Employee stock ownership plans (ESOPs) provide a number of tax benefits to corporations that implement them including tax-deductible employee benefit expenses as well as the potential for tax-deductible dividends. In addition, S corporation income flowing to ESOPs escapes all current taxation (ignoring any built-in gains or other entity-level S corporation taxes), because an ESOP is tax-exempt.
Often, selling shareholders and businesses are so caught up in the details of an ESOP transaction that it can be difficult to add other planning into the equation. However, a corporation’s tax position before and after ESOP implementation should always be analyzed and understood by the corporation prior to any transaction, because integrating accounting method planning prior to a transaction can increase the benefits even more.
The maximum tax benefits are usually present in entities planning to become 100 percent ESOP-owned S corporations. Prior to this status being in place, the business has a unique opportunity to receive permanent tax savings from deferring taxable income or accelerating expense recognition through fact or accounting method changes because the entity will be entirely tax-exempt in the future when the items reverse. A business has several areas with which to consider whether additional tax benefits can be harvested prior to an ESOP transaction.
Accelerating deductions and deferring income
Many businesses are already on accounting methods that allow them to report deductions as soon as possible and income as late as possible within the rules. Prior to an ESOP transaction, though, these methods only result in timing differences that may not have led to large enough savings for companies to change a method of accounting that had been established in the past. The permanent savings from an ESOP transaction may be enough to make the associated cost of the accounting method changes less than the resulting benefits so it is a good time to revisit them. It should also be noted that these timing differences may also be realized by changing the facts that apply to a current accounting method. For example, if the company is expecting a large capital expenditure in the near future, making it before the transaction rather than after may be beneficial. Other examples of items to consider shifting the tax timing include prepaid expenses, deferred revenue, and other accruals.
Correcting impermissible methods
Certain accounting method changes provide audit protection which can help ensure no tax liabilities from prior years arise after ESOP ownership, as well as segregating any associated section 481(a) adjustment in the period applicable to owners that either benefited from or paid for, the impermissible methods. In addition, the corporation remains available to be purchased even after an ESOP exists so keeping the business on permissible accounting methods is beneficial from a potential future due to diligence perspective.
Regardless of whether a company may benefit from accounting method changes prior to selling shares to an ESOP, many businesses may want to consider changing accounting methods after implementing an ESOP to match as closely as possible to book treatment on certain items. This can help minimize tax compliance complexity and costs with no negative effect since taxable income is irrelevant if it is a 100 percent ESOP-owned S corporation. Not only does it not have a current effect, but it also preserves some future benefit in the event the ESOP sells the shares in the future and the entity becomes taxable again because the maximum amount of deductions remains available. Examples of methods to consider in this category include depreciation, inventory, and prepaid expenses. It should be noted that there is a period of time in which methods that might have been changed prior to the ESOP transaction cannot be changed back to the previous method.
ESOP transaction details
The prior categories relate to considerations of the tax aspects of general business operations. In addition to understanding how the tax impact of those normal, recurring operations will be affected by an ESOP transaction, having the ESOP in place will bring new tax consequences for the company. Aside from tax-deductible contributions to the plan and the potential for tax-deductible dividends paid by C corporations, one important item to not overlook is annual bonuses. If the entity is an S corporation, employees will become related parties under the tax rules as soon as stock is allocated to their ESOP accounts. This means that the corporation cannot deduct bonuses or other accrued payments to the employees who participate in the ESOP until the year in which the employee reports the income. Many businesses operating on the accrual method can be caught off-guard by the implication of this rule in the first year the ESOP is implemented.
Example: An accrual-basis, calendar-year S corporation that typically pays its 2016 annual bonus by March 15, 2017, and meets the all-events test by year-end will deduct that 2016 bonus on the 2016 tax return, the year before it is paid in cash to employees. Once an S corporation employee has stock allocated in his or her ESOP account, he or she is a related party to the employer and the employer is not allowed to deduct the bonus until 2017 when the employee reports it in income. Therefore, if the employer implements an ESOP in 2016 and employees are allocated shares in 2016, the employer receives no deduction for employee bonuses on its 2016 tax return. This is because the 2015 bonuses that were paid in early 2016 were already deducted on the 2015 tax return, and the 2016 bonuses are not deductible until the 2017 tax return in the year of payment. For companies with many employees, not reporting an annual bonus deduction for the 2016 tax year can have a large effect on taxable income.
One solution to plan for this impact in a leveraged ESOP scenario is for the ESOP to not make its first debt payment until the year after the transaction. In this case, employees do not have shares in their accounts in the first year because the company holds all of the shares as collateral. It is only after the ESOP makes a debt payment that releases some shares into employee accounts that the employee should become a related party. If this event is postponed until the following tax year, items accrued to employees at the end of the previous tax year are likely still deductible in the earlier year. So in the event of a 100 percent ESOP-owned S corporation, this preserves the deduction in the year before the entity becomes tax-exempt (assuming the ESOP is implemented late in the employer’s tax year such that the majority of income during the year of the transaction is allocated to taxable shareholders).
Of course, another option is to consider actually paying the bonuses for the year of the transaction in the year of the transaction, but this also requires special consideration since it is likely a change to the company’s annual process that may be tied to financial results and performance evaluations that are not always easy to accelerate. In addition, there can be another tax benefit from having the ESOP’s loan payment due in the following year rather than the year of the transaction, if the transaction occurs at or near the end of the employer’s tax year. Contributions made to the plan by the extended due date of the employer’s tax return may be deducted from the prior year’s tax return if certain requirements are met. Thus, setting the amortization schedule for payments to be due during this period allows the employer an annual choice of whether to deduct a given contribution on the prior year’s or current year’s tax return. While a 100 percent ESOP-owned S corporation does not necessarily benefit from that timing choice, the flexibility will be an advantage any time there are still taxpaying shareholders.
The specific facts and circumstances of each entity will dictate what specific tax planning should be completed and how large the potential benefit might be. Nonetheless, in all cases, the corporation may be leaving money on the table if accounting method planning is not integrated prior to an ESOP transaction.