Introduction

Employee Stock Ownership Plans (ESOPs) are innovative and flexible financial instruments that allow employees to have a stake in the ownership of their company. While ESOPs are often associated with employee ownership and wealth accumulation, its use goes beyond these traditional structures. In the realm of charitable giving, ESOPs offer a creative avenue for companies and their employees to make a significant impact. By donating shares to a charitable organization, donors can contribute to philanthropic causes.

This article will explore the concept of an ESOP, discuss strategies and opportunities to support nonprofit organizations using ESOPs and shed light on common compliance concerns flagged by the Internal Revenue Service (IRS) along with anti-abuse measures.

Employee Stock Ownership Plans (ESOPs)

An ESOP is a type of tax-qualified employee benefit plan under IRC Section 401(a) that provides an employee with an ownership interest in a company in which he or she is currently employed. ESOPs are created to give employees a stake in the company’s success and are commonly used as a retirement benefit. ESOPs are used to create a market for the shares of departing owners of closely held companies and to incentivize and reward employees. As a qualified retirement plan, ESOPs allow income to accumulate tax deferred. ESOP employees pay taxes when they receive distributions.

In an ESOP arrangement, a corporation establishes a trust and contributes new shares of its stock or cash to acquire existing shares from current owners. ESOPs are unique in that employees are not required to contribute to benefit from the plan. If the company does not have the cash to do this at the outset, the ESOP can opt to borrow funds to purchase new or existing shares. If the ESOP borrows money, the company contributes to the plan to repay the loan. Employees are not taxed on the amounts contributed by the company to the ESOP or the income earned in the ESOP account until the employees receive distributions from the ESOP. Employees receive shares in the trust and when an employee either retires or leaves the company, they receive their stock, which the company must buy back from them at fair market value (unless there is a public market for the shares). The employees receive the value of their shares from the trust, generally in the form of cash.

Non-Leveraged versus Leveraged ESOPs

One of the most notable differences between an ESOP and a qualified contribution plan is the ESOP’s ability to use funds from a loan to purchase employer securities. While the IRS defines only one type of ESOP, there are two main structures when discussing ESOPs, non-leveraged and leveraged. Under a non-leveraged ESOP, the trust is funded by contributions of cash or stock directly from the employer. Once the cash or shares are contributed to the ESOP, it is allocated to participating employees’ accounts based on several factors including their salary, tenure, or a combination. The company then receives a tax deduction for the fair market value of the shares or cash contributed to the plan, up to certain limits. However, dividends paid on ESOP-owned shares are generally not tax-deductible to the company. Employees may incur tax liability upon distribution of their ESOP benefits, but distributions may qualify for favorable tax treatment if certain conditions are met.

A leveraged ESOP uses the proceeds of a loan to purchase employer stock. Under the leveraged ESOP setup, the ESOP trust borrows money from a lender to purchase new shares of stock or existing shares from current owners. The shares are transferred to the ESOP but are held in a suspense account and are generally held by a trustee or custodian appointed by the company. As the loan used to finance the ESOP purchase is repaid, the shares are gradually released to the individual accounts of participating employees.

ESOP shares require valuation at least once a year by an independent appraiser (unless they are publicly traded). For closely held companies, departing employees' shares must be repurchased at their fair market value, determined by an independent appraiser. Contributions made by the company to repay the borrowed funds used to finance the ESOP in a leveraged ESOP structure are tax-deductible, subject to certain limitations. Additionally, dividends paid on ESOP-owned shares used to repay the ESOP loan may be tax-deductible to the company. However, employees may incur a tax liability upon distribution from an ESOP.

Section 1042 Rollover

Section 1042 of the Internal Revenue Code provides a tax-deferred rollover option for owners of C corporation stock who sell shares to an ESOP. Under this provision, stockholders can postpone capital gains taxes if they meet specific conditions and reinvest the sale proceeds into qualified replacement property (QRP). To be eligible, the company must be structured as a C corporation, the stock must be held for a minimum of three years, and the ESOP must maintain ownership of at least 30% of the stock after the sale. QRP typically consists of stocks and bonds issued by domestic operating corporations. Sec. 1042(c)(4). However, specific types of QRP are excluded from eligibility for a Section 1042 rollover. This includes municipal bonds, U.S. government bonds, mutual funds, foreign securities, REITs and bank-issued CDs. Additionally, the reinvestment into QRP must occur within a specific period after the sale of the ESOP shares, generally within 12 months. While the capital gains tax on the sale of ESOP shares is deferred, it is important to note that the tax is not eliminated. When the QRP is eventually sold, the deferred capital gains tax becomes due.

QRP to CRT

Most business owners have little or no basis in the stock of their businesses. Since the QRP takes the basis of the owner's stock, it frequently has virtually no basis. Therefore, this public stock is an excellent candidate for a charitable remainder unitrust. The holder of QRP may transfer the public securities to a charitable remainder unitrust, bypass gain and receive a charitable deduction.

Example

Allan and Jane are married and are the owners of a successful family business structured as a C corporation. They have decided to cash out a significant portion of their equity in the company to diversify their investments and plan for their future retirement. Given their desire to share ownership with their employees and potentially benefit from tax advantages, they opt to establish a non-leveraged ESOP.

With approximately 40 employees, Allan and Jane set up the ESOP and sold 50% of their shares in the company to the ESOP trust. This allows them to provide ownership opportunities for their employees but also provides liquidity for their finances.

After the sale to the ESOP, Allan and Jane receive cash proceeds from the transaction. They decide to reinvest these funds into qualified replacement property (QRP), consisting of a mix of stocks and bonds from publicly traded operating corporations. This strategy aims to further diversify their investment portfolio and potentially generate additional income for their retirement years.

However, Allan and Jane also want to leverage their assets for charitable purposes while maximizing tax benefits. They decide to transfer $800,000 worth of their QRP stock into a charitable remainder unitrust (CRUT) for their lifetimes. The CRUT is structured to provide them with a 5% unitrust payout annually, ensuring a steady income stream while allowing for potential growth of the trust assets.

By transferring the stock into the CRUT, Allan and Jane can bypass capital gains taxes on the sale of the stock. Additionally, they are eligible for an income tax deduction based on the present value of the remainder interest passing to charity after their lifetimes. This fulfills their charitable goals and provides them with valuable tax advantages and financial flexibility in their retirement planning.

S Corporations and ESOPs

Initially, S corporations were barred from holding ESOPs due to restrictions preventing tax-exempt trusts, such as ESOP trusts, from being shareholders. However, through subsequent legislation, Congress allowed ESOPs and other employee benefit trusts to hold stock in S corporations. Profits derived from the ESOP's ownership of S corporation stock are exempt from federal income tax and many states mirror this provision in their tax regulations. Through this legislation, Congress aimed to allow S corporations, similar to C corporations, to promote employee ownership through ESOPs. However, S corporation ESOPs have certain criteria that must be met and do not qualify for all the same benefits as C corporation ESOPs. Over time, the Treasury Department and the IRS have attempted to address S corporations' efforts to circumvent or violate specific rules and regulations pertaining to S corporations and ESOPs. They have sought to uncover schemes in which S corporations utilize this framework to unfairly benefit certain employees and to detect schemes where S corporations evade paying taxes on income.

Management Company S Corp ESOPs

One scheme identified by the IRS involves a plan where an S corporation owned entirely by an ESOP is used to help a different business avoid paying income taxes. In this scheme, the owner of a business creates an S corporation and the business and the S corporation agree that the business will pay the S corporation in exchange for management and other services, generally in the form of administrative services. The S corporation will then set up an ESOP and the ESOP becomes the owner of the S corporation. The owner of the business also becomes an officer of the S corporation and manages the ESOP. The S corporation will then lend money to the business or its owners. Individuals involved in these plans argue that the business is allowed to deduct the payments made to the S corporation for services and the S corporation’s income is passed to the ESOP, which does not pay taxes on it. Individuals who structure these types of plans argue that because the ESOP is not subject to income tax on the income it receives from the S corporation, the fees paid to the S corporation for services should not be taxed. However, the IRS disagrees with this interpretation and has found the agreement for services with the S corporation does not truly benefit the business. Thus, the payments are not deductible. Additionally, the IRS has found that the loans from the S corporation to the business or its owners are not authentic and should be considered taxable income to the recipient of the payments. Under this plan, the ESOP fails various requirements to be a qualified plan under IRC Section 401(a).

ESOP Coverage Requirements

Another ESOP requirement involves adhering to nondiscrimination rules in IRC Section 401(a)(4), as well as coverage rules of IRC Section 410(b). The nondiscrimination rules state that contributions or benefits from a plan should not favor employees with higher pay. An employee can be considered highly compensated by either owning at least 5% of the employer’s business or by having a salary above a certain threshold. According to Sec. 410(b), an ESOP must benefit either a certain percentage of the employer's lower-paid employees or a group of employees that does not favor those with higher pay. For instance, if an ESOP gives benefits only to highly compensated employees but not to lower-paid ones, it does not meet these rules and will not be considered a qualified ESOP. The IRS has examined ESOP arrangements where the ESOP provides benefits to an employer’s highly compensated employees without providing the same benefits to non-highly compensated employees. As a result, the ESOP fails the coverage rules under Sec. 410(b), becomes disqualified as an ESOP and loses any tax benefits associated with being an ESOP.

IRC Section 409(p) Violation

Internal Revenue Code Section 409(p) states that during defined periods, an ESOP linked to an S Corporation cannot provide excess benefits to “disqualified persons” including executives, high earners or original owners. The goal of this rule is to ensure that ESOPs set up by S Corporations benefit a wide range of employees, not just the top earners.

Generally, these rules apply to new ESOPs set up after March 14, 2001. Existing ESOPs became subject to the rules by December 31, 2004. Promoters have attempted to circumvent these rules by marketing ESOP arrangements that owned S Corporation stock in hopes of delaying the rules of Sec. 409(p). However, ESOPs of an S corporation are also subject to the rules of Sec. 409(p). If disqualified persons have excess benefits from the ESOP, it is treated as if they received stocks and income, instead of deferred benefits. They may also have to pay additional taxes under IRC Sec. 4979A for prohibited allocations.

The IRS is actively working to uncover abusive methods and implement measures to stop them. It is crucial to understand which setups qualify as legitimate ESOP structures to avoid unintended tax issues or ESOP disqualification.

Conclusion

ESOPs are highly complex structures that offer many tax advantages and significant benefits for companies and employees when established correctly. ESOPs must adhere closely to regulations set forth by both the IRS and the Employment Retirement Income Security Act. It is crucial for professional advisors to guide their clients through the complexities of ESOPs and any charitable planned gifts involving them, ensuring full compliance with tax laws and regulations. Additionally, advisors should point out common red flags or potential abuses of ESOPs, especially in the context of S corporations. Donors who benefit through an ESOP can take advantage of these structures to serve both personal interests and charitable goals effectively. Donors should consult a professional advisor when determining how to convert ESOP ownership into QRP. A thorough understanding of the rules and tax implications is important. With expert guidance, donors can optimize their charitable giving strategies while upholding compliance with tax laws.