Employee Stock Ownership Plans (ESOP) for S Corporations


By Jason Lumpkin

Prior to 1997, S corporations could not sponsor an Employee Stock Ownership Plan (“ESOP”) because a tax-exempt trust could not be an S corporation shareholder.

Subsequent rules and regulations have eliminated this restriction, allowing S corporations (and/or C corporations considering an S-election) to take advantage of powerful tax savings associated with maintaining an ESOP.

The S corporation is a form of business ownership in which the company does not pay federal income tax on its earnings. Rather, the owners of the S corporation pay taxes on their proportionate share of earnings at their own individual income tax rates. This type of structure allows the owners of the S corporation to avoid the double taxation applicable to C corporations, where the company pays taxes on its earnings and the owners pay taxes on any income that may be distributed to them.

Current laws provide that any earnings attributable to an ESOP’s ownership of stock in an S corporation are not subject to federal income tax and most state income taxes. For example, where an ESOP owns 40% of the stock of an S corporation, only 60% of the S corporation’s income would pass through to non-ESOP owners to be taxed. If the ESOP owned 100% of the stock, none of S corporation’s earnings would be subject to federal income tax.

While there is a potentially significant income tax incentive associated with ESOP ownership of an S corporation, there are also strict limitations with respect to the accumulation of ownership within the ESOP. Abusive or poorly designed ESOPs that primarily benefit a select few individuals within an organization could result in harsh penalties. However, a properly designed ESOP sponsored by an S corporation can provide a valuable retirement plan program for employees and employers while creating additional corporate cash flow as a result of the favorable tax attributes of ESOP ownership.

For further information, please contact Jason Lumpkin.

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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.


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