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ESOP Boot Camp, Part 4: The ESOP Tax Advantage Explained

• Menke • Season 1 • Episode 6

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0:00 | 19:20

What are the real tax advantages of an ESOP—and how do they actually work in practice?

In Part 4 of the ESOP Boot Camp series, Trevor Gilmore, CEO of Menke, and Ben Spadt, ESOP Investment Banking Consultant at Menke, break down the three primary tax benefits available to ESOPs and selling shareholders.

This episode explains the Section 1042 rollover, the differences between C corporation and S corporation ESOP tax treatment, and how 100% S corporation ESOPs can operate without paying federal income tax. The discussion stays high-level and practical, focusing on how these tax advantages influence owner decision-making, transaction structure, and long-term strategy.

Topics covered include:

  • Section 1042 rollover basics and eligibility requirements
  • Qualified Replacement Property (QRP) and common strategies
  • Comparing a taxable sale versus a 1042 deferral
  • ESOP tax deductions for C corporations
  • How S corporation ESOPs eliminate federal income tax
  • Partial versus 100% ESOP ownership and tax implications
  • Why tax planning must align with long-term ownership goals

This episode is designed for owners, CEOs, and CFOs who want a clear, plain-English explanation of how ESOP tax advantages work—and why they are often a central driver in ESOP decision-making.

Hi everyone. Welcome to the official ESOP Radio. Thanks for joining episode four of the Esop bootcamp, the Esop Tax Advantage. Everyone talks about and explains simply, we're going to talk about Esop tax benefits today. Our goal with the boot camp is to give you the owner, CEO, or CFO of a successful business. The lowdown on Esops in a quick, straightforward manner. Because your time is valuable, we disclaim that we are not providing investment advice. I'm Trevor Gilmore, CEO of Menke and I'm Ben Spadt. Investment banking with Menke. Since 1974, Menke has been a full service Esop advisor. We've seen it all from capital raise to structure to regulatory compliance, value and M&A. We've done thousands of Esops over the last 51 years, and as an Esop ourselves, we're Esop native and today we're going to cover the three tax benefits that are available to Esops. Number one, a section 1042 rollover, its first decision to make. And it drives everything. Number two, Esop tax deductions, whether you're a C Corp or an S Corp. And the difference between the two and number three how Esops can eliminate the federal income tax for the corporation. All right Trevor, let's kick things off. Head us off with 1042. Thanks, Ben. It's a big picture. What is 1042? It's a part of the tax code and it's very similar to a 1031 exchange. So for you people out there who have had real estate investments that have gone through a 1031, the 1042 spirit is very similar, except it applies to owners of C corporations who sell their stock to an Esop. So that's one key requirement. You have to be a shareholder of a C corporation. And so that's not directly to the the SOP. And also in that transaction you need to sell an aggregate of 30% of the shares and more on the exact requirements later. You know, we could talk about the 1042, you know, for like two hours, right? And it's supposed to be at a high level over here. So let's get into it. So big picture 1042 like a 1031 okay. And I'll give an example here. So I saw business to these off. I'm a C Corp shareholder. And let's say I sell all my stock to the stock for 50 million okay. Now I want to left 1042. And what I need to do, I need to buy 50 million worth of QP. What is QP has qualified replacement property. Basically QP is U.S. stocks and bonds of active operating businesses. Also some private C corporations apply as well. Generally, real estate is excluded because it is not considered active. So with that okay, what is this menu of QRP options out there? The overall 1042 market by and large is dominated by a lot of U.S like large U.S banks here, you know, so think the big ones you see on the news J.P. Morgan, Morgan Stanley, RBC, UBS, Deutsche Bank, Wells Fargo, B of and so on. And one of the common strategies out there is what is called a floating rate note. Now what is that? It's basically issued by a corporation and long dated, because if you're buying this ship and by the way, you can't sell your QRP and buy a new QRP and still defer the tax. If you sell QRP, you pay the capital gains related to that piece. So it does allow you some tax time in here. But let's get back to the example. So friends are out there a long dated you know if you're doing this strategy and let's say you want to hold this QP until it becomes part of your estate, your heirs queue to step up in basis. So, you know, it could be a valuable long term legacy in estate play, right? When you think of generational wealth and so on. But friends is one strategy and more on that later. Another strategy is equities. Right. And or a combination of the two. Usually what you're going to see overall is the form of some leverage to acquire the full QP portfolio. And the reason being is that in this example, they sold 50 million worth of stock to the Esop. But I don't have 50 million of cash. And you have 12 months from close to get this QRP. So how do I achieve 50 million a QRP when maybe I got upfront cash of, you know, maybe ten, 15, maybe 20 million? And the answer is leverage. So nearly all of these QRP strategies out there involve leverage. Meaning I'm going to put up maybe ten, 15, 20%. In this case. Let's just say it's 20%, so 20% of 50 million, there is 10 million. So I put that 10 million of cash to buy 50 million worth of QRP. And then a financial advisor who sells these products is then going to show you, what does that long term strategy look like in terms of if it's friends, the interest income. And then you're of course going to have some leverage expense, right. Or if you go equities, same thing. Friends you know usually can be leveraged up there. You know we see that out there. There's some equity strategies as well for architects, some other players that are in that space, you know, and they have solutions out there too, involving more equity, you know. So for people that are looking for more of an equity style return, you know, and again, when you think about this, the math is, okay. For one, tax deferral, right. Can be powerful. But you also need to compare opportunity costs, right. And so on. And look at the long term. And it's very much an individual decision. If the 1042 makes sense you know. So if working with your wealth advisor, your overall long term trusts and estate planning, you know, it's so on to make that proper decision. We cover in our Esop fit analysis, we do a bit of a deep dive here to to show you, hey, these are what possible outcomes look like. The alternative to not going down the 1042 path is having a taxable sale. And what does that mean? It means I'm going to pay capital gains probably on the installment basis. Because if I'm carrying a seller note, you know, plus maybe some being financing. More on that later. We have next episode is all about how you finance and Esop, you know. But that's the alternative is paying capital gains versus deferring. So key takeaway here is number one, if you're interested in selling to an Esop, is that the 1042 is probably one of the most important decisions you're going to make heading into an Esop, and is something you need to figure out before you go through the negotiations and so on, because a lot of things drive this. The corporate form does for us as corp. Now you're going to have to convert to C Corp. If you're a C Corp now okay, you're probably in good shape. But we need to do some research to look at your holding period and so on. And then also we need to figure out working with your advisor. What is your QRP strategy. Because that dictates how much liquidity up front you get out of this Esop transaction. And that dictates whether you go on the big financing path or if there's excess cash, or if you have assets on your personal balance sheet that you can use to get this portfolio. So in a nutshell, QRP options and the 1042 by and large friends, equities, you know, so on. And there's no right or wrong answer. As I pointed out there with the 1042, QRP now gave you the example of sell on, you know, 50 million there. So, yeah, you know, we can talk about this for hours, but let's go ahead and move on here. And you can always reach out to us LinkedIn email so on, you know, to continue the discussion here. So let's go ahead. Had been talk about the actual corporate tax benefits for both the S Corp and Seahawks. Absolutely. Those are some great points there Trevor on the 1042. And you're right it can become very complex. But part of that is up fit analysis is showing taxable sale versus 1042. How big of an impact does it make. And then we talk about the requirements. So we try to guide you through every step on that one. But let's keep with the C Corp structure. You've sold your company $50 million. Now the company is owned 100% by the Esop. So then what what what what does this mean for everybody? Well, in a C Corp, you know, federally you're taxed at 21%. State might tax you go to add another rate on top of that at the entity level the enterprise level. So in order to reduce that you know, Trevor sold his company perhaps with a seller. Now we'll say he didn't go to a bank at all. So the payments that the company makes on that loan is deductible. You know, those interest expense would be deductible a things like that. In addition to that, because the Esop is now set up, the company is going to make a retirement contribution to that Esop, which is also deductible as an employee benefit. So we get a little bit of help there by reducing our taxes at the corporate level. But let's think about this in another lens, where the company is 100% owned by the Esop, the one that Trevor sold here. If we're an S Corp, an S Corp being a pass through entity would pass through pass through those profits to the Esop. And the Esop is set up as a trust. It would get a K-1, but the trust doesn't pay any tax because it's a retirement plan. So because of that, regardless of how much profit you're sending down to the bottom line, the Esop never pays tax. So in a 100%, ownership scenario that means no tax. And we'll we'll talk about that a little bit more. And some of the nuances there, there will be in other examples, like the 49% examples we talked on the last episode. Or, you know, we'll trade Trevor's company out for one that's selling a minority interest, that 49%, then that flows through those profits that would flow through to the, to the S Corp shareholders flows through to the Esop. You don't pay tax on that 49%, but the other partners or the other owners do the other S Corp owners. So if Trevor still owns 51%, he's going to owe tax at that personal rate. You know, max rate being 37% plus your, state. So the company often issues an S distribution out to the, the selling shareholder or the shareholders at this point. So they would send one to Trevor, but they would also have to send one to the 49% owner, which is the Esop. And so that is not a retirement contribution, but is required as a an S distribution. If you're going to give it to one, give it to all that sort of thing. So that's another way to get some cash into the Esop. But maybe where that's versus C question comes into play. What's more preferable. And you know, you'd have to have conversations with your CPA as well as your Esop advisor to figure out what the best strategy is on a minority transaction. Seems pretty black and white on a 100%, but exactly a lot of nuance here, a minority. And, you know, we see that out there with a minority, let's say an S Corp, you know, coming in buying, let's say, 25, 30% of the stock and then it stays there forever, you know, never increases the ownership. So what do you see long term is the S Corp continues to get those Esop. The share of the tax distributions for the it doesn't have to be tax right. Because as a tax as a shareholder. So you see the participants in the Esops account balance really grow grow grow. You know, and you see that in over a long term, you know, can be huge. You know, we have some clients who have like, you know, 15, 20 million in their Esop because they're partial S Corp Esops and they've had that structure in place for a long time, and the company now is kicking off 15, 20 million. But, you know, the Esop is just getting this right. So people are retiring with these very sizable cash account. And from a corporate perspective, like, okay, should these up at some point go hundred percent or not? Right. And that's all part of the strategy. Right is it's a very much you know, you think what makes sense now over the next 135 years. And then of course long term, you know, and there's ways to Correct strategy and so on. And I think you covered very clearly the differences between CNS. You know, it's a little bit I, I liked your point there and not to interrupt, but I really liked your point there. It depends on where you are in the lifecycle of what strategy is best for you. And working with your Esop advisor would help you early. Esops are pretty much as the plan is written up. That's how it's going to operate. But five years down the road, that might not be the best idea. Or perhaps some tweaks are needed, whether it be a window amendment, small plan amendment, or there are things you can do to your distribution policy, what have you all conversations for another episode, but it just illustrates the importance of having an advisor with you. You know, every step of the way, not just during the transaction, not just during, you know, perhaps a second stage transaction, but having somebody there with you along the way. Exactly. Yeah. We had those conversations with clients all the time. Right. You know. Yeah, especially on our Esop sustainability side. You know, we do these transactions, you know, working with business owners like everyone listening help with the transition. And then as we do the ongoing compliance advisory we're there. So what makes sense today might not make sense in 510 years. Right. And there's always levers you can pull that's, you know, 100% accurate actions. You right I know when I got my master's in tax, you know and the key things was, you know, hey taxes couldn't change. You know everyone with Congress or so you know what makes sense. What's eligible today might not be tomorrow. And so on the plus side, just like a tax, I wanted to say, you know, I alluded it to a little bit. And last episode we had sort of the downer at the end of, you know, when is an Esop not a good fit? Today we have a little bit of dessert at the end, and I think everybody would want to know, how do you not pay tax? And Trevor, you want to talk about how an Esop can potentially be tax free. Yeah, exactly. And this is the endgame for a lot of Esop companies that envision themselves becoming 100% employee owned. So let's think this through here. So an S Corp is a flow through all you S Corp shareholders out there. You get a K-1 every year. You know and you're paying taxes right. Based on on that corporation. Right. You get a cash flow distribution to pay those taxes and so on versus a C corp which is a taxable entity. So C Corp's are not flow through is they pay the tax at the entity level. You know meaning the federal right now is 21%. We're recording this and late January 2026. So that's the fed rate right now it's 21%. And then state two. If you're in a state that has a corporate income tax rate, then the Seahawks on the hook for that. Now I know some states as corp. So you can do the PT the pass through. You know you know some you can do that for state. But any case big picture of C Corp taxable entity S Corp flow through. So the individual shareholders pay the tax. Now what is the Isa up top is a tax exempt trust meaning it does not pay current income tax. Participants in the Esop are taxed when they pull money out. If they don't rollover. So the roll of money over to another qualified plan I think IRA you know think for one K so on you know then you're rolling over just like any other retirement plan. You need. You're going to pay the piper when you actually take that money out of some point. But let's say, you know, someone retires and they, you know, take money of off and they just use the cash. And yeah, that's that's when they pay the piper. That's when they pay the tax. But the whole time the Esop as a shareholder it is not paying tax. So you think okay S Corp 100% owned by a an Esop then does not need to make tax distributions because the Esop is not paying current income tax of the corporate earnings. So that is huge. So you think you know, 21% said, you know, I'm based here in California. Overall effective rate for most a C corp is 28%. But if you're an S Corp shareholder in California, you're effectively using round numbers about 50%, right? So if you don't have that cash going out the door, what can it be used for? Well, for one, it's going to fit on these, debt that's huge to help fund the Esop repurchase obligation. And three help you once that Esop debt is pay down, acquire companies, grow your company. You know so on. And we are seeing that a lot of Esop hold Co's out there you know kind of grow in that way. So it's a huge benefit 100% S-corp Esop. You know and there's many, many successful examples out there, you know, of that. So, you know, it is a journey, right? You know, some people go right out the gate 100% S Corp Esop. Others say, hey, let's do a phased approach here, you know, and so on. And especially at the 1042, as you talked about earlier, you know, you're an ass and you really wanted to do. 1042 and then we have to work with your CPA to convert you over to a C Corp, and you can do the 1042. And then you generally have to be a C for a while, you know, five years is, you know, the general guidance there before you can transfer back to us. And then you also might be faced with a five year building gains as well from the C to S conversion. So it's a very much a nuanced decision, right, to go back to the 1042 and one thing, and I know we're going to wrap this up here, in a second. But about that 1042 discussion, how do you inform the IRS that you well, let's do 1042 is you file a statement on your tax return and the year of sale, and you also list all the securities you bought, and that's how you inform the IRS that you elected. 1042 so that's one thing I think I missed an hour earlier. And that's the personal tax return, not the corporate tax return. Exactly. Yeah. So in that example tell us 50 million of stock to the Esop. Then on my personal tax return on file that 1042 and list out all the securities I bought, you know, and so on. So that's that's how that works. Of course. More on that, you know, consult with your tax advisor, you know, of course, financial advisor, etc.. I mean, that's really it for episode four. And we covered a lot, but basically three essential topics here. Number one is the 1042 that Trevor was just talking about. Number two, the Esop tax deductions C versus S, what can we do. And then finally how Esops can eliminate the federal income tax and thanks for joining us today. We hope you enjoyed it. Connect with us on LinkedIn. Myself Benjamin Spade or Trevor Gilmore, a connect with Esop radio also on LinkedIn. Or just come straight to Macomb where we have a wealth of information webinars, case studies, things like that, where you can learn more about becoming an Esop if you're interested. And if so, reach out to us to learn more about this and our Esop fit analysis, which is really the first step in assessing if an Esop is right for you. Have a great day and join us for episode five next time. How to finance your Esop. Thanks and goodbye. Thanks everyone. Take care.