S Corporations are companies that have elected to pass corporate income and losses through to shareholders for federal income tax purposes. As a result, individual shareholders must report their pro-rata portion of the company’s income and losses on their individual tax return. Taxes on earnings are computed based on applicable federal personal income tax rates.

By law, an ESOP is a federally tax-exempt entity. As such, the pro-rata earnings of an S Corporation allocable to an ESOP (as a corporate shareholder) are exempt from federal income taxes. As a result, in a scenario where an ESOP owns 100% of the common stock of an S Corporation, 100% of that company’s earnings are exempt from federal income taxes. In other words, earnings that would have otherwise been used to pay income taxes can be retained in the business, or used for capital expenditures, debt repayment, acquisitions, working capital needs or other productive uses that enhance value. It is this tax savings that makes the ESOP shareholder unique and different than any other corporate shareholder.

What’s the difference between S corporations and C corporations? Flip through the SlideShare below:

Creating the S Corp

Creating an ESOP owned S Corporation is accomplished through the purchase of company stock by the ESOP from selling shareholders. Due to the statutory requirements governing the tax savings benefits accruing to an ESOP, it is important to seek the help of professionals experienced in negotiating and structuring ownership transition using an ESOP in order to insure the benefits of the tax savings fully inure to the S Corporation.