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Do the tax benefits make an ESOP worth it?

Your company has numerous options when it comes to providing benefits to its employees. You may have asked around to try to figure out what would not only benefit your employees, but also your company. You want to foster an atmosphere in which your employees feel invested in its success, and that's when you came across the employee stock option plan.

An ESOP provides advantages for your employees, but it also allows the company a way to purchase shares owned by an owner who leaves the company. It may allow it a way to borrow money to purchase those shares and repay the loan as tax-deductible contributions to the plan. You may already know the business advantages of setting up an ESOP, but may not yet understand the tax benefits gained through this type of plan.

The tax advantages of an ESOP

In addition to lower tax obligations connected with loans for the company, an ESOP provides the following tax advantages:

  • Employees only pay taxes on the distributions they receive from their accounts (often at a lower rate) and not their contributions.
  • The stock contributions, dividends and cash contributions receive tax-deductible status.
  • Those who reinvest the money earned from the sale of the stock of a C corporation into other securities can defer the taxes.
  • The ESOP's ownership percentage of an S corporation doesn't incur a federal (and possibly Kansas) income tax liability.

As with any other tax benefit, limitations may apply. In order to ensure that neither the company nor the employees exceed those limits, it may be a good idea to consult with a tax attorney.

The potential disadvantages of an ESOP

If your company is an S corporation, it does have lower contribution limits but may not take advantage of the rollover treatment. Moreover, most professional corporations and all partnerships may not use ESOPs. The costs associated with setting up an ESOP can be significant, and a private company must repurchase a departing employee's shares.

Existing owners' stock ends up diluted when your company issues new shares, so careful consideration needs to be given to ensure the benefits outweigh this. Each year your company must obtain an outside valuation of the stock to determine its value. Employees must also be given the right to weigh in on major decisions affecting the company.

The need for the right advice and assistance

Understanding all of the ins and outs associated with an ESOP, including the tax implications, can be complex. It may benefit you and your company to find the right advice and assistance in setting up the program and maintaining it so that it does not interfere with your company's chances at success.

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