Transitioning the ownership of an S-Corporation (S-Corp) to an Employee Stock Ownership Plan (ESOP) trust offers a strategic opportunity for business owners to transfer ownership to their employees while benefiting from significant tax advantages. ESOPs, structured as qualified retirement plans under the Employee Retirement Income Security Act (ERISA), allow employees to hold shares in their company. In the case of S-Corps, this type of structure can enable the company to operate tax-free.
Understanding S-Corp ESOPs
Whereas the typical S-Corp produces taxable income passed through to shareholders who bear the responsibility of paying taxes on their respective share of the company’s profits, the ESOP as a shareholder pays no taxes on the income—at least not until employees receive distributions from the ESOP. This means the company retains its earnings without the tax liabilities that individual shareholders would otherwise face, giving the business more resources to reinvest in growth, pay down debt, or fund future initiatives. For instance, in a company generating $1 million in profits, individual shareholders might face combined federal and state tax liabilities of around 40%, leaving the company with only $600,000 in net income after distributions to cover tax. In contrast, when an ESOP holds 100% of the shares, the full $1 million remains within the business, significantly enhancing cash flow.
Selling to an ESOP
The process of selling an S-Corp to an ESOP typically begins in earnest with a feasibility study to evaluate whether the company is financially suited for employee ownership. This study includes an estimate of the value of the company’s stock and a review of the company’s financial position to determine if an ESOP transaction and continuing structure is viable. If so, an attorney specialized in ESOPs should be retained and the provisions of the plan will begin to take shape. A true valuation by an independent third party follows to determine the actual value the selling price will be based on.
Most ESOP transactions are leveraged, meaning that the company borrows money to buy shares from the exiting owner. The loan is repaid using the company’s tax-free earnings, a key benefit of the ESOP structure. The selling shareholder often receives either cash (usually from third-party financing obtained by the Company), or a promissory note directly with the company, in exchange for their shares. The shares are transferred to the ESOP trust for the benefit of the employees. An important consideration during this stage is whether the company can support the debt, although concerns may be mitigated if the seller holds the debt and there are provisions to control when payments on the debt can be made based on company performance and metrics.
When an owner sells their interest in an S-Corp, they will typically be taxed as they would be by selling to any other buyer—as they receive cash, they pay taxes on the proportionate amount of gain embedded in the amount they receive.
There are other agreements which can be put into place that may benefit selling owners and other top management, as they cannot typically receive more than their proportionate allocation of shares within the ESOP. These agreements are generally tied to the Company’s growth in stock value after becoming an ESOP and can be lucrative depending on the performance of the Company. “Synthetic equity” agreements must be carefully constructed to ensure they will not run afoul of IRS rules; however, they frequently serve in keeping management incentivized to stay with the company and improve the company’s financial strength over the long term.
Fiduciary Responsibilities and Compliance
ESOPs are managed by a trustee, who has fiduciary duties under ERISA to act in the best interests of employee participants. This includes the responsibility to oversee the annual valuation of the company’s shares and ensure the proper operation of the ESOP. A crucial aspect of compliance is avoiding a “nonallocation year,” a situation in which too much ownership is concentrated in the hands of disqualified individuals—those who hold 10% or more of the stock, or 20% if family members are considered.
Section 409(p) of the Internal Revenue Code governs these rules and imposes taxes and penalties when ownership becomes too concentrated. Companies must, therefore, ensure that stock and other “effective ownership” (such as the synthetic equity noted above) is broadly distributed among eligible employees to maintain compliance. If a nonallocation year occurs, the company and the involved individuals would face significant tax penalties, including disqualification of the ESOP and additional excise taxes.
Challenges and Considerations
While the advantages of selling an S-Corp to an ESOP are clear, there are also challenges that must be carefully considered. One limitation is that employees typically cannot access the value of their shares until they leave the company or reach retirement age. This can make ESOPs less attractive to younger employees who may not see the immediate benefits of ownership. Additionally, managing an ESOP requires careful annual and ongoing planning and compliance with a host of legal and tax requirements.
Another challenge is ensuring that the company has strong enough cash flow to support the loan typically used in leveraged ESOP transactions. While the tax benefits of an ESOP provide significant financial advantages, the company must still generate sufficient income to meet its debt obligations. Further down the road, it will need sufficient cash to pay for the ongoing distributions of shares.
Looking Ahead
Selling an S-Corp to an ESOP trust offers a compelling pathway for business owners seeking to transfer ownership while maintaining the company’s independence and preserving legacy. The tax benefits associated with an ESOP structure can dramatically increase cash flow, while the ownership transition fosters a culture of employee engagement and loyalty. For companies with the right financial profile, an ESOP can be a powerful tool for succession planning and employee ownership. Keep in mind that this process requires careful legal and financial planning to ensure compliance and sustainability. Consult your advisory team to determine the best course of action for your business.
Ben Lord is a Principal at ARB specializing in audit and consulting services for employee benefit plans. Ben manages employee benefit plan audits in an efficient, cost-effective way by customizing services to meet a plan’s specific needs. He also specializes in consulting and financial accounting services for construction, real estate development, manufacturing, and professional services firms.
