Many bankers are not as familiar with employee stock ownership plans, or ESOPs, as they are with other types of qualified retirement plans. An ESOP is a qualified retirement plan for the benefit of employees that invests primarily in employer stock, thus making all employees of the bank “owners.” Like other qualified plans, ESOPs are generally exempt from income tax. ESOPs also provide other special benefits due to Congress’s desire to encourage employee ownership, loyalty and productivity.
Most importantly to S corporations, tax provisions unique to ESOPs cause S corporation income allocated to an ESOP to escape current taxation. The income tax is essentially deferred until the ESOP pays distributions out to employees.
Assume an ESOP owns 20 percent of an S corporation and the S corporation has current year taxable income of $1 million. While the $800,000 allocated to non-ESOP shareholders will be subject to income tax, the ESOP’s share of $200,000 is exempt from current tax.
Ideally, S corporations pay tax distributions to shareholders in an amount sufficient to pay the federal and state income taxes on their respective shares of the S corporation’s income. If the S corporation in this example distributes 40 percent of its earnings to help cover the shareholders’ taxes, the ESOP receives cash of $80,000 that is available to buy additional stock of the S corporation on behalf of the plan participants. This provides an important potential source of liquidity for the S corporation’s stock.
Disqualified Person Rule
The favored tax status of ESOPs carries complicated rules under IRC Section 409(p), designed to prevent abuses by overly aggressive taxpayers. Under these rules that are specific to S corporation ESOPs, any employee who is a “disqualified person” can’t accrue any benefits under the ESOP in a year in which they own 50 percent or more of the S corporation’s total outstanding shares, taking into account shares directly owned, “deemed-owned” shares and shares allocated through tax attribution rules. A “disqualified person” is generally a person who owns 10 percent or more deemed-owned shares of the S corporation, or collectively with other family members owns 20 percent or more deemed-owned shares (deemed-owned shares take into account only the stock treated as owned through the ESOP and other shares the employee can acquire in the future under certain stock arrangements). This limitation can prevent some shareholder-employees from becoming ESOP participants.
Weighing Benefits and Complications
Having an ESOP as a shareholder of a community bank involves many complex fiduciary and income tax issues, for both S corporations and C corporations. Annual stock appraisals are generally required, and plan administration could be more costly than other types of qualified plans. Banks and bank holding companies must navigate regulatory issues, as well. Still, profitable banks that wish to provide ownership benefits to employees and create a liquid market for its shareholders should consider whether the advantages of ESOP ownership outweigh the complications.