As a family business owner, you understand the vast planning and strategizing required to achieve, maintain and perpetuate success.
Often overlooked in business succession and estate planning is use of an Employee Stock Ownership Plan (“ESOP”) to hold the stock of the family business. To a retiring business owner, an ESOP can provide significant tax savings, difficult-to-obtain liquidity, and a well structured estate plan. To the family business, an ESOP produces tax savings, improves company morale, and enhances success.
A Bit of History
An ESOP is a defined contribution retirement plan which invests primarily in a company’s stock. The stock is held in a trust and managed by a trustee for the benefit of the employees who participate in the ESOP. Employees are not taxed on their share of the ESOP assets, nor on their share of appreciation of the ESOP stock. Upon an employee’s departure from the company, the stock in the employee’s account is purchased by the company from the employee at fair market value.
Advantages to a Retiring Business Owner
Deferred Capital Gains. Federal law provides a significant tax incentive to selling one’s stock to an ESOP. Subject to certain conditions, the seller incurs no taxable gain on the sale;1 any replacement property receives a carry-over basis, thereby deferring tax until its later sale, or if held until death, potentially eliminating the tax through a step-up in basis if held until death.
Tax-free Diversification. In many cases, a business owner holds an un-diversified portfolio, as her wealth is largely comprised of his company stock. Selling that stock to an ESOP at retirement allows the business owner to diversify his portfolio in a tax-free exchange.
A Ready Market for Closely-Held Stock. Finding a willing buyer of closely-held stock, and at a good price, is extremely difficult. This factor alone makes an ESOP attractive, as it creates a ready market for the stock, often at a price in excess of what a third party is willing to pay.
“I’m ready to retire, but, give up control? No thank you!”
Maintaining Control. Finally, certain techniques can be implemented that will enable the owner to keep control over the business after the sale, which in many cases is a key concern and sensitive issue for a business owner.
A More-Effective Estate Plan. When a business owner’s net worth is comprised largely of stock in the family business, at least two estate planning concerns arise; i.e. liquidity and equalizing the inheritances of one’s children, each of whom is set to receive a stock interest in the family business, whether active in the business or not. Sale to an ESOP can resolve each of these concerns.
Liquidity. The family of a business owner, whose portfolio consists mainly of closely-held stock and who dies with a taxable estate, is hard-pressed to raise cash to pay the estate taxes. By selling stock to an ESOP, the business owner obtains liquidity at retirement (and on a tax-deferred (or tax-free) basis).
Who Inherits the Closely-Held Stock? A family business is often operated by some, but not all, family members. If a business owner’s main asset is stock in the family business, achieving equality among his children through his estate plan means that a portion of that stock, which is often coupled with voting rights, must pass to the non-active family members. Selling stock to an ESOP enables the business owner to invest in a diversified portfolio, ultimately allowing the children to share equally in the business’s success without sharing in the management and control of the business.
Benefits to the Family Business
Employee Incentives. An ESOP provides participating employees with an ownership stake in the company. This opportunity is viewed by the employees as a significant financial benefit and is a proven motivational tool which translates into improved company morale and increased chances for corporate success.
Tax Deductions. Up to certain limits, the company’s contributions to the ESOP are tax deductible. If the business contributes cash, the ESOP can use the cash to purchase company stock (as in the case of a retiring business owner). The business can also directly contribute shares of company stock, giving rise to a deduction for the full value of the contribution. This use of pre-tax earnings can significantly increase the company’s cash flow.
Leveraged ESOPs. An ESOP is unique among qualified employee benefit plans in its ability to borrow money. A leveraged ESOP uses borrowed funds to purchase company stock, which can result in additional tax advantages. Contributions used to repay both interest and principal on an ESOP loan are deductible, as may be dividends paid to the ESOP on stock acquired with debt, where the dividends are used to make principal or interest payments.
An ESOP can provide significant benefits to a business owner’s estate and business succession plan, as well as to the business itself. Please contact us at SGR to learn more.
Capital gains tax is deferred if: (i) the shareholder owned the stock for more than 3 years; (ii) he reinvests in a portfolio of domestic operating companies; and (iii) the ESOP owns at least 30% of the company’s stock. Note that an S corporation shareholder is not eligible for this tax deferral. ↩