High Payrolls, Accelerated ESOP Tax Benefits

Shifting Gears to Accelerate | CSG Partners

May 19, 2021 Steve Berman

High payroll companies – such as staffing and professional services firms – are uniquely positioned to maximize the advantages of an employee stock ownership plan. 

In addition to wielding a valuable talent-retention tool, an employee-owned company in these industries can expect ESOP-related tax deductions to have a greater and more immediate impact.

Corporate ESOP Tax Deductions

One of the most meaningful advantages held by an employee-owned company is the ability to reduce or potentially eliminate its annual tax burden. 100% employee-owned S corporations are exempt from federal and state income taxes (with a few state exceptions).

C corporations with leveraged ESOPs also are also entitled to unique tax incentives. These deductions are equivalent to the total price of equity sold to the employee trust. For example, if 30% of a business is sold for $20MM in an ESOP transaction, that company is entitled to $20MM in income tax deductions, spread out over multiple years. When a sponsor makes annual contributions to its employee trust, these tax deductions are made available.


Unlocking the ESOP Sale Price Deduction

An employee-owned company is permitted to make an annual contribution to its ESOP trust, equivalent to 25% of its eligible payroll. The trust uses this contribution to repay an internal loan, made by the plan sponsor, to facilitate the original leveraged transaction (see below).

ESOP Contribution Diagram | CSG Partners

The sponsor is entitled to an annual income tax deduction equivalent to the contribution amount. If the company’s annual payroll is $10MM, it could make a maximum annual ESOP contribution of $2.5MM and receive an equivalent income tax deduction.


High Payrolls, Accelerated Tax Deduction Accruals

Most staffing and professional services companies – including consulting firms, accountants, engineers, and architects – have high payroll-to-income ratios. Thus, they can typically make larger contributions, relative to ESOPs from other industries. In doing so, these firms can access their pool of sale price deductions at a faster rate and more substantially reduce their taxable income in the years immediately following their ESOP sale.

The incremental cash flow from these tax savings can be used by the company for working capital, debt reduction, acquisitions, growth, or to increase cash reserves. Once the tax benefit is exhausted, employee-owned C corps seeking to extend their ESOP tax advantages may opt to:

  1. Sell an additional equity stake to the ESOP and secure new sale price deductions;
  2. Convert to an S corp, when permissible, and secure ESOP tax advantages in perpetuity (any earnings attributable to ESOP-owned equity in an S corp are shielded from federal and most state income taxes).

Overcoming Cash-Based Accounting Liabilities

There’s another tax wrinkle that makes ESOPs particularly advantageous to staffing and professional services companies. While most of these firms maintain generally accepted accounting principles (GAAP) financial statements, many report taxes on a cash basis. Taxes are only paid on cash receipts, as receivables are collected. Substantial variances between accrued taxable revenue and accounts receivable are common.

This cash vs. accrual variance is an embedded tax liability – one that is often overlooked until a corporate sale takes place. Prior to a transaction, including an ESOP sale, a cash basis acquisition target will be required to adopt the accrual accounting method. That change may result in a substantial recognition of revenue (and income).

In the event of a third-party or private equity transaction, this tax liability can erode sale value. An employee stock ownership plan transaction is subject to the same taxes, but the previously discussed ESOP tax deductions can reduce or eliminate a cash-to-accrual to liability. That buffer can make a significant difference in terms of sale proceeds.


Consult Your Advisors

Of course, the ESOP tax implications referenced here are nuanced. An employee ownership sale is a multifaceted transaction with unique costs and benefits. It should not be viewed as a fool-proof path to tax deductions. Instead, a leveraged ESOP transaction, or a secondary sale, merits careful planning with relevant tax, accounting, and financial advisors.

But, when an employee stock ownership plan makes sense for all relevant stakeholders, it can drive meaningful benefits for already high-performing companies – especially those in the staffing and professional services industries.

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