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Writer's pictureCraig W. Smalley, E.A.

Understanding Employee Stock Option Plans


An ESOP is a qualified defined contribution plan that is either a stock bonus plan or a combination stock bonus and money purchase plan that invests primarily in your employer's securities. Generally, this is common stock issued by your employer that is traded on an established securities market. However, many privately held ESOP stock values are determined by an outside valuation expert. An ESOP may use employer contributions to buy common stock from the controlling stockholders if the price reflects the value of the stock in the open market.


One of the key aspects of an ESOP is its ability to borrow to acquire employer securities—a so-called exempt loan—and its ability to use plan assets to repay an exempt loan. As a participant, you will be entitled to decide how you want to direct the securities that have been allocated to your account.


Another important feature of these plans is your right, each year, to direct the investment of at least 25 percent of your account balance once you've reached age 55 with at least 10 years of plan participation. This “diversification of investments” election permits older employees to select investments suitable for their anticipated retirement. If the ESOP is part of a larger plan, like a profit sharing plan, that permits employee contributions, you may be able to divest the employer stock and allocate it to other plan investments once you have completed three years of service as a participant.


If your employment terminates, there is an ESOP distribution rule which is meant to accelerate the date when benefits can begin. ESOP benefit payments must begin no later than one year after the end of the plan year when you separate on account of retirement or disability or one year after the end of the plan year that is the fifth plan year following separation from service due to some other cause. Since these rules are meant to speed up the date benefits begin, if benefits would begin sooner under the distribution rules applicable to all qualified plans, that would override the ESOP rules.


For 2019, the limit on contributions to defined contribution plans, including contributions to the ESOP on your behalf, are limited to the lesser of $56,000 or 100 percent of compensation. However, certain forfeitures and payments of interest on loans to the ESOP will not be taken into account in calculating these limits, which may have the effect of increasing the amounts that go into your account.


Once you're entitled to a distribution from the ESOP, you will have the right to take your benefits in the form of your employer's securities, with certain exceptions. The right to receive employer securities will not extend to that portion of your account you elect to have reinvested under the diversification rules I have mentioned above. Taking a lump-sum distribution of your ESOP account in the form of employer stock (and of all amounts held in the plan) may allow you to further defer taxation of the value of that stock to the extent of the “net unrealized appreciation” or “NUA” in the employer stock. That NUA, as adjusted for later changes in the value of the underlying stock, will be taxed to you at long-term capital gain rates on your ultimate sale of the shares.


The most important tax benefit you receive if you transfer stock of your corporation to an ESOP is that the ESOP's share of the corporation's income is not taxed. Since the S corporation is not subject to tax, the portion of the income allocated to the ESOP escapes tax entirely.


The following example illustrates the tax benefits of transferring stock to an ESOP.


Assume that the ESOP owns 30 percent of the S corporation's stock, which has taxable income of $100,000. The S corporation is not subject to tax. Instead, its income is passed through to the shareholders. Thus, while the shareholders other than the ESOP are subject to tax on the $70,000 of the S corporation's income allocated to them, the ESOP's $30,000 allocation remains tax free.


S corporations normally make distributions to shareholders in an amount sufficient to pay the federal and state taxes on the shareholders' portions of the company's income. If we assume that the S corporation distributes 35 percent of its taxable income to its shareholders, the ESOP will receive a dividend of $10,500, which it can use to buy additional shares of the S corporation.


However, “disqualified persons,” generally persons who are 10 percent or greater shareholders of the corporation or members of families that are 20 percent or greater shareholders of the corporation, may not accrue any benefits under the plan in a year in which disqualified persons own 50 percent or more of the shares of the corporation. Disqualified persons are determined by taking various attribution rules into account. This limitation may prevent some of the shareholder employees from becoming ESOP beneficiaries.


Another of the ESOP tax benefits available is that a shareholder who sells stock to one may elect to defer the recognition of gain on the sale by reinvesting the proceeds in certain other securities. However, the deferral is not available where the corporation is an S corporation. In your case, some of the shareholders may not want to elect this deferral, since a shareholder who elects deferral cannot be allocated any of the shares held by the ESOP. However, if any of your shareholder-employees plan to retire and intend to defer the gain on their sales of stock to the ESOP, it is necessary that the sale of stock to the ESOP take place before the S corporation election is made.

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