# ESOPs for California Business Owners

> How an ESOP buys a California owner's stock, the section 1042 rollover, California's tax treatment under Rev. & Tax. Code 18042 and 23802, and who you need.

Source: https://ridleylawoffices.com/esop-california/

**Short answer:** An ESOP is a federally regulated retirement plan that buys the owner’s stock for the employees, usually with money the company borrows and repays. California follows most of the federal tax rules, including the owner’s gain deferral for a sale of C corporation stock. An ESOP needs a valuation firm, a trustee, and ERISA counsel from the start. It isn’t a do-it-yourself sale or a general business lawyer’s project.

- An ESOP is a qualified stock bonus plan designed to invest primarily in the employer’s stock (IRC § 4975(e)(7)).
- A seller of C corporation stock can defer gain if the ESOP owns at least 30 percent after the sale and the seller reinvests in qualified replacement property (IRC § 1042).
- California applies section 1042 to individuals but limits it to domestic C corporations for tax years before 2028 (Rev. & Tax. Code § 18042).
- An S corporation owned by an ESOP still pays California’s 1.5 percent franchise tax on its income (Rev. & Tax. Code § 23802).
- Valuations of stock that isn’t publicly traded must be done by an independent appraiser (IRC § 401(a)(28)(C)).

ESOPs come up when an owner wants to retire, has no family successor, and doesn’t want to sell to a competitor. They can work well. They’re also a regulated retirement plan with fiduciaries, annual valuations, and a repurchase promise that lasts for decades. Below is how an ESOP works, how California taxes it, and who you’ll need on the team. For the other ways out, start with [how to sell a small business in California](https://ridleylawoffices.com/how-to-sell-a-business-california/).

## What is an ESOP?

An employee stock ownership plan is a retirement plan that owns company stock for the employees. The Internal Revenue Code defines it as a defined contribution plan that is a qualified stock bonus plan, or a stock bonus and money purchase plan, designed to invest primarily in qualifying employer securities ([IRC § 4975(e)(7)](https://www.law.cornell.edu/uscode/text/26/4975)).

The employees don’t buy their shares. The company funds the plan, a trust holds the stock, and shares are allocated to employee accounts over time. When employees leave or retire, they’re paid out.

An ESOP holds “employer securities,” which the Code defines as common stock of the employer ([IRC § 409(l)](https://www.law.cornell.edu/uscode/text/26/409)). That’s why an ESOP company is a corporation. An LLC taxed as a partnership would have to reorganize before an ESOP could buy in. See [LLC vs. S corp in California](https://ridleylawoffices.com/llc-vs-s-corp-california/) for how the entity types differ.

## How does an owner sell to an ESOP?

Most owner sales are financed with a loan. The steps usually run like this:

1. A feasibility study and a preliminary valuation test whether the company can carry the debt.
2. The company adopts the plan and trust, and a trustee is appointed to act for the plan.
3. The trustee’s independent appraiser values the stock, and the trustee negotiates the price with the owner.
4. The company borrows from a bank, from the owner, or both, and lends the money to the ESOP.
5. The ESOP buys the owner’s shares, often with part of the price paid by a seller note.
6. Each year, the company makes contributions to the ESOP, and the ESOP uses them to repay the loan. Shares are released to employee accounts as the loan is paid down.

Company contributions an ESOP uses to repay principal or interest on a loan taken out to buy employer stock are deductible, within the limits in [IRC § 404(a)(9)](https://www.law.cornell.edu/uscode/text/26/404). That deduction is much of what makes the math work.

A plan can buy employer stock from the owner, who is a party in interest, only for adequate consideration ([29 U.S.C. § 1108(e)](https://www.law.cornell.edu/uscode/text/29/1108)). In practice, that means the trustee can’t pay more than fair market value. That’s why the trustee and the appraiser need to be independent of the owner. For the valuation methods themselves, see [how to value a small business in California](https://ridleylawoffices.com/how-to-value-a-small-business-california/).

## Who has to be on the team?

An ESOP needs a valuation firm, a trustee, and ERISA counsel. ERISA is the federal law that governs retirement plans, and the plan and trust documents are ERISA work.

| Role | What they do |
| --- | --- |
| Independent appraiser (valuation firm) | Values the stock for the sale and every year afterward. Required for stock that isn’t publicly traded ([IRC § 401(a)(28)(C)](https://www.law.cornell.edu/uscode/text/26/401)). |
| ESOP trustee | A fiduciary who acts for the employees, negotiates the price, and votes the shares. Often an independent professional trustee. |
| ERISA counsel | Drafts the plan and trust, represents the company or the trustee, and handles IRS and Department of Labor compliance. |
| Owner’s counsel | Represents you, the seller, across the table from the trustee. |
| CPA | Models the tax results for you and the company, including section 1042 and the S corporation question. |
| Lender and plan administrator | Finances the purchase, and runs the plan’s annual accounting and filings. |

My role is narrower. I don’t draft ESOP plans or act as ERISA counsel. I work with an owner on the estate plan around the sale: holding the note and the replacement securities in the trust, updating beneficiaries, and making sure the business documents and the plan fit together. That work is at my hourly rate.

## How does the section 1042 rollover work?

An owner who sells C corporation stock to an ESOP can elect to defer the gain if the proceeds are reinvested in qualified replacement property, meaning securities of domestic operating corporations ([IRC § 1042](https://www.law.cornell.edu/uscode/text/26/1042)). The main requirements:

- The ESOP owns at least 30 percent of the company’s stock immediately after the sale (IRC § 1042(b)(2)).
- The seller held the stock for at least three years before the sale (IRC § 1042(b)(4)).
- The seller buys the replacement property within a period that starts three months before the sale and ends 12 months after it (IRC § 1042(c)(3)).
- The deferred gain reduces the seller’s basis in the replacement property (IRC § 1042(d)), so the tax comes due when that property is sold.

For sales after December 31, 2027, federal law extends a limited version to S corporation stock. The election can cover no more than 10 percent of the amount realized (IRC § 1042(h)). That’s far less generous than the C corporation rule, and your CPA should run both versions.

## How does California tax an ESOP sale?

California follows section 1042, with a timing difference that matters. For individual sellers, Rev. & Tax. Code § 18042 applies IRC § 1042 and, for tax years beginning from 1998 through 2027, reads “domestic corporation” as “domestic C corporation” ([Rev. & Tax. Code § 18042](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=18042)). The same section applies the new S corporation rule in IRC § 1042(h) for tax years beginning on or after January 1, 2028.

A corporate seller is covered by a separate section that also adopts section 1042 ([Rev. & Tax. Code § 24954](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=24954)). Because California taxes capital gains at ordinary income rates, according to the FTB, deferring the state gain on a C corporation sale can be worth a great deal.

The S corporation side works differently. Federally, income from S corporation stock held by an ESOP isn’t unrelated business taxable income to the plan ([IRC § 512(e)(3)](https://www.law.cornell.edu/uscode/text/26/512)), so a company fully owned by an ESOP can pay little or no federal income tax. California generally adopts IRC § 512 ([Rev. & Tax. Code § 23732](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=23732)).

The company itself still owes California tax. An S corporation stays subject to California’s franchise tax at a rate of 1.5 percent ([Rev. & Tax. Code § 23802](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=23802)). The same section keeps the S corporation subject to the minimum franchise tax. Ownership by an ESOP doesn’t change either one, so a 100 percent ESOP-owned California S corporation isn’t tax-free at the state level. Some national articles miss this.

S corporation ESOPs also carry an anti-abuse rule. If the plan is structured so that a small group of “disqualified persons” would effectively own the company, allocations to them during a nonallocation year are prohibited, with harsh tax results ([IRC § 409(p)](https://www.law.cornell.edu/uscode/text/26/409)). ERISA counsel and the CPA test for it every year.

## What does the company owe employees later?

It owes a repurchase obligation. When a departing employee receives shares that aren’t publicly traded, the employee has the right to make the company buy them back under a fair valuation formula (IRC § 409(h)).

The put option has to be open for at least 60 days after the distribution, and for another 60 days in the following plan year if it isn’t used (IRC § 409(h)(4)). A company that pays in installments can spread payments over up to five years (IRC § 409(h)(5)). A seller who also takes a note from the company should read [installment sales of a California business](https://ridleylawoffices.com/installment-sale-of-business-california/). Every retirement cashes out real money, so the repurchase liability belongs in the company’s long-range cash planning.

## Is there California help for employee ownership?

Yes. The California Employee Ownership Act directed the state’s Office of the Small Business Advocate to set up a California Employee Ownership Hub. Its listed duties include sharing materials on employee ownership and providing a referral service for legal, financial, and technical resources ([Gov. Code § 12100.33](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=GOV&sectionNum=12100.33)).

The Hub’s materials also cover alternatives to an ESOP, like worker cooperatives and employee ownership trusts, which cost less to set up and suit smaller companies.

## A worked example: an Oxnard distributor

Linda has owned all the stock of a C corporation distribution company in Oxnard for 15 years. The trustee’s appraiser values the company at $8,000,000, and she sells 40 percent to a new ESOP for $3,200,000. The company borrows $2,000,000 from a bank, and Linda takes a $1,200,000 note for the rest.

- The ESOP owns at least 30 percent after the sale, and Linda held the stock for more than three years, so she can elect section 1042.
- She buys $3,200,000 of qualified replacement securities within 12 months after the sale. Her federal gain is deferred, and her basis in the new securities is her old basis in the stock.
- Because she’s selling C corporation stock in a year before 2028, California’s § 18042 lets her defer the state gain too.
- Linda keeps 60 percent and her board seat, and she can sell more to the ESOP later.
- Her living trust is updated to hold the note and the replacement securities, with a successor trustee who can manage them if she can’t.

If the same company were an S corporation, the federal section 1042 deferral wouldn’t be available on a 2026 sale, and the 10 percent version applies only to sales after December 31, 2027. Her CPA would compare that cost against the company’s future tax savings.

## Frequently asked questions

### Is an ESOP right for a small business?

Often not for the smallest. Setup and annual costs are high, because of the valuations, trustee, and plan administration. The CalOSBA Employee Ownership Hub’s own comparison describes ESOPs as suited to companies with about 40 or more employees and $750,000 or more in EBITDA.

### Do employees pay for their ESOP shares?

No. The company funds the plan, and shares are allocated to employee accounts. Employees are paid for their vested shares when they leave or retire.

### Can an LLC have an ESOP?

Not as a partnership. An ESOP holds employer securities, which IRC § 409(l) defines as common stock, so the business needs to be a corporation. An LLC can sometimes elect to be taxed as a corporation or convert, which your CPA and ERISA counsel should review.

### Can I keep control after selling to an ESOP?

Often, yes, at least for a time. A partial sale leaves you as a major shareholder, and the trustee votes the ESOP’s shares. The trustee owes its duties to the employees, not to you, and that changes how the board has to operate.

### Does California tax the section 1042 deferral differently?

California follows section 1042 for individuals under Rev. & Tax. Code § 18042. It limits the deferral to C corporation stock for tax years before 2028 and adopts the federal S corporation rule starting in 2028.

### What happens if the company can’t repay the ESOP loan?

The loan terms and the plan documents decide it, and it can become a dispute among the lender, the trustee, and the seller. That’s a matter for ERISA counsel and, if it turns into a lawsuit, litigation counsel.

More in this series

- [How to sell a small business in California](https://ridleylawoffices.com/how-to-sell-a-business-california/)
- [How to value a small business in California](https://ridleylawoffices.com/how-to-value-a-small-business-california/)
- [Installment sales of a California business](https://ridleylawoffices.com/installment-sale-of-business-california/)
- [The letter of intent to buy a California business](https://ridleylawoffices.com/letter-of-intent-buy-business-california/)
- [Due diligence checklist for buying a California business](https://ridleylawoffices.com/due-diligence-checklist-buying-business-california/)
- [All business owner guides](https://ridleylawoffices.com/business-guides/)

I review ESOP term sheets from the owner’s side alongside ERISA counsel, and I handle the estate plan around the sale, at my hourly rate of $500. See [fees](https://ridleylawoffices.com/fees/), [business succession planning](https://ridleylawoffices.com/business-succession-planning-california/), and my [business law](https://ridleylawoffices.com/business-law-attorney/) page.

[Talk to Eric](https://ridley.click/eric-60)

Book a consultation at [ridley.click/eric-60](https://ridley.click/eric-60) or call 805-244-5291. I work with business owners in Ventura, Santa Barbara, and Los Angeles counties by Zoom or phone.

**Please read:** This page is general information about California law as of September 2026. It isn’t legal, tax, or financial advice, and reading it doesn’t make you my client. ESOP tax treatment depends on facts this page can’t see, so talk with your CPA and ERISA counsel as well. An attorney-client relationship starts only with a signed engagement agreement.