In An Uncertain Time, Consider ESOPs

August 2017

By Jay Powers

In an uncertain time for government budgets and priorities, government contractors may consider implementing Employee Stock Ownership Plans (ESOP) as a smart way to reward company stakeholders and encourage cash flow. An ESOP is a qualified, defined contribution employee benefit plan, much like a traditional profit-sharing plan that invests primarily in the sponsoring employer’s stock. They are unique among qualified benefit plans because the ability to borrow money may be used as a technique of corporate finance.

There are approximately 10,000 ESOPs in place in the U.S., covering 11 million employees, or 10 percent of the private sector workforce. Most of these companies have other retirement plans, such as defined benefit pension plans, or 401(k) plans, to supplement their ESOP. About 800 ESOPs are in place at publicly traded companies.

Tax advantages of Implementing ESOPs
While there are many benefits to implementing ESOPs, like fluidity and independence, it’s important not to overlook the tax advantages to government contractors:

Deductibility of Principal and Interest Payments
Principal and interest payments of an ESOP loan are considered contributions to a tax-qualified employee benefit plan and thus are tax deductible. For an S corporation, the maximum deductible amount is 25 percent of covered eligible payroll and—unlike a C corporation—both principal and interest are included in the 25 percent limit. However, an ESOP is a non-tax-paying shareholder, so an S corporation that is owned fully by an ESOP should not pay any federal income tax and could avoid state income tax.

Deductibility of Dividends
In a C corporation, dividends paid on stock held by the ESOP are tax deductible to the corporation if they are distributed to the ESOP, and do not count toward the 25 percent limit on principal and interest deductibility. Thus, these dividends may be used to pay additional principal and interest on the ESOP loan. It’s important to note, however, that dividends are not deductible for S corporation ESOPs.

ESOP Rollover
Shareholders selling to a C corporation may leverage ESOPs to qualify to defer capital gains taxes on the gain from the sale by purchasing “qualified replacement securities” with the proceeds from the sale.

Step-Up in Cost Basis to Seller’s Estate
Should a selling shareholder “roll over” assets in a IRC §1042 transaction, the estate could receive a step-up in cost basis on the qualified replacement securities at death, thus eliminating the capital gains tax liability.
Transitioning to an ESOP presents government contractors with flexibility and benefits that may be advantageous in the current industry climate.

Jay Powers is the National Practice Leader for BDO’s ESOP Transaction Services and may be reached at jpowers@bdo.com.

Read the next article, "Another Year in the Books: DCAA’s FY 2016 Report to Congress"

Return to BDO Knows Government Contracting Newsletter - Summer 2017