Using an ESOP to Purchase Stock of a Retiring Owner on a Tax Deductible and Tax-Free Basis
Posted on October 12, 2014
By: Thomas. M. DiPiazza, Jr., Esq.
Stock in a closely held business often represents the largest asset in a business owner's estate. At some point the owner may want to "cash in" on the success of the business. In those situations where a viable third party purchaser exists, the owner will often be faced with significant tax consequences arising from the sale.
Taxes on the sale of stock can approximate 20% of the purchase price. Furthermore, many buyers prefer to purchase assets from the business rather than stock which, in the context of a "C" corporation, results in double taxation. There is a tax at the corporate level followed by a tax at the shareholder level. This double tax can take approximately 50% of the purchase price.
Where a viable third party purchaser is not available, the only feasible purchaser may be the business' key employees. However, the key employees often will not have sufficient economic resources to make the purchase, and the business owner may be reluctant to enter into extended payment terms with the attendant non-payment risk.
Sale of Stock to ESOP
Where a sale to a third party is either not possible or would result in unacceptable tax consequences, the sale of stock to an employee stock option plan (ESOP) is often the way to provide a purchaser for the retiring owner's business interest. An ESOP is a qualified retirement plan that invests primarily in the stock of the employer sponsoring the plan. If the plan is properly structured, the business owner's stock can be purchased by the ESOP with tax deductible dollars and the owner can avoid paying tax on the sale by reinvesting the proceeds in securities (i.e. stock, bonds, etc.) of domestic operating companies within a fifteen (15) month period beginning three (3) months before and ending twelve (12) months after the sale to the ESOP.
In a typical transaction, the ESOP will purchase sufficient shares from the business owner to own at least 30% of the company after the sale. In order to fund the acquisition, a loan from a bank or other qualified lender is made either to the company (which in turn loans it to the ESOP), or directly to the ESOP. The loan is repaid by tax deductible contributions from the company to the ESOP. These contributions can be either in cash or directly in the form of company stock. Where company stock is contributed, the company may take a deduction for the full value of the stock.
Each year the company can deduct contributions to the ESOP of up to 25% of covered payroll, plus any dividends on ESOP owned stock which are used to repay the loan. Thus, the size of the loan to purchase the stock will be influenced by the company's covered payroll and cash flow. In the event that the ESOP does not purchase all of the business owner's shares initially, it is possible to have multiple sales to the ESOP over time.
Stock purchased by the ESOP is held in a suspense account and allocated to the plan participants as the loan is repaid. Typically, employees are eligible to participate in the plan and begin receiving allocations after completing one year of service with the company. Any year in which an employee works at least 1,000 hours is counted as a year of service. Generally, stock purchased by the ESOP is allocated to the participants' individual accounts according to a vesting schedule. Vesting is a process in which the participants become entitled to an increasing percentage of their individual accounts over time. The ESOP can be structured so that the employees participating in the plan receive the value of the vested portion of their accounts upon termination of employment, disability, death or retirement in company stock, or its cash equivalent.
In order for the sale of stock to the ESOP to qualify for tax-free treatment, certain relatives of the seller, and greater-than-25% shareholders of the company are prohibited from receiving allocations of stock acquired by the ESOP. Thus, where there is a desire to transition ownership of the company to these individuals, other arrangements may need to be made (i.e. gifts, stock options, phantom stock or other non-qualified deferred compensation arrangements).
A successful ESOP transaction has the following benefits:
1. The sale of company stock to an ESOP can assist in transitioning ownership of the business to family members and/or key management employees.
2. Selling to the ESOP preserves the company's independent identity. It also provides a significant financial benefit to valued employees and assures the continuation of jobs.
3. The business owner can avoid any taxes on the sale of stock to the ESOP by purchaseing suitable replacement securities. This allows the owner to exchange an interest in the company for a safely diversified portfolio of securities. The owner's tax basis in the company stock which was sold will be carried over to the replacement securities. If the replacement securities are held until death, a stepped-up basis for those securities is provided under current tax laws which allows the owner's estate/heirs to sell the securities without any income tax.
4. Since the ESOP loan is repaid with tax deductible contributions from the company to the ESOP, the company indirectly finances the purchase with pre-tax dollars. The use of the ESOP makes principal payments deductible, as well as interest on the ESOP loan and cash dividends used to repay the loan.
5. The business owner can save gift/estate taxes by selling enough stock to the ESOP to qualify for tax free treatment, while retaining a minority stock interest (ie. below 50%) that can be gifted to the younger generation family members who are active in the business. The gifts can be valued taking into account discounts for lack of control and lack of marketability. These discounts can result in significant gift and estate tax savings. For a business owner who is in a marginal estate and gift tax bracket of approximately 50%, taxes equal to one-half of the discount can be saved. For example, a valuation discount of $500,000 would result in a savings of $250,000.
Planning Point: Where a business owner wants to avoid the significant tax consequences of selling to a third party (or needs to create a market for his or her shares and has suitable key employees capable of running the business), a sale to an ESOP should be considered. Unlike other techniques used to convert a business owner's interest into cash, the use of an ESOP, in combination with an acquisition loan, is extremely powerful since it allows for the acquisition on a tax deductible basis and allows the business owner to avoid paying tax on the gain from the sale. If you are interested in discussing whether you may be a candidate for an ESOP sale, please contact the author at 585-987-2861.