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Tax Benefits of Investing in Your Own Employee Stock Ownership Plan

Written by First Bank of the Lake | Jan 4, 2023 10:10:08 PM

As an entrepreneur, an employee stock ownership plan can be an appealing way to give your employees an ownership stake in the business via stocks. This investment vehicle empowers your workers to invest tax-free money directly in your company and cash out their funds when they reach retirement age. But the benefits of an ESOP go beyond perks for your crew — investing in your own employee stock ownership plan comes with its own tax benefits. Here’s a look at how investing in your ESOP can benefit you.

Take advantage of these deductions

Employee stock ownership plans are an increasingly popular way to provide retirement benefits for your employees — but your workers aren’t the only ones who can enjoy the perks from an ESOP. According to Investopedia contributor George D. Lambert, your company’s discretionary corporate annual cash contributions to your ESOP come with hefty deductions. You may be able to deduct up to 25% of the pay of your plan’s participants. Bankrate reporter Georgina Tzanetos further explains that your company can also make tax-deductible deposits into an ESOP trust fund, which you can later use to purchase shares to distribute amongst your workforce.

Furthermore, employee stock ownership plans are not subject to federal income taxes. Even your employees won’t have to pay income taxes on their ESOP stocks until they cash out their investments. This benefit can encourage employee participation in the plan, driving further investment in your company.

Planning for succession

Every small business owner has to consider the future of the company — and that includes coming up with a way to hand the reins over to a successor. An ESOP can enable you to transfer ownership of your company without losing a large chunk of that wealth to taxes, explains Lambert. If your business is a C-corporation, and you sell 30% or more of your ownership stake to the ESOP, you may defer or completely bypass capital gains taxes. In order to receive this tax benefit, you’ll need to reinvest the money into the bonds or stocks of other operating companies in the United States. Mutual funds and government bonds aren’t eligible, according to Lambert.

Potential drawbacks

While ESOPs offer entrepreneurs a variety of benefits, they carry certain drawbacks, like all financial decisions. Lambert explains that ESOPs only apply to S- and C-corporations, and are not applicable to partnerships or other business structures. Second, you can run into trouble if many employees simultaneously quit or retire, since ESOPs are obligated to buy back their shares in the company. Third, as you issue more shares to your growing business, each share will represent a proportionally smaller stake in the company. And finally, Lambert reports that ESOPs can be quite costly to establish, with the most basic plans starting at around $40,000.

If investing in your own ESOP is the right move for your needs, you could reap benefits for years to come. Before establishing or modifying an employee stock ownership plan, consider the counsel of your company’s leadership and the advice of a financial advisor.