Taxation of an ESOP

Employee stock ownership plans, or ESOPs, allow companies to compensate employees with stock in their companies. Many ESOPs benefit the company and the worker, as the company gains from the worker's willingness to work hard and to increase the profitability of his stock holdings. ESOPs also offer tax advantages for workers and their companies.

ESOP Accounts

ESOPs work a lot like 401(k) accounts or individual retirement accounts. The Internal Revenue Service lets employees contribute their own money to buy stock in an ESOP while employers contribute company stock, both on a pre-tax basis. Like the other accounts, the money in the ESOP grows tax free until the employee starts taking distributions. Then the distributions are taxed as regular income.

Diversification

Having a large portion of your retirement funds in an ESOP can be risky, especially if the company experiences financial trouble. Once you've spent 10 years in the plan and had your 55th birthday, you can diversify 25 percent of your ESOP and a total of 50 percent of it by your 60th birthday. The company can give you cash that you can roll over into an IRA, or it can transfer the money from the sale of shares into a company-run 401(k) plan for you. In either case, the transfer is tax free as long as you do a direct transfer or deposit the money in 60 days. Transfers to a Roth IRA, though, are subject to tax.

Dividends

ESOPs can pay dividends inside the plan or, if the underlying company is a C corporation, directly to shareholders outside the plan. In the latter case, the dividends are taxable, but they aren't treated as early distributions and aren't subject to income tax withholding -- you just pay taxes on them at the end of the year, like you would with most other dividends. Dividends paid within the ESOP fund aren't taxed until they're withdrawn as a part of a distribution.

Employer Tax Benefits

Employers also get tax benefits when they set up ESOPs. The value of any stock that gets contributed to the ESOP is tax deductible with other employer contributions to retirement plans -- up to 25 percent of the company's payroll. C corporation dividends can also be tax deductible if they're paid in cash to ESOP participants, if they're used for loan payments on a leveraged ESOP or if employees choose to use them to buy more company stock in their ESOP accounts.