According to the National Center for Employee Ownership (NCEO), more than 6,500 companies in the U.S. have an employee stock ownership plan (ESOP).1 ESOP-owned companies and their accountants should make sure they understand the unique tax reporting issues presented by this type of ownership structure.
There are a few common ESOP-specific income tax implications that should be considered to help make sure these items are accounted for appropriately:
- Internal Loan Debt Service Payments for Leveraged ESOPs
- U.S GAAP ESOP Compensation Expense
- Accrued Employee Compensation
Internal Loan Debt Service Payments for Leveraged ESOPs
In a leveraged ESOP transaction, the plan sponsor borrows funds from a third-party lender and/or from the selling shareholder(s) of the company to purchase shares of stock from the selling shareholder(s). The plan sponsor will then loan the funds to the ESOP trust to enable the ESOP to purchase the shares of stock from the selling shareholder(s). This loan between the plan sponsor and the ESOP trust is referred to as an internal loan. The shares acquired by the ESOP trust are held as collateral for the internal loan.
The plan sponsor will make a cash contribution to the ESOP trust each year to allow the ESOP trust to cover the debt service payment (principal and interest) required on the internal loan. Upon repayment of the internal loan by the ESOP trust back to the plan sponsor, shares of stock are released from collateral and allocated to the ESOP plan participants.
Unique to ESOPs is the treatment of the internal debt service payments for tax purposes. For income tax reporting purposes, the total contribution used to fund the internal loan repayment (including principal and interest) may be deductible, subject to contribution limits. However, any interest calculated on the internal note repayment is considered taxable interest income to the plan sponsor. This interest income is not recognized for financial reporting purposes, as the internal loan is not considered an asset for U.S. GAAP, and is instead reported as a contra-equity account. As a result, the net impact to taxable income for the plan sponsor for the ESOP contribution is a reduction in overall taxable income equal to the principal portion of the internal note payment.
The amount of the ESOP contribution considered deductible for income tax purposes is also subject to a limitation of 25% of “eligible compensation” under Internal Revenue Code (IRC) Section 404. It’s important to remember that contributions to other qualified retirement plans, such as 401(k) plans, must be aggregated when considering the 25% limitation. This can limit the amount of tax-deductible ESOP contributions for the plan sponsor.
In addition, there is a special rule that applies only to C corporations. C corporations may deduct contributions to the ESOP that are used to pay interest on the internal loan, without consideration of the §404 limitation. In this situation, contributions to the ESOP that are used to pay principal on an internal loan are still subject to the §404 limit. Lastly, Section 404(a)(3) allows C corporations to also make deductible employer non-elective contributions up to an additional 25% of eligible compensation paid to ESOP participants.
U.S GAAP ESOP Compensation Expense
Also, unique to ESOPs is the treatment of ESOP compensation expense for U.S. GAAP. For U.S. GAAP purposes, each year the company records a non-cash ESOP compensation expense in an amount equal to the fair value of shares released as a result of payments on the internal ESOP loan.
For U.S. GAAP purposes, the total U.S. GAAP ESOP compensation is a reduction of U.S. GAAP net income. However, for income tax reporting, the U.S. GAAP ESOP compensation expense is disallowed as a tax deduction because it is an estimate of compensation expense attributable to shares released into the plan and does not reflect an actual cash outlay for an ESOP contribution to the plan.
Accrued Compensation
One item commonly overlooked by ESOP-owned S corporations is the deductibility of accrued compensation such as accrued payroll, accrued vacation, and accrued bonuses to employee owners. For S corporations that are ESOP owned, consideration should be given to the deductibility of these accrued compensation accounts.
IRC Section 267(a)(2) notes a taxpayer, including an S corporation, may only deduct an expense in the same year that the payment is includible in the related party’s gross income. Further, IRC Section 267(e)(1)(B)(ii) states a related party includes any person who directly or indirectly owns any of the S-corporation’s stock.
The stock owned by the ESOP trust is deemed to be constructively owned by the beneficiaries of the ESOP trust, and therefore, any accrued compensation will not be deductible until paid.
Income tax reporting for leveraged ESOPs can be complex. Every ESOP structure is different, so it’s important to have a knowledgeable advisor on your ESOP team. For more information on common ESOP income tax reporting issues, please reach out to a professional at Forvis Mazars.
- 1“Employee Ownership by the Numbers,” nceo.org.