A C-corporation can generally deduct contributions to an Employee Stock Ownership Plan (ESOP) of up to 25% of eligible employee payroll. A C-corp that funds its ESOP with a loan can deduct much more than that.
Each employee also has a personal ceiling. The Section 415(c) annual additions limit is $72,000 for 2026 and $75,000 for 2027, under Internal Revenue Service (IRS) Notice 2026-66.
Most problems come from a clash between two parts of the Internal Revenue Code (IRC). IRC § 404 controls how much the company can deduct. IRC § 415 controls how much can land in one employee's account each year.
A contribution can be fully legal for the company and still overfill the accounts of its highest-paid people. The plan then has to correct the excess, and the correction is taxable to those employees.
The payoff for getting the rules right is real. A National Center for Employee Ownership study of workers aged 28 to 34 found that employee-owners had 92% higher median household net worth than their peers at other companies.
The Three Pillars of ESOP Contribution Law
Three parts of the tax code govern ESOP limits. Each one has its own job, and each one affects the others.
The first is IRC § 404, which sets the company-wide limit. It caps the employer contributions a business can make to all of its retirement plans and still deduct. Think of it as the total size of the pie the company can serve.
The second is IRC § 415, the individual limit. It ignores the company's total. It looks only at how much goes into one person's account in a single year. This is the size of one employee's slice.
The third is IRC § 404(k), a rule just for C-corporations. It lets the company deduct dividends paid on ESOP stock, and those dividends are not counted toward the other two limits. It is a lawful way to make the pie bigger.
2026 and 2027 ESOP and Retirement Plan Limits at a Glance
The IRS adjusts the dollar limits every fall. The 2026 figures come from Notice 2025-67. The 2027 figures come from Notice 2026-66, released on Nov. 12, 2026.
| Limit | 2026 | 2027 |
|---|---|---|
| Annual additions per employee (§ 415(c)) | $72,000 | $75,000 |
| Compensation cap (§ 401(a)(17)) | $360,000 | $375,000 |
| 401(k) elective deferral (§ 402(g)) | $24,500 | $25,500 |
| Catch-up, age 50 and older | $8,000 | $8,500 |
| Catch-up, ages 60 to 63 | $11,250 | $11,750 |
| Highly compensated employee threshold | $160,000 | $170,000 |
| Key employee (officer) threshold | $235,000 | $245,000 |
| ESOP distribution threshold (§ 409(o)) | $1,455,000 | $1,505,000 |
| ESOP distribution extension amount (§ 409(o)) | $290,000 | $300,000 |
The last two rows control how long an ESOP can stretch out payments on very large account balances. They do not change how much the company can contribute.
Owners who also fund individual retirement accounts or health savings accounts can check the 2026 retirement and HSA limits for those accounts, since they follow separate rules.
IRC § 404: The Company's Master Deduction Limit
The main rule for company contributions is in Internal Revenue Code Section 404. It stops a business from wiping out its tax bill by pouring unlimited money into retirement plans. It sets a ceiling on the deduction each year.
For 2026 and 2027, the deduction limit for all defined contribution plans combined, including 401(k) plans and ESOPs, is 25% of eligible payroll. Eligible payroll is the total compensation of every employee who benefits under the plans.
One person's pay is capped in that total. The cap is $360,000 for 2026 and $375,000 for 2027, as shown in the IRS cost-of-living table. Pay above the cap is ignored.
This limit is a shared ceiling for employer money. The company match, profit-sharing contributions and ESOP contributions all count against it.
Employee 401(k) deferrals do not count against it. IRC § 404(n) keeps them out of the limit. IRC § 404(a)(12) also puts those deferrals back into the payroll base, so they make the base larger, not smaller.
Here is the trade-off in practice. Say your company makes a 2026 profit-sharing contribution equal to 6% of payroll. That leaves 19% of 2026 payroll for a deductible ESOP contribution. Advisers call this the "crowding out" effect.
If a company contributes more than it can deduct for 2026 or 2027, it owes a 10% excise tax on the excess under IRC § 4972. The employer reports and pays that tax on Form 5330.
The excess generally cannot be handed back to the company. It stays in the plan and may be deducted in a later year, but the excise tax can apply again each year the excess remains.
Timing matters as much as the amount. Under IRC § 404(a)(6), a C-corp can deduct a contribution made after year-end if it is paid by the due date of the corporate return, including extensions.
For a calendar-year C-corp, that due date is April 15. With an extension, it is October 15. A contribution paid one day late counts for the next tax year.
The C-Corp Superpower: Special Deductions for Leveraged ESOPs
A leveraged ESOP is one that borrows money to buy company stock. The company then makes contributions to the plan, and the plan uses them to repay the loan.
C-corporations with a leveraged ESOP get more generous deduction rules under IRC § 404(a)(9). S-corporations do not get these rules. They are the main reason the crowding out problem is easier to solve in a C-corp.
First, contributions used to pay interest on the ESOP loan are deductible without any payroll limit. The interest does not count toward the general limit at all. This helps most in the early years of a loan, when interest costs are highest.
Second, contributions used to repay loan principal get their own limit. It is the same percentage of payroll as the general limit, but it is separate. It is not shared with the 401(k) match or profit sharing.
The two limits stack. A C-corp can deduct employer contributions to its 401(k) plan up to the general limit under IRC § 404(a)(3). It can then deduct principal payments up to a second limit of the same size, plus all of the interest.
One condition applies. The ESOP must actually use the contributions to repay the exempt loan in the year the company claims the deduction. Money that sits in the plan unused does not qualify under these special rules.
The loan terms shape how much interest and principal fall in each year. Owners planning a buyout should understand how leveraged ESOP financing is built before they project deductions.
IRC § 415: The Employee's Personal Contribution Ceiling
IRC § 404 limits the company. IRC § 415 limits the individual. It keeps any one person from sheltering too much money in a single year.
A company can be well inside its deduction limit and still break this rule for one employee. That surprises many owners, because the two tests use different math.
The rule says a person's annual additions cannot be more than the lesser of 100% of compensation or a dollar limit. The dollar limit is $72,000 for 2026 and $75,000 for 2027.
The limit applies across all defined contribution plans of the same employer. An employee's ESOP account and 401(k) account are added together and tested as one.
Annual additions are the sum of three things:
- Employer contributions, including the ESOP contribution, the 401(k) match and profit sharing.
- Employee contributions, including pre-tax, Roth and after-tax 401(k) deferrals.
- Forfeitures from former employees who were not vested, when they are reallocated to the account.
Many employees mix this up with the 401(k) deferral limit. The deferral limit covers only what you choose to put in from your paycheck. The annual additions limit covers that money plus everything the company adds for you.
Rollovers from another plan or an individual retirement account (IRA) are not annual additions. Moving old retirement money into the plan does not use up any of the limit.
If annual additions go over the limit, the plan must fix it. The most common fix is to return the employee's own 401(k) deferrals, with earnings.
The returned deferrals are taxable in the year they are distributed, not the year they were contributed. The plan reports them on Form 1099-R.
Catch-up contributions are not annual additions. They sit on top of the limit.
For 2026, a participant aged 50 or older can receive up to $80,000 in total, which is that year's annual additions limit plus the $8,000 catch-up. At ages 60 to 63, the 2026 total is $83,250.
For 2027, the total is $83,500, which is that year's limit plus the $8,500 catch-up. At ages 60 to 63, the 2027 total is $86,750.
One rule changed how catch-ups are made. Starting in 2026, employees whose prior-year Social Security wages from the employer were above an indexed threshold must make catch-ups as Roth contributions. For 2026, the threshold is $150,000 of 2025 wages.
C-Corp Advantage: Special Exclusions from Annual Additions
C-corporations get another break under IRC § 415(c)(6). When its test is met, two items are left out of each person's annual additions:
- Employer contributions used to pay interest on the ESOP loan.
- Forfeitures of shares that were bought with the ESOP loan.
The test is specific. No more than one-third of the employer contributions applied to the loan for the year can be allocated to highly compensated employees (HCEs).
An HCE is generally a more-than-5% owner or someone whose pay was above a set threshold. The threshold is $160,000 for the 2026 plan year and $170,000 for the 2027 plan year. It is measured against pay in the prior year.
When the test is met, participants get extra room under that year's annual additions cap. The company can make larger loan payments without pushing people over their personal limits as fast.
When the test is failed, the interest and forfeitures count for everyone. A company with a small, well-paid workforce can fail it without anyone noticing until year-end testing.
S-corporations do not get this exclusion. The way ESOP shares are allocated across the workforce often decides whether a C-corp passes the one-third test.
Popular Scenarios: Seeing the Rules in Action
Abstract rules become clear with real numbers. These three situations show how the limits play out in the most common ESOP structures.
Scenario 1: The Standard Company with a 401(k) and ESOP
A C-corp has a 401(k) plan and wants to add a non-leveraged ESOP. The employer's match and profit-sharing contributions share the IRC § 404 deduction limit with the ESOP. Employee deferrals do not.
Assume $2,000,000 of eligible payroll for 2026. The 2026 deduction limit is $500,000. The company makes a $120,000 employer profit-sharing contribution to the 401(k) plan for 2026.
| Contribution Type | Deduction Impact | 2026 Example ($2,000,000 payroll) |
|---|---|---|
| Employer 401(k) match/profit sharing | Uses part of the single payroll deduction limit | $120,000 of the $500,000 limit |
| ESOP contribution | Must fit into what is left of that limit | Up to $380,000 |
| Employee 401(k) deferrals | Do not count against the 25% limit | $0 of the limit used |
This crowding out effect means the company cannot max out employer contributions to both plans. It has to decide how to split one $500,000 limit for 2026 between the 401(k) and the ESOP.
Employees can still defer as much as the 401(k) rules allow. Their deferrals leave the full $380,000 open for the 2026 ESOP contribution.
Scenario 2: The Leveraged C-Corp Buyout
A C-corp's ESOP borrows money to buy out a founder. This structure opens the special C-corp deduction rules. The company can fund its 401(k) plan and the ESOP loan payments in the same year.
| Funding Source | Tax Deduction | 2026 Example ($3,000,000 payroll) |
|---|---|---|
| Employer 401(k) contributions | Deductible up to the general payroll limit | Up to $750,000 |
| ESOP loan interest | Fully deductible with no payroll limit | $400,000, for example |
| ESOP loan principal | Deductible up to a separate limit of the same size | Up to another $750,000 |
| Total possible deduction | All three added together | $1,900,000 |
Here the company can contribute to its 401(k) plan and still make large, deductible payments on the ESOP loan. The total deduction can run far past the general limit that binds the company in Scenario 1.
Worked Example: Leveraged C-Corp Deduction for 2026
A company has 40 ESOP participants. Its eligible 2026 payroll is $3,000,000 after each person's pay is cut off at the 2026 compensation cap.
The 2026 math runs in four steps:
- General limit: one-quarter of $3,000,000 is $750,000 for 2026. The company deducts $250,000 of employer 401(k) contributions under it.
- Loan interest: the company contributes $400,000 in 2026 that the ESOP uses to pay interest. All of it is deductible, with no cap.
- Loan principal: the separate 2026 limit is also $750,000. The company contributes $700,000 that the ESOP uses to repay principal, and deducts all of it.
- Total for 2026: $250,000 plus $400,000 plus $700,000 equals $1,350,000.
The total 2026 deduction is 45% of payroll. A non-leveraged plan with the same payroll would stop at $750,000 for 2026.
The company-level math is only half the job. Each employee's allocation is still tested against the 2026 annual additions limit.
If the one-third HCE test under IRC § 415(c)(6) is met, the $400,000 of 2026 interest is left out of that test. Only the principal payments, the 401(k) money and any other forfeitures count toward each person's limit.
Scenario 3: The "HCE Squeeze"
A high-earning executive under age 50 works at a company with a leveraged ESOP. Her own 401(k) savings plus large company contributions push her over the IRC § 415 limit, even though the company's total contribution is legal.
This is the situation behind a common office story. A coworker says the ESOP contribution was so large this year that he is getting a check back for some of his 401(k) money.
| Contribution Source | 2026 Annual Addition Amount |
|---|---|
| Executive's 401(k) deferral | $24,500 |
| Company 401(k) match | $15,000 |
| ESOP allocation | $35,000 |
| Total annual additions | $74,500 (exceeds the 2026 limit of $72,000) |
The result is an excess of $2,500. The plan refunds $2,500 of the executive's own 401(k) deferrals, plus earnings. The refund is taxable to her in the year it is distributed.
The 2027 numbers are tighter but still over. With the 2027 deferral limit of $25,500 and the 2027 cap of $75,000, the same pay mix totals $75,500. That is $500 over.
Age changes the answer. If she were 50 or older, the excess deferral could be recharacterized as a catch-up contribution, up to that year's catch-up limit. Nothing would need to be refunded.
IRC § 404(k): The C-Corp's Dividend Relief Valve
C-corporations have one more tool for managing these limits: deductible dividends under IRC § 404(k). A C-corp can pay dividends on stock held by the ESOP and deduct them if they are used in approved ways.
There are three approved uses. The dividend can repay the ESOP's acquisition loan. It can be paid to participants in cash. Or it can be reinvested in employer stock when the participant elects that.
Repaying the loan is the most strategic use, and it brings two benefits. The dividend is not an employer contribution under the IRC § 404 deduction limit. It is also not an annual addition under IRC § 415.
That makes dividends a direct answer to the HCE squeeze. If a large loan payment would push executives over their personal limits, the company can cover part of it with a dividend. The company still gets a deduction, and nobody's personal limit is touched.
The deduction comes with conditions. The dividend must be reasonable, and the IRS can disallow one that is not. A dividend far above what the company would normally pay on its stock invites that challenge.
Timing is fixed too. The deduction is allowed in the year the dividend is paid to participants or used to repay the loan, not the year it is declared.
A special rule protects employees. When dividends on shares already allocated to their accounts are used for loan payments, those participants must receive released shares with a value at least equal to the dividend.
Critical Comparison: C-Corp vs. S-Corp ESOPs
The contribution rules are very different for C-corporations and S-corporations. Applying the wrong set can lead to major tax penalties. C-corps have more flexibility and higher potential deductions, especially in leveraged plans.
Rules for 2026 and 2027 plan years:
| Feature | C-Corporation (2026 and 2027) | S-Corporation (2026 and 2027) |
|---|---|---|
| Deduction for loan interest | Unlimited. Does not count toward any payroll-based limit. | Limited. Counts toward the single payroll limit. |
| Deduction for loan principal | Deductible up to a separate payroll limit of the same size. | Deductible, but shares the single payroll limit. |
| Deductible dividends (IRC § 404(k)) | Yes. Can be used for loan payments and bypass other limits. | No. S-corp distributions are not tax-deductible. |
| Seller tax deferral (IRC § 1042) | Yes. Sellers can defer capital gains tax on the sale. | Partial. For sales after Dec. 31, 2027, a seller can elect to defer gain on up to 10% of the amount realized. Before then, none. |
| Interest and leveraged-forfeiture exclusion from § 415 (§ 415(c)(6)) | Yes, if the one-third HCE test is met. | No. |
| Tax on the ESOP's share of profits | Profits are taxed at the 21% corporate rate. | The ESOP's share of income is not subject to federal income tax. |
The S-corp entry in the seller deferral row comes from SECURE 2.0 Act § 114, which added IRC § 1042(h). Until sales made after that date, an S-corp seller gets no deferral at all.
The last row explains why many companies still pick S-corp status despite the tighter contribution rules. A C-corp owner weighing the two should also look at how sellers defer capital gains on the sale itself, because that benefit can outweigh the annual deduction math.
Common and Costly Contribution Mistakes to Avoid
ESOP contribution limits take planning. A few errors show up again and again, and each one leads to tax penalties or cleanup work. They sit beside the broader list of common ESOP admin mistakes that plan sponsors run into.
Mistake 1 is forgetting to aggregate plans. Employer contributions to the ESOP, the 401(k) match, profit sharing and any other defined contribution plan are added together under IRC § 404. Employee deferrals are not part of that total.
The result of missing this is a contribution above the deductible limit. For 2026 and 2027, the company then owes the 10% excise tax under IRC § 4972 on the overage.
Mistake 2 is ignoring the individual IRC § 415 limits. Looking only at the company's total deduction can overfill the accounts of your highest-paid employees.
The result is a plan failure that has to be corrected. Your key people get part of their 401(k) deferrals back as taxable income, usually with no warning.
Mistake 3 is applying C-corp rules to an S-corp. An S-corp does not get a separate deduction for loan interest or loan principal. Everything shares one limit.
The result is a large overstatement of the company's deduction. Back taxes, interest and penalties follow when the error is found.
Mistake 4 is using the wrong definition of compensation. The plan document picks one definition. It may be W-2 wages, wages subject to income tax withholding under IRC § 3401(a), or an IRC § 415 safe-harbor definition.
Using a different definition than the document names throws off every calculation, from the payroll base to each person's limit. The fix usually means redoing the testing for the year.
Owner-employees make a related error. The limits are based on the salary the company pays you, not on the profit of the business. A large profit with a small salary does not create a larger personal limit.
Do's and Don'ts for Managing C-Corp Contributions
| Do's | Don'ts |
|---|---|
| Do coordinate employer ESOP and 401(k) contributions to stay under the combined IRC § 404 limit. | Don't assume the payroll limit applies only to the ESOP. |
| Do project annual additions for your HCEs early in the year to spot IRC § 415 problems. | Don't wait until year-end to find out an individual limit was breached. |
| Do use deductible IRC § 404(k) dividends for loan payments without affecting individual limits. | Don't forget this tool when you face an HCE squeeze. |
| Do confirm the plan document's definition of compensation before running any calculation. | Don't use a generic payroll number for compliance testing. |
| Do work with an experienced third-party administrator so the testing is done correctly. | Don't try to manage these compliance rules on your own. |
| Do check each year's limits when the IRS publishes them and update payroll projections. The 2027 limits came out in Notice 2026-66. | Don't carry last year's dollar limits into a new plan year. |
The Step-by-Step Process for Fixing an IRC § 415 Violation
Excess annual additions are corrected under the IRS Employee Plans Compliance Resolution System. The current version is Rev. Proc. 2026-34, which took effect on Oct. 22, 2026 and replaced Rev. Proc. 2021-30.
The goal is to bring the employee's account down by the excess amount. The standard correction method under that system starts with the employee's own money and reaches employer money last.
- Refund unmatched deferrals. The plan first distributes the employee's 401(k) deferrals that did not receive a company match, plus earnings on them.
- Refund matched deferrals. If an excess remains, the plan distributes matched deferrals. The related match is forfeited and moved to a plan suspense account.
- Forfeit employer contributions. If an excess still remains, the plan forfeits other employer money, such as the ESOP contribution or profit sharing.
Refunded deferrals and their earnings are taxable in the year distributed. The plan reports them on Form 1099-R, and they cannot be rolled over to an IRA or another plan.
Money in the suspense account is used for future contributions or plan expenses. Step 3 is the last resort, because it cuts the benefit the company meant to provide for the year.
What to Do Next
- Read your plan document and write down the definition of compensation it uses for testing.
- Total last year's eligible payroll, capping each person at that year's compensation cap.
- Add up employer contributions to every defined contribution plan and compare the total with the IRC § 404 limit.
- Ask your administrator for a mid-year projection of annual additions for every HCE.
- Pay year-end contributions by the due date of your Form 1120, including extensions.
Frequently Asked Questions (FAQs)
Can a C-Corp deduct more than 25% of payroll for its ESOP?
Yes. In a leveraged ESOP, IRC § 404(a)(9) makes contributions used for loan interest deductible without limit. Contributions used for loan principal get their own separate payroll limit. Together they can push total deductions well past the general limit.
Do my 401(k) contributions affect my ESOP limits?
Yes. Your 401(k) deferrals count toward your annual additions limit under IRC § 415, which is $72,000 for 2026 and $75,000 for 2027. Catch-up contributions do not count. Large deferrals can shrink the ESOP allocation you are able to receive in a given year.
What happens if my personal account gets too much money in one year?
The plan corrects the excess under the IRS plan correction program, usually by refunding your own 401(k) deferrals plus their earnings. The refund is taxable in the year it is paid to you, and the plan reports it on Form 1099-R.
Are dividends paid to the ESOP tax-deductible?
Yes, for a C-corporation, if the dividends are reasonable and are used to repay the ESOP loan, passed through to employees, or reinvested in company stock at their election. Cash dividends passed through are taxable to the employees, but the 10% early-distribution tax does not apply to them.
Is there a limit on my salary for these calculations?
Yes. An individual's pay is capped when the company figures its deduction limit. The cap is $360,000 for 2026 and $375,000 for 2027. Salary above that amount is left out of the payroll base.
What are the ESOP contribution limits for 2027?
For 2027, the per-employee annual additions limit rises by $3,000 from the 2026 figure, and the compensation cap rises by $15,000, under Notice 2026-66. The company deduction limit is not indexed. It stays at the same share of eligible payroll, plus the leveraged C-corp exceptions.
Do catch-up contributions count toward the ESOP annual additions limit?
No. Catch-up contributions are excluded from the IRC § 415(c) limit. They are $8,000 for 2026 and $8,500 for 2027, or $11,250 and $11,750 at ages 60 to 63. An older employee's excess deferral can sometimes be recharacterized as a catch-up instead of being refunded.
Can S corporation owners get the Section 1042 tax deferral when selling to an ESOP?
Only partly, and not yet. For sales after Dec. 31, 2027, an S-corp seller can elect to defer gain on up to 10% of the amount realized, under SECURE 2.0 Act § 114. C-corp sellers can defer the full gain if every IRC § 1042 requirement is met.
Related reading
- What Makes A Business A Good Fit For An ESOP? (w/Examples) + FAQs
- What Are The Tax Benefits Of An S-Corp ESOP? (w/Examples) + FAQs
- Why Must ESOPs Be Broad-Based For All Employees? (w/Examples) + FAQs
- What Are The S-Corp ESOP Nonallocation Rules? (w/Examples) + FAQs
- Can an ESOP Be an S Corp Shareholder? (w/Examples) + FAQs
- Can Shareholders Really Get ESOPs? (w/Examples) + FAQs