ESOP Business Solutions

The Problem. Owners of closely held businesses face a difficult tax scenario when they decide to diversify their personal wealth or transition the ownership of their company. A common scenario is an owner who would like to diversify his/her personal wealth or transition the company to family or a management group. The problem is that these groups seldom have the funds to purchase the stock outright. As an alternative, many owners investigate the ability of the company to "fund" the transition by either redeeming the owner's shares or bonusing dollars out to family or management to provide them with the funds to purchase. Due to various levels of federal and state taxation, on average such a scenario will cost the company $3 in revenue for every $1 received by the owner net of tax. It is easy to see that such a scenario creates significant cash flow issues for the company.

The Solution. How does such a business solve, what is referred to as, the "3 for 1" problem? One increasingly popular method is to use the tax benefits of an ESOP to facilitate the transition of ownership. By using an ESOP, the scenario is structured to allow $1 of company revenue to flow through to the owner untaxed. Therefore, the 3 for 1 problem has become a 1 for 1 solution. By solving the problem, the company's cash flow issues are eased and the company can afford to purchase the owner's stock. Therefore, allowing the shareholder to diversify his wealth and provide a smooth transition of management succession.

What are the Motivations that Prompt The Use of an ESOP?
Shareholder Motivations

• To diversify personal wealth without incurring tax liability or giving up control of the company.
• To facilitate the transfer of ownership to the next generation without giving ownership away.
• To pass ownership to key management, who may not have the funds available to acquire the shares outright and wants a future market for their acquired shares.
• To buy out a partner.
• To implement a plan to minimize estate tax liability.

Company Motivations

• To raise capital at a reduced cost to expand the business.

• To create an employee ownership culture to increase profitability and aid in employee recruiting and retention.

• To create a 100% employee owned company that is also 100% exempt from federal (and most state) taxation.

• To spin off a line of business without selling to an industry competitor.

What are the Tax Incentives Created by an ESOP Transaction?Shareholder Tax Incentives

• §1042 Tax Free Exchange. To encourage employee ownership, Congress added Section 1042 to the Internal Revenue Code to provide eligible selling shareholders with the opportunity to sell their shares to an ESOP and defer (potentially forever) tax on the proceeds. As long as the selling shareholder reinvests the proceeds in qualified replacement property (debt or equity in U.S. companies) within the period beginning three months before or ending twelve months after the date of sale, the selling shareholder does not pay capital gains tax on the shares sold to the ESOP. If properly structured, the selling shareholder can have almost complete flexibility in the use of the sale proceeds without worrying about triggering capital gain taxation.

• Minimize Estate Burden. ESOPs also provide shareholders the opportunity to minimize their estate tax burden. The period immediately following an ESOP sale is an attractive time to implement an estate tax reduction strategy. This is because an ESOP transaction generally will temporarily reduce the value of a company's shares, thereby creating a window of opportunity to make gifts of stock to the shareholder's family. The use of a family limited partnership in conjunction with an ESOP can substantially reduce, if not eliminate, the future estate tax burden. Additionally, if the selling shareholder has a charitable intent, an ESOP combined with a charitable remainder trust is a powerful tax planning and charitable giving strategy.

Company Tax Incentives

• Deductible Principal on ESOP Loans. Company contributions to an ESOP are tax deductible. Consequently, a company's contribution to the ESOP to repay a loan used by the ESOP to acquire shares of the Company's stock (an ESOP loan) is tax deductible within certain limits. This results in both the principal and interest on an ESOP loan being deductible, as compared with an ordinary (non-ESOP) loan where only interest is deductible. This tax incentive creates the opportunity to raise tax-efficient capital for acquisition of stock from shareholders or expansion of the business.

• Deductible Corporate Dividends. If either used to pay down an existing ESOP loan or passed through to participants, the dividends attributable to stock held by the ESOP are tax deductible by the company.

• S corporation ESOP Planning Opportunities. ESOPs are particularly effective when combined with a Subchapter S Corporation (or simply "S Corporation"). Together, they create a powerful tool for income tax deferral and capital accumulation within a business. S Corporations are "pass through" entities, meaning their income is not subject to a corporate level income tax. Instead, income is passed through to the company's shareholders, who individually pay tax on the income. Since ESOPs are tax-exempt entities, to the extent that income from the S Corporation is passed through to an ESOP as a shareholder, that income escapes current income taxation at both the corporate and individual levels. Since the corporation doesn't have to distribute any cash to the shareholder to use to pay taxes on income, that money can be kept in the Corporation and used for other (business) purposes. If an ESOP owns 100% of an S Corporation, no income tax will be paid on the corporation's current income (i.e., because the income is allocated to the ESOP, which is a tax-exempt shareholder). However, the tradeoff is that the selling shareholder of an S corporation cannot take advantage of §1042 treatments (see above).

Employee Tax Incentives

• Additional Retirement Planning. Like other qualified retirement accounts, the growth of the employees' ESOP accounts is tax-deferred until retirement. In addition, special tax incentives are available to employees who receive distributions of company stock from the ESOP.

Key Management Tax Incentives

• Market for Key Management Stock. When a company proposes a business succession strategy to key management, one question that always arises is "how and when do we eventually cash in our stock?" When properly structured and maintained, an ESOP can provide a perpetual market for each succeeding management generation.