ESOP Tax Structures: C Corp vs. S Corp - Weighing Shareholder Benefit vs. Company

I'm John Gogolak with PCE Investment Bankers. Are you ready to make one of the most impactful decisions for your ESOP structure? The choice between an S corp and C corp for tax purposes isn't just required, but also holds the key to accessing the most significant tax benefit available to selling shareholders - which is the 1042 tax deferral. Join me as we explore the crucial factors and make an informed decision that will shape the future of your ESOP. Let's dive in. S corp vs C corp is one of the more crucial decisions because not only is it a requirement as part of an ESOP structure, but it also has implications to accessing the most significant tax benefit available to selling shareholders to an ESOP. And that is the 1042 tax deferral in which the company must be a C corp. Structurally speaking, the ESOP, the ESOP trust, which holds the stock for the benefit of the employees, becomes a legal shareholder and it is required that the trust owns the stock in a corporation. It cannot hold membership units in an LLC or an ownership interest in any other type of entity such as a partnership. It is this limitation that requires the underlying company to be taxed as either an S corp or a C corp. In order to qualify for a 1042 tax deferral, the company must be a C corp at the time of sale. However, being a C corp comes with some drawbacks and you're going to want to review and weigh those impacts before deciding which tax election the company should make. So when you are getting ready to determine which tax structure to use, there are a few key comparisons that we can make between a C corp and an S corp. In the C corp, the seller can defer capital gains taxes whereas in an S corp, the seller pays capital gains taxes on their sale to an ESOP. Also, as a C corp, there is a corporate level tax on income, meaning that the corporation will pay taxes on the entire amount of its taxable income regardless of the shareholders. This is also referred to as double taxation. But in S corp, the taxable income is not paid at the corporate level, but rather flows through to the shareholders. So the important issue for taxation and S Corp is understanding your personal tax rate. Another comparison would be that the C corp does have the ability to reduce that corporate level tax with any dividends it pays in an ESOP. One way to achieve this structurally is through the selling of preferred shares which acts as a great mechanism to reduce taxable income in the C corp. However, there is no tax on an ESOP's share of earnings in an S corp. The ultimate example of this is if an ESOP trust owns 100% of the S corp, that company is not subject to any federal income tax, and neither is the ESOP shareholder, effectively creating a tax-exempt organization. An ESOP tax advantage that is shared by both, regardless, is that debt is reduced on a pre-tax basis. This is because if the ESOP transaction is structured properly, both principal, and not just interest, can be paid with pre-tax income. Meaning that the company cash flow to the company changes based on the ESOP ownership. So while you as the shareholder would have the advantage in the C corp scenario, the company would have the advantage in the S corp where it can become a tax exempt entity. Therefore, the decision often comes down to the comparison of how much capital gains the shareholder can defer in the C corp to how much free cash flow the company has in the S corp scenario. To assist in making this comparison, shareholders will typically engage with an investment banking professional to perform a feasibility study which would run through the comparison and quantify the impacts of each option. For more information about what a feasibility study entails, check out our video linked In the description below. For you as a potential selling shareholder, it is important to make the decision, C or S corp, from a position of knowledge and understanding of the dollar impacts the election has not only on personal sale proceeds but company cash flow as well. Having all the information will put you in a position to confidently make the best decision.