Tax Treatment of ESOP

Employers wishing to motivate the best and the brightest will often provide benefits in the form of stock options and ownership plans. Employees want to be able to invest in their company and employers want to attract the best workers.

Contributions are Deductible

• As of 2010, employers are allowed to deduct up to 25 percent of their total payroll of any contributions they make to the ESOPs. If the ESOP is a leveraged ESOP, the employer can deduct the contributions and the interest on the loan. With a leveraged ESOP, a company borrows money from a lender to fund the ESOP trust account. This trust account is used to pay in stock or cash whenever an employee retires from or leaves the company.

Dividends Paid on ESOP are Deductible

• There are three ways that a company can deduct dividends paid on ESOP-held stock. First, dividends paid in cash to the employees participating in the ESOP program can be deducted. Second, any dividends can be applied to the ESOP loan in a leveraged ESOP as long as the dividends are received by those whose shares were purchased with the loan. Third, if the employee chooses to reinvest company dividends, this is also deductible.

Section 1042 Rollover

• When an owner or key manager has to sell her share of the business due to death in the family or retirement, the ESOP provides an option of allowing the shareholders to buy out the owners with pre-tax dollars from the ESOP funds. The seller can then defer the capital gains taxes on the proceeds of the sale. This ruling is part of the Section 1042 of the Internal Revenue Code.