For S-corps and C-corps, ESOPs offer different, but significant, tax benefits to both the selling shareholder and the surviving company.
This article is a sequel to an earlier piece, “Understanding ESOPs (Part 1),” where we discussed the more intangible side of ESOPs, including culture, recruitment, and legacy. This follow up article will deliver clarity surrounding the more tangible side of ESOPs, specifically, the significant tax benefits available to both the selling shareholder and the surviving company.
When it comes to transitioning a business, a selling shareholder has finite options, including a strategic buyer, private equity, its management team, or an ESOP. These options all have different tax implications to all of the parties involved. It is important to note that ESOP ownership offers significant tax advantages to both the selling shareholders as well as the surviving company. In order to more accurately assess the economics behind all potential offerings, these tax advantages should be well understood before a shareholder commits to a preferred sale path.
ESOPs can only take the form of a C-corporation or an S-corporation. Because in its simplest form an ESOP is a qualified benefit plan, the contributions it makes to the trust (established to oversee the transaction on behalf of the employees) are tax deductible, thereby reducing taxable income. C-corps also have the ability to make a tax deductible dividend (typically allowable up to certain market driven parameters), which results in a further reduction of taxable income. Oftentimes, the combination of these two tax deductible line items can effectively eliminate an otherwise taxable situation.
Please note, this strategy does accelerate share allocation, and consequently must be analyzed and understood in order to assess the overall effectiveness and sustainability of the ESOP. A further benefit in a C-corp scenario is offered to the selling shareholders. In the case where at least 30 percent of the company is sold to the ESOP, the selling shareholders have the ability to elect a tax deferral of the capital gains of the transaction (Section 1042 of the Internal Revenue Code). This strategy can be an extremely effective mechanism, including the potential to permanently defer capital gain taxes. Please note, selling shareholders who elect 1042 tax deferral are not eligible to participate in the ESOP.
In the case of an S-corp ESOP (assuming 100 percent sale) the surviving S-corp ESOP is a federal tax exempt entity, and therefore is not subject to federal taxation. S-corp ESOPs are also exempt from most state taxes (please verify according to your individual state). It is important to note that in most cases an S-corp has the ability to convert to a C-corp (pre-transaction) in order for the selling shareholders to utilize Section 1042 deferral. However, there are certain restrictions governing the time periods for converting back to S-corp status which should be understood prior to making the election. Importantly, if a selling shareholder sells his or her stock as an S-corp, that selling shareholder is not eligible for 1042 tax deferral.
It is important to surround your AEC firms with banking partners who are dedicated to your industry, and understand the day-to-day challenges business owners face. Wintrust is among a select few commercial banks that, on a national basis, brings a dedicated team of professionals to provide financing to both the ESOP and AEC space. Consequently, we remain enthused about bringing ideas and much needed education to a business transition alternative that deserves continued focus and educational attention. We look forward to continuing to share our expertise and experiences with the group.
Wintrust Financial Corporation is a more than $30 billion financial services company headquartered in the Chicago area. With its national niche lending groups, including Wintrust ESOP Finance and Wintrust Construction, Engineering & Architecture, our experts have the knowledge and expertise to provide a business owner in the AEC space with a relationship-focused partner and key trusted advisor. Pat Stoltz and Jim Swabowski can be reached at pstoltz@wintrust.com and jswabowski@wintrust.com.