Many businesses in our region have transitioned toward employee ownership, otherwise known as Employee Stock Ownership Plan (ESOP) owned. Modern transaction designs offer distinct advantages – and complexities. Management would be well-advised to have frequent discussions with its ESOP professionals to be sure there is a mutual understanding of how transactions will be reported. In particular, ESOP benefit payments require special attention.
Some ESOPs have incorporated a Roth provision. This allows a participant to elect current taxation of his/her benefit when the annual stock allocation is made (these are generally small amounts) and to withdraw his/her benefit later on a tax-free basis, when presumably the stock value is much higher. Under this scenario, it is important to advise those participants who make such elections that for tax-free withdrawal to apply, the shares must not be distributed for at least five years. Upon withdrawal of the Roth balance, a 1099-R will be issued for the value of the stock and the taxable amount should be reported as zero.
Another ESOP benefits reporting issue pertains to benefit payments made by the Plan in stock, rather than in cash. The ESOP distributes stock to the participant and the participant immediately puts the stock to the company for redemption. Under this scenario, the withdrawal check should come from a company-owned account. Assuming no Roth treatment (as previously described) was elected, the ESOP will issue a 1099-R for the fair value of the stock distributed. The taxable amount on the 1099-R will be the cost basis of the stock. In turn, the employer redeems the stock for cash when the participant puts it to the company. The company should issue a Form 1099-B to the participant for the cash payment. The participant will be taxed only on the net appreciation of the stock after he/she reduces the gain by the cost basis. In this way, the participant will pay ordinary tax rates on the cost basis of the stock distributed, and capital gains tax on the net appreciation of the stock cashed in. If reported properly, significant tax savings for the participant should result.
If your company is ESOP owned, be sure that management has a good plan for benefit payment reporting, to generate tax savings for participants and to avoid costly errors.
