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Employee stock ownership plans offer many advantages
Employee Stock Ownership Plans, or ESOPs, have been used as succession planning tools for family-owned businesses for 40 years.
However, not all business owners or their attorneys, accountants or other advisors are familiar with the advantages an ESOP offers to a family-owned corporation and its shareholders. To test your ESOP IQ, let's take a little quiz:
1. Can a shareholder of a closely held corporation sell some or all of his or her stock to an ESOP at fair market value without incurring current federal or state income tax on the realized gain?
2. Can an ESOP give shareholders in a closely held corporation a ready market for sale of some, or all, of their stock?
3. Can a company effectively buy out some or all of its shareholders using fully tax deductible dollars?
4. Can an ESOP motivate employees of a closely held company to deliver their best performance for the company, thereby maximizing the company’s profits and the value of their investment in the company?
5. Can current federal income tax be avoided on income of an S corporation to the extent stock in the corporation is owned by an ESOP?
If you answered "no" to any of these questions, you may want to brush up on the advantages of ESOPs to closely held corporations and their shareholders.
What is an ESOP?
An ESOP is a qualified retirement plan, similar in structure to a 401(k) or profit-sharing plan with respect to the general rules concerning eligibility to participate, vesting and non-discrimination.
Each ESOP participant has an account that accumulates benefits to be paid at retirement or other termination of employment. However, unlike other retirement plans, an ESOP is designed to invest primarily in stock of the sponsoring employer and many ESOPs only own employer stock.
Also, an ESOP is able to borrow funds to purchase stock of the employer. This "leveraging" capability leads to many creative uses unique to ESOPs. Congress has also provided several major tax incentives to encourage the creation of ESOPs, including:
Fully deductible loan repayments. Employer contributions to the ESOP are fully deductible for federal income tax purposes. The contributions may be used by the ESOP to repay a loan. Thus, tax deductions are available for payment of loan principal as well as interest. That means an ESOP purchase of a shareholder’s stock is much more tax efficient than a redemption of the shares by the corporation or the purchase by another shareholder.
Avoidance of capital gains tax on sale of stock. An owner who sells stock of a closely held C corporation to an ESOP may defer, or completely avoid, income tax on the realized gain if 1) immediately after the sale, the ESOP owns at least 30 percent of the corporation’s outstanding stock, and 2) within 12 months the sale proceeds are reinvested in securities issued by other U.S. operating corporations ("qualified replacement property").
The individual's basis in the employer stock carries over to the qualified replacement property. Upon selling the qualified replacement property, the owner will incur federal and state income tax on the excess of the net sale proceeds over his or her basis in the property. But if the owner holds the qualified replacement property until death, then the owner’s beneficiaries or heirs will take the property at a basis equal to its fair market value on the date of the owner’s death (or an optional date six months later), forever avoiding income tax on pre-death appreciation in the property.
Cash dividends paid on ESOP stock are deductible. A C corporation may deduct for income tax purposes cash dividends that it contributes to an ESOP. The ESOP can allocate the dividend to participant accounts, pay the dividend directly to participants, or use it to pay an ESOP loan.
Reduction or elimination of corporate income tax. An ESOP may own stock in an S corporation, and to the extent it does, the income of the S corporation is attributed to the ESOP, which is a tax-exempt trust that does not pay income tax. That means a 100 percent ESOP-owned S corporation is able to completely avoid income taxation. Also, the unrelated business taxable income rules do not apply to S corporation stock owned by an ESOP.
Using an ESOP in tax planning
Ownership succession planning is critically important in a family-owned business. What will happen to the company when the family members who are actively running the business retire or die? Are other family members active in the business and can they afford to buy it? How does the senior generation divide its estate fairly when some family members are active in the business but others are not? Are key employees willing and able to purchase the company? Is a sale to an outsider feasible and desirable? What are the tax consequences of a sale? What is the impact of a sale on the company’s employees, culture and future?
In reviewing these issues, the use of an ESOP should always be considered. An ESOP may be the ideal solution for the corporation and its shareholders.
Family business owners and their advisors should review the advantages of an ESOP with succession-minded shareholders of a family-owned business to determine whether an ESOP is advisable for them.
Justin W. Stemple is a partner in the law firm of Warner Norcross & Judd LLP. He focuses his practice in employee benefits law, with an emphasis on Employee Stock Ownership Plans. Thanks to Vernon P. Saper for his contributions to this article. Justin can be reached at (616) 752-2375 or firstname.lastname@example.org.