Why Careful Planning Is Key
Employee stock ownership plans (ESOPs) can be powerful wealth-building tools, especially for high-income earners and business owners. However, they come with unique tax implications that require careful planning to help avoid surprises and maximize benefits.
Below is a look at several key tax considerations for high earners participating in an ESOP, along with strategies to help minimize your tax liability and support your long-term financial goals.
1. Ordinary Income Tax on Distributions
Distributions from an ESOP are typically taxed as ordinary income rather than capital gains. You can defer these taxes by rolling the distribution into an IRA or another qualified retirement plan, but future withdrawals will still be taxed at ordinary income rates.
High earners should be especially mindful of how these distributions may increase their taxable income in retirement and potentially push them into higher tax brackets. Remember, it’s not what you make — it’s what you keep!
2. Exposure to Net Investment Income Tax (NIIT)
The net investment income tax (NIIT) adds an additional 3.8% tax on certain types of investment income for those with a modified adjusted gross income (MAGI) above $200,000 for single filers or $250,000 for married couples filing jointly.
ESOP distributions aren’t considered investment income, but if shares are sold outside a qualified retirement plan, the resulting capital gains may be subject to the NIIT.
3. Required Minimum Distributions (RMDs)
Like other retirement plans, ESOP participants must begin taking required minimum distributions (RMDs) at age 73 (age 75 for those born in 1960 or later).
For high-income retirees, RMDs can cause unplanned spikes in taxable income. This increase can affect tax brackets, Medicare premiums and eligibility for other benefits. Planning ahead can help smooth out retirement income and reduce these effects.
4. Capital Gains Deferral With Section 1042 Rollover
Business owners who sell shares to an ESOP may be eligible for a Section 1042 rollover, which allows for the deferral of capital gains taxes if the proceeds are reinvested in a qualified replacement property (QRP).
This tax strategy is only available for sales to C-corporation ESOPs and requires that the seller has held the shares for at least three years. When structured properly, this strategy has the potential to preserve a portion of the sale proceeds for long-term financial planning.
5. Watch for the Alternative Minimum Tax (AMT)
If the ESOP includes incentive stock options (ISOs), exercising those options may trigger the alternative minimum tax (AMT).
High-income earners are more likely to face this issue because the difference between the exercise price and the fair market value is treated as income for AMT purposes even if the shares aren’t sold. Modeling this impact ahead of time is critical.
6. ESOP Contribution Limits and Deductibility
Employers can deduct ESOP contributions of up to 25% of covered payroll. This ability makes ESOPs an attractive way for high-income earners to build retirement savings in a tax-deferred environment.
However, contributions that exceed IRS limits may not be deductible and could result in penalties. Coordination with a tax advisor is essential to stay within the limits and take full advantage of the ESOP structure.
Tax Planning Strategies for High-Income ESOP Participants
Below are a few ways to mitigate tax exposure and help optimize your plan:
- Diversify account types by combining ESOP benefits with Roth IRAs, taxable accounts and other vehicles to create flexibility in retirement.
- Coordinate distributions to avoid significant increases in taxable income in any one year.
- Use charitable giving strategies, such as donor-advised funds or appreciated stock, to reduce taxable income.
- Consider Roth conversions to shift tax liability into lower-income years.
- If selling a business, begin planning early to take advantage of the Section 1042 rollover.
