For trucking companies, employee stock ownership plans (ESOPs) may be a powerful tool for succession planning and long-term financial stability. For their employees, ESOPs offer a tax-deferred path to ownership and retirement savings, aligning their interests with the company’s success. The first article in our three-part series, “From Highways to Ownership: Exploring ESOPs for Trucking,” outlined an ESOP structure and provided an overview of the potential benefits. This second article will focus on tax advantages and planning strategies for both the stockholders and the company.
Stockholder Benefits
Not only can the ESOP pay fair market value for the owner’s stock, but the sale transaction can be structured to create tax advantages for the seller. In general, the ESOP purchases stock instead of company assets. A seller who has held their stock for longer than one year can take advantage of long-term capital gains rates. In addition, a seller financing all or part of the purchase price has the option to take installment treatment on the portion of the transaction financed with a seller note, allowing the seller to pay capital gains tax over a period of time as the seller note is repaid.
If the seller is taking back a seller note, they may be provided with detachable warrants as an interest rate enhancement for financing all or a portion of the ESOP transaction. The warrants are considered part of the overall financing package and are taken into consideration in the overall rate of return on the seller note, including the cash payments of interest. Warrants give the seller the right to purchase a certain number of company shares at a future date (usually after the seller note is repaid). In general, the exercise price equals the post-transaction ESOP price, and the put or call price is based on the company’s most recent ESOP appraisal. Detachable warrants have the benefit of easing the interest burden on the company while providing the selling stockholders with potential upside in the company, depending upon future company performance.
Another tax planning strategy is covered under Internal Revenue Code Section 1042. This allows owners meeting certain qualifications to sell their stock in a tax-deferred or potentially tax-free transaction. To take advantage of §1042, the company must be a C corporation at the time of the sale transaction, and the ESOP must own at least 30% of the employer stock after the transaction’s completion. The taxpayer also must have held the securities for at least three years prior to the sale.
Effective for sales after December 31, 2027, S corp shareholders can defer 10% of their gain on their sale to the ESOP. This change was implemented as part of the Setting Every Community Up for Retirement Enhancement (SECURE) 2.0 Act of 2022.
To achieve gain deferral, the selling stockholder is required to reinvest in qualified replacement property (QRP) within 12 months of the sale date. QRP is essentially stocks or bonds of domestic operating companies. Mutual funds, municipal bonds, and certain other investments aren’t considered qualifying property. The tax basis in the company stock sold carries over to the QRP. The deferred gain is realized only when the QRP is sold. However, if the selling stockholder holds the QRP until death, the QRP will become part of the stockholder’s estate. At that time, the QRP will receive a step-up in basis (in years where the estate tax is in effect), resulting in income tax avoidance.
Certain strategies allow the stockholder to invest in QRP and retain the tax deferral while retaining access to most of the sale proceeds. Due to historically low long-term capital gains rates, §1042 gain deferral hasn’t been widely used in recent years. However, this strategy may be more appealing for taxpayers in certain high-income tax rate states.
Company Savings
The selling stockholder certainly isn’t the only one to reap the tax advantages of an ESOP transaction. The company can realize substantial tax savings as well. Because a leveraged ESOP company can deduct principal payments on debt used to purchase company stock (subject to certain tax deduction limits), a significant portion of the transaction can be repaid with company tax savings.
There are even greater benefits for ESOPs taxed as S corps. The portion of the company’s earnings attributable to the ESOP is exempt from federal and most state income tax (except in certain states that don’t recognize S corp status). When an S corp is 100% owned by an ESOP, the potential for savings is even greater. In this case, the company no longer pays federal or, in general, most state income taxes because the ESOP is a tax-exempt retirement plan. The company can retain this cash to pay off acquisition debt, support company growth, or even fund acquisitions. This tax-advantaged structure can make a leveraged transaction more palatable to key stakeholders, such as sureties. The additional cash from the tax savings may allow the company to deleverage more quickly than in other leveraged transactions.
In the final article in this series, we will explore how an ESOP can be an incentive in the recruitment and retention of skilled labor, as well as preserve a company’s name and history.
How Forvis Mazars Can Help
Forvis Mazars understands how critical it is to consider various ESOP matters when developing plans for the future. If you have any questions or need assistance, please reach out to one of our professionals.