An annual valuation must be performed for an independent outside appraiser.  The resulting share price is used to value the shares in participant accounts.  A vesting schedule may apply for up to a six year period.

 

In certain cases, a taxpayer who has held company shares for at least 3 years, can elect to defer the long-term capital gain on a sale to an ESOP under Internal Revenue Code Section 1042.  In order to qualify for tax deferral, the ESOP must own at least 30% of the corporation’s outstanding stock immediately after the sale.  The selling shareholder must replace the shares sold with “qualified replacement property” (QRP) during the 15 month period beginning 3 months before the date of sale, and ending 12 months after the date of sale.  QRP must be securities of domestic operating companies not making more than 25% of their income from passive investment.  Thus mutual funds or government bonds are not QRP.

 

The plan is governed by a Trustee.  Many times the Trustee is an outside corporate trustee.  Participants must be entitled to direct the plan how to vote any shares allocated to their accounts on any corporate matter in connection with the a corporate merger, consolidation, recapitalization, reclassification, liquidation, dissolution, sale of substantially all the assets of a trade or business, or similar transaction.