Employee stock ownership programs (ESOPs) long have been an appealing way for financial institutions to supplement other retirement programs, and the industry recently has seen an uptick in ESOP activity. But some confusion remains over the specific tax benefits (also known as tax attributes) available to banks that establish the programs and how the benefits vary based on a bank’s corporate structure.
General Tax Implications of Different Corporate Structures
S corporations and C corporations both can take a deduction for either 1) contributing cash to the ESOP that’s used to buy company stock or 2) contributing newly issued or treasury stock to the ESOP. Employer contributions generally are limited to a standard deduction of 25 percent of covered payroll. But some important differences must be noted between the other potential tax attributes for each respective structure.
For example, because an S corporation is a pass-through entity, the income attributable to company shares held by the ESOP generally is not subject to federal and most state income taxes. As a shareholder, the ESOP receives its share of income distributions (dividends) paid to shareholders; unlike other shareholders, it does not need to pay income tax on its pass-through income. Because of the income distributions, the ESOP participants’ wealth accumulation is often significantly greater than it would be if the institution were a C corporation.
For C corporations, matters are more complicated. For example, if certain conditions are satisfied, the bank might gain a tax deduction in excess of the standard deduction limit by paying dividends on ESOP-held stock. To be eligible for deduction, dividends on the ESOP-held stock must be used in one of following ways:
- Paid in cash to ESOP participants, either directly or as payments to the ESOP that are distributed to participants within 90 days after the close of the plan year
- Applied to a leveraged ESOP's loan payments (but generally only dividends on the shares bought with the loan can be used to make such payments)
- At the election of the participant, voluntarily reinvested in company stock in the ESOP or distributed using one of the above methods
For both C and S corporations, the standard deduction limit applies to the combined employer contributions to the ESOP and other qualified retirement plans maintained by the employer, such as a 401(k) plan.
Treatment of Leveraged ESOPs
An ESOP can borrow money (typically from the bank or holding company) to purchase the company’s stock, thereby becoming a “leveraged ESOP.” For a C corporation, the standard 25 percent deduction limit applies to contributions not used to pay debt. A C corporation can contribute and deduct up to another 25 percent of covered payroll to make principal payments on the loan and an unlimited amount to make interest payments. In an S corporation, only the standard 25 percent deduction applies, and it includes any employer contribution used for any purpose – including interest payments.
Profit-sharing Plans as an Alternative to a Nonleveraged ESOP
Some banks that don’t want leveraged transactions might opt to use a profit sharing 401(k) plan. An S corporation can’t take this route because putting company stock in a profit sharing 401(k) plan would subject the company earnings attributed to the stock to unrelated business income tax, but the option often makes sense for C corporations.
Several features could make a profit sharing 401(k) plan appealing to a C-corp bank. Specifically, these plans aren’t required to meet rules that apply to ESOPs, including those that require them to:
- Pass through voting rights on the shares to the plan participants, in certain situations
- Give employees the right to receive stock distributions
- Perform per-share accounting, which translates to lower costs related to establishing and administering a plan
- Offer diversification rights required with ESOPs that allow participants to diversify a portion of their holdings after 10 years’ participation and age 55
- Invest primarily in employer securities
Choosing a profit-sharing plan over an ESOP isn’t without disadvantages, of course. For example, dividends paid on company stock held in a profit-sharing plan can’t be deducted. Profit sharing plans also can’t use debt to purchase stock. If a bank at a later time wanted to use debt to buy stock, though, it could establish a separate ESOP and transfer the stock in the profit sharing plan to the new ESOP.
Need for Valuation
Valuations are critical if a bank with an ESOP isn’t publicly traded, which means readily tradable on an established securities market. The institution must obtain an independent valuation of its shares at the end of each year. If the bank contributes stock to its ESOP, it also will need an independent fair market value appraisal of its shares (as of the date of the contribution) to determine the appropriate tax deduction. If the bank contributes cash to purchase stock, an independent valuation as of the date of stock purchase is required. Many banks that want to avoid having to do multiple valuations during a year will make stock contributions on or about the last day of the plan year. The year-end stock valuation then will determine the value for deduction purposes and ESOP reporting purposes.
Banks that are considered actively traded on a public exchange must comply with some additional rules that should be considered before forming an ESOP but aren’t covered in this article.
For many banks, an ESOP offers a tax-effective, equity-based approach for increasing employees’ retirement benefits. An ESOP not only can increase employee satisfaction but also can provide the bank with intangible advantages like having a friendly and motivated shareholder and creating a market for its stock. Finally, a bank can employ an ESOP as a long-term strategy to enable the ESOP to become the majority shareholder.