2028 Tax Benefit for S Corporation ESOP Owners: What You Need to Know
Starting January 1, 2028, S corporation owners selling to an ESOP will gain access to a valuable tax benefit that has never been available before. Understanding this change now will help you plan an exit strategy that maximizes both your personal outcome and your company's future success.
What's Changing: A New Tax Deferral Option for S Corps
A provision in the SECURE 2.0 Act of 2022 extends Section 1042 tax deferral treatment to S corporation ESOP sellers beginning January 1, 2028. S corp owners will be able to defer capital gains taxes on 10% of their sale proceeds by reinvesting those funds in Qualified Replacement Property.Section 1042 allows business owners who sell to an ESOP to defer capital gains taxes by reinvesting proceeds in Qualified Replacement Property (stocks and bonds of domestic operating companies). If held until death, the deferred gains can potentially be eliminated entirely through step-up in basis.»The key point: This is entirely NEW. Before 2028, S corp sellers had no access to Section 1042 deferral at all. Starting in 2028, you can defer taxes on 10% of your gain.
The Math That Matters
After January 1, 2028 (with new benefit):
- Capital gain: $4,500,000
- Amount eligible for deferral: $450,000 (10% of gain)
- Tax on deferred portion: ~$90,000 (deferred, potentially eliminated at death)
- Immediate tax on remaining 90%: ~$810,000
- Total immediate tax bill: $810,000
Before 2028 (current rules):
- Capital gain: $4,500,000
- Deferral eligible: $0
Why Your S Corp ESOP Status Is Extremely Valuable
Before considering any changes to your corporate structure, understand what you already have:
100% ESOP-owned S corporations pay NO federal income tax. The ESOP is a tax-exempt trust, so all profits attributable to ESOP ownership are tax-free at the corporate level. Most states follow this rule as well.
Partial ESOP ownership: If the ESOP owns 60% of your S corp, that 60% of profits is tax-free. You only pay taxes on the 40% owned by other shareholders.
Section 1042 Requirements for S Corps (After 2028)
To qualify for the 10% deferral starting in 2028, you must meet these requirements:
1. 30% ESOP ownership
The ESOP must own at least 30% of company stock immediately after your sale
2. Three-year holding period
You must have held the stock for at least three years prior to sale
3. Reinvestment in QRP
- You must reinvest the eligible proceeds ($450,000 in our example) in Qualified Replacement Property within 12 months after the sale
4. Proper documentation
File Statement of Election with your tax return for the year of sale
- Stock or bonds of U.S. operating companies
- Must be domestic corporations
- Company cannot have more than 25% passive income
- Real estate or REITs
- Mutual funds
- Municipal bonds
- International securities
- Stock in the company you just sold
Strategic Considerations for S Corp ESOP Sales
If your exit timeline is 2027 or earlier: Consider whether you can delay until 2028 to access the new benefit. Even a few months' delay could save you $90,000+ in taxes.If your exit timeline is 2028 or later: Plan now but understand you'll have access to the new benefit. ESOP transactions typically take 6-12 months from initiation to closing, so starting conversations 12-18 months before your target date is prudent.If you're flexible: Waiting until 2028 is financially advantageous. Use the interim time to:
- Clean up financials and get regular audits
- Document business processes
- Strengthen management team
- Improve profitability
- Reduce owner dependency
100% Sale:
- Maximum company tax benefit (zero federal income tax)
- Highest employee benefit
- Complete exit for owner
- Most straightforward ESOP structure
- New 10% deferral applies to entire gain
Partial Sale (30-50%):
- Owner retains some equity and involvement
- Company still gets substantial tax benefits (proportional to ESOP ownership)
- Staged transition allows time for leadership development
- Can sell remaining shares later
- New 10% deferral applies to each sale
Staged Sale:
- Sell 40% in 2028, 60% in 2030 (for example)
- Allows gradual transition
- Multiple opportunities to use 10% deferral
- Retains leadership continuity
Alternative Exit Strategies for S Corps
Not every S corporation owner should pursue an ESOP sale, even with the new tax benefit. Consider these alternatives:
1. Management Buyout
Best for: Companies with 1-5 key leaders who should own the business
Advantages:
- Faster timeline: 30-60 days versus 6-12 months for ESOPs
- Lower setup costs: $25,000-$50,000 versus $100,000-$250,000
- No ongoing ESOP compliance requirements
- Simpler structure and administration
- Works well for smaller companies (under 20 employees)
Disadvantages:
- Management team needs financing capability
- No Section 1042 deferral available
- No corporate income tax benefits
- Fewer employees benefit from ownership
Tax treatment: Standard capital gains tax applies (no deferral), but transaction closes quickly
2. Strategic Sale to Third Party
Best for: Owners prioritizing maximum sale price and immediate liquidity
Advantages:
- Often commands premium pricing
- Complete, immediate exit
- No need to maintain involvement
- Cash in hand at closing
- Simple, clean transaction
Disadvantages:
- Less control over company culture and employee retention
- Full capital gains tax due immediately (no deferral)
- Loss of company independence
- Employees don't gain ownership
Tax treatment: Full capital gains tax, but deal closes in 3-6 months typically
3. Hybrid Structures
Partial ESOP + Management Buyout:
- ESOP owns 30-40%, management team buys 20-30%, you retain 30-40%
- Provides some Section 1042 benefit (10% of the 30-40% sold to ESOP)
- Staged transition with multiple exit points
- Shares tax benefits with broader employee base
Staged ESOP with Put Options:
- Sell 40% to ESOP now
- Company grants you puts for remaining 60% over 3-5 years
- Multiple chances to use 10% deferral benefit
- Retains S corp tax advantages throughout
- Month 1-2: Feasibility Analysis
- Month 3-4: Detailed Planning
- Month 5-8: Documentation and Approval
- Month 9-12: Closing and Implementation
Key Decision Factors
When ESOP makes sense:
- Company has consistent EBITDA of $1M+
- Strong cash flow to service ESOP debt
- Reasonable debt-to-EBITDA ratio post-transaction
- Management team capable of running company
- 20+ employees to benefit from plan
When to consider alternatives:
- Company has fewer than 15 employees
- Inconsistent profitability
- High debt levels already
- Weak management bench
- Owner needs 100% cash at closing (ESOP sales often include seller notes)
ESOP may be right if you:
- Care deeply about employee welfare and retention
- Want to preserve company culture and independence
- Can wait 12 months for transaction to close
- Are comfortable with seller financing (receiving payments over time)
- Can reinvest proceeds in stocks/bonds (not real estate)
- Want to remain involved for 2-5 years post-sale
Consider alternatives if you:
- Need immediate 100% liquidity
- Want a clean break with no ongoing involvement
- Prefer to invest proceeds in real estate or other non-QRP assets
- Have fewer than 15 employees
- Want to maximize sale price above all else
Questions to Ask Yourself Now
Timing:
- Is my target exit between now and 2027? (Consider waiting until 2028 for the new benefit)
- Can I wait 6-12 months for an ESOP transaction to close?
- Am I prepared to stay involved for 2-5 years during transition?
Financial:
- Does my company have sufficient cash flow to support ESOP debt?
- Do I need 100% cash at closing, or can I accept seller financing?
- Can I afford to reinvest sale proceeds in stocks/bonds rather than real estate?
- Will the 10% deferral (~$90,000 on a $5M sale) meaningfully impact my retirement?
Legacy:
- How important is employee ownership to me?
- Do I want to preserve company independence and culture?
- Am I comfortable with broad-based employee ownership versus selling to 1-2 key people?
Practical:
- Does my company have 20+ employees to benefit from an ESOP?
- Is my management team strong enough to run the company?
- Are my financials audit-ready?
The Bottom Line
Starting January 1, 2028, S corporation owners gain a valuable new tax benefit: the ability to defer capital gains on 10% of ESOP sale proceeds. While this represents a smaller deferral than what's available to other corporate structures, it's a significant improvement over the current rule (zero deferral).
- This is a new benefit, not a deadline. There's no need to rush transactions before 2028—in fact, waiting lets you access the benefit.
- Your S corp ESOP status is extremely valuable. The company's tax-free status on ESOP-owned profits is a massive ongoing benefit that supports employees and growth.
- The 10% deferral isn't the only reason to do an ESOP. Consider culture, legacy, employee welfare, and long-term company sustainability.
- ESOPs aren't right for everyone. Management buyouts and strategic sales are legitimate alternatives with different benefits and drawbacks.
- Plan ahead. ESOP transactions take 6-12 months, so start conversations 12-18 months before your target exit date.
Need Help Evaluating Your Options?
Our team specializes in S corporation exit planning, including ESOP sales, management buyouts, and strategic alternatives. We help you model the real numbers, understand your options, and design a transition that works for you, your employees, and your company's future.Contact us for a confidential consultation to discuss your specific situation.
