From the September 2004 issue of Entrepreneur

S corporations offer a plethora of tax benefits, but one you may not have considered involves Employee Stock Ownership Plans (ESOPs). Nova Engineering, a Cincinnati-based S corporation, has discovered the tax benefits of ESOPs. CFO Jeff Wyatt says the ESOP's tax-deferral benefits have been a boon to the company's cash flow.

Wyatt says Nova established an ESOP in 1998 because the company leaders strongly believed in employee ownership. Owning a piece of the pie has also made employees more committed and dedicated to the success of Nova, Wyatt believes. "The best thing about the ESOP is what it has done for the employees," he says. "As owners, they are motivated to do the best work for us."

An ESOP is an employee benefit plan that makes the employees owners of the company stock. By law, the income of the S corporation attributable to the stock owned by the ESOP escapes current federal income tax. For example, if you have a company that is an S corporation in which 70 percent is owned by the ESOP and 30 percent is owned by individual shareholders, 70 percent of the taxable income of the S corporation would escape income tax currently.

"The ESOP of an S corporation is normally set up as a tax-exempt trust and thus pays no income tax," explains accountant Jim Rolfes with the Cincinnati firm of Jackson, Rolfes, Spurgeon & Co. When employees retire or leave the company, however, they pay federal taxes on the proceeds from the sale of their shares in the company. In contrast, if the same company is organized as a regular corporation and is entirely owned by an ESOP, the regular corporation is required to pay tax on its income.

Keep in mind that an ESOP is not for every entrepreneur. ESOPs work best for companies that are stable or growing. "Further, if you set up an ESOP, you're selling the company to the employees, and they're going to become the beneficial owners of the shares over a period of time," says Rolfes. Therefore, owners must be committed to the employee ownership concept.

In addition, companies that establish ESOPs must pay the cost of drafting the original ESOP documents. There are also annual administrative costs and the expenses involved in having the company valued each year.

If you're interested in establishing an ESOP, consult with your tax professional. For more on the advantages of ESOPs, check with The ESOP Association at www.esopassociation.org.


Great Falls, Virginia, writer Joan Szabo has reported on tax issues for 17 years.