Louis Diamond

Employee Stock Ownership Plans

The exceptional small business planning device that’s a mystery to most, misunderstood and underutilized.

June 13, 2011
by Louis Diamond, Esq.

Employee Stock Ownership Plans (ESOPs) were added to the Internal Revenue Code by Congress in Employee Retirement Income Security Act (ERISA) in 1974 as a way to encourage employee ownership. The premise was that this would create a more motivated workforce and, in turn, make U.S. business more productive and competitive internationally. Numerous studies have borne out the accuracy of this premise. And, in the intervening years the Code has been periodically amended to make ESOPs even more attractive. This process is ongoing as evidenced by the recently introduced H.R. 1244, the bi-partisan “Promotion and Expansion of Private Employee Ownership Act of 2011.”

In designing the ESOP law, Congress recognized that extending ownership to employees entails the dilution of existing owners, so it provided enticing tax incentives to induce small business owners and their companies to go the ESOP route. However, to best assure that these inducements were not abused, Congress also added harsh penalties where it deemed them appropriate.

The end result has been a complex ensemble of laws, regulations and rulings that are not easily understood and usually avoided. But, should we “throw the baby out with the bathwater?” The ESOPs maze, like many others, can be traversed and we should not deny our clients the opportunity to assess whether these attainable benefits are worth the cost and logical to pursue. They frequently are and I will now attempt to show you why.

The ‘Upside’ Through ESOPs

  • Successful businesses can become tax-exempt.
  • Ordinary income can be converted into long-term capital gain (LTCG).
  • The tax on the sale of company stock can be indefinitely deferred or, even, avoided.
  • Dividends can be made to be deductible.
  • Up to all of a company’s stock can be sold while equity and control are maintained.
  • Deductible company contributions to qualified deferred compensation plans can be expanded well beyond limits applicable to other defined contribution plans.
  • Employees can be enabled to use funds set aside in other qualified plans to purchase company stock if they so desire.
  • And much more can be accomplished.

ESOPs and Subchapter S

Until 1987 ESOPs were not eligible to own stock in an S corporation. Congress changed this, but then discovered that its intended purpose (i.e. to enable an ESOP’s share of the S corporation’s income to not be currently taxed) was thwarted due to the application of the Unrelated Business Income Tax (UBIT), which imposes a tax at the top corporate rate (now 35%) on the unrelated active income of a tax-exempt entity (including an ESOP). Accordingly, in 1988, Congress exempted ESOPs and only ESOPs, from the UBIT and now an ESOP’s K-1 share of an S corporation’s earnings is not taxed. Thus, when an ESOP owns all of the stock of an S corporation, its income is not currently taxed and can be used to pay debt incurred to buy that stock, then retained to both finance corporate growth and pay ESOP participants when they retire.

But, does this mean that the S corporation’s former owners have been totally excluded from owning equity in the company they formerly owned? No, not if they are also active participants in the ESOP (which is usually the case) or own something known as “synthetic equity” (e.g. stock warrants, options or appreciation rights), which can be obtained pursuant to arm’s-length bargaining with the company. The combination of this ESOP ownership and synthetic equity cannot, however, reach 50 percent or those dire consequences referred to above will come into play. Although called “synthetic,” that equity is real and the application of simple math shows us that, for example, a 42 percent equity interest in the income of a tax-exempt entity is equivalent to a 70 percent equity interest in a taxable one since 70 percent less a 40 percent (combined federal and state) tax nets out to 42 percent. Also, those former owners can continue to serve as officers and members of the board of directors of that corporation. This is why an ever-increasing number of ESOP companies are now wholly-owned by their ESOP.

Moreover, when the owner of an S corporation has most of his stock redeemed largely for an installment note and then sells what’s left to its ESOP, corporate earnings that would otherwise constitute K-1 income, can then be used to pay that note thereby converting what would otherwise be ordinary income into LTCG. Then when the seller decides to retire or wants additional revenue, he can sell his synthetic equity (usually warrants) to the company thereby realizing more LTCG. Ultimately, after the former owner has been paid in full, in accordance with congressional intent, the employees, usually quite pleased with their lot, in effect “inherit” the company — subject to the obligation to pay themselves the value of the company stock that has accrued to their benefit under the ESOP, which is, in turn, accomplished using untaxed corporate profits.

The IRC §1042 Tax–Deferred (or Tax-free) Sale
One of the most popular ESOP benefits is the entitlement of stockholders of a C corporation to sell stock to an ESOP and “rollover” their sale proceeds into “qualified replacement property” (QRP) (i.e. stock, bonds or notes of other active US corporations, including publicly traded ones listed on the New York or other stock exchanges). The potential here is illustrated below.

Sale to ESOP at $7M vs. Sale to Company at $7M
  After-Tax Benefits to Seller After-Tax Cost to Company
ESOP Alternative $7 million 1 $4.2 million 2
Non-ESOP Alternative $5.6 million 3 $7 million 4
Total Tax Savings Using ESOP $4.2 million  
1 The full sale price not reduced by taxes because of §1042.
2 $7 million contributed to its ESOP and deducted by the Company reduced by the worth of a 40 percent (federal 34% and state 6%) tax deduction.
3 $7 million sales proceeds reduced by a 20 percent long-term capital gain tax (federal 15% and state 5%).
4 Non-deductible money paid by the Company to purchase this stock.

As you can see, the tax saving can be dramatic.

But, § 1042 is subject to many requirements and is now losing favor largely due to the fact that it does not extend to S corporation shareholders and triggers recognition of the deferred tax in the event that the QRP is “disposed of” prior to the seller’s death. But, where it fits, this potential ESOP benefit can be quite worthwhile and should be explored.

Potential Inherent in ‘Lateral Transfers’

Corporate employees can transfer funds accrued to their benefit laterally in other qualified plans into their account in the company’s ESOP and designate them to be used to buy company stock usually from stockholders wanting to be brought out. While this opportunity must be presented to all ESOP participants, in my experience only management personnel choose to take advantage of it.

Where Do You, As CPAs, Fit Into This Picture?

Numerous benefits can be obtained through ESOPs and your clients look to you to make them aware of ways to reduce their income tax burden. For example, in business succession planning, it is reasonable for your clients to expect you to alert them to this potential. Almost all ESOP’s should be preceded by a “feasibility study” and it is logical for you to be an integral part of this process. ESOPs themselves need an independent accountant — a role that you can fulfill. Those of you who are qualified to do so, can perform the annual appraisal that is required for all ESOP companies. And you can build ESOPs in, as another element in your practice.


While ESOPs are complex, they can be readily dealt with and administered. You should take pride in being able to spot instances in which ESOPs might fit and then participate in their implementation. As I see it, you belong in this picture. Do you agree?

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Louis Diamond, Esq., is president of Washington, DC-based Diamond ESOP Advisors PLLC. He is a past chairman of the ESOP Association’s Legislative and Regulatory Advisory Committee. He will be speaking at the AICPA Small Business Practitioners Tax Conference, July 10-12 in Las Vegas, on Using ESOPs for Business and Succession Planning.