ESOPs aid business owners in succession, liquidity

by John Qua

for the Business Journal

Perhaps you're a business owner in your 60s, thinking about succession options for your business. The outright sale of your business doesn't appeal to you, because you'd like some involvement in the business over the next few years. Is there a way to transfer ownership in your business yet retain some measure of control? These desires can seem like competing goals.

It is possible to fulfill these two goals with the help of a qualified retirement plan called an employee stock ownership plan. ESOPs allow you to gain liquidity from a business' assets for a number of reasons, including succession.

Through an ESOP, you can sell shares of your company to your employees and receive a fair-market price in return, yet at the same time defer capital gains taxes and create tax deductions for your business.

How ESOPs work. In most cases, a company sponsors an ESOP, which is a qualified retirement plan for all eligible employees, by making tax-deductible, profit-sharing contributions. The ESOP then borrows money from a financial institution, and the loan is guaranteed by the sponsoring corporation. Proceeds of the loan are used to purchase the company's stock from its owner.

Occasionally, an ESOP is not a leveraged transaction that involves borrowing. In these cases, an employer instead periodically contributes cash or stock directly to the ESOP.

Each year, the company contributes to the ESOP to reduce the principal and interest on the loan. As the debt is repaid, participating employees become the beneficiary owners of the shares. As employees retire or leave the company, they receive their vested shares. At that time, the company must offer to buy back an employee's shares at fair-market value for cash.

Tax benefits of ESOPs. Even though recent tax legislation reduced the capital gains tax on assets held 18 months or longer from 28 percent to 20 percent, tax deferral remains an attractive feature of an ESOP. Under certain circumstances, an ESOP even allows you and your heirs to avoid capital gains taxation altogether.

If you sell at least 30 percent of the stock of your closely held corporation to an ESOP, the IRS allows you to defer recognition of a taxable gain in the sale, as long as you meet certain criteria.

You must reinvest the proceeds in what is called "qualified replacement property" within 15 months of the sale (three months prior to and 12 months following the sale). As the selling shareholder, you must have held your shares for three years prior to the sale, and your capital must have been at risk when you originally acquired the stock.

Qualified replacement property may be any combination of securities of a qualifying publicly or privately held domestic operating company. The tax deferral remains in effect as long as you hold the securities.

In addition, if you hold these securities until your death and do not alter the composition of the portfolio after the 12-month period following the sale, the capital gain recognition may be avoided altogether.

This can create substantial liquidity for your estate.

Because the principal payments you make on ESOP loans are considered contributions to a qualified retirement plan, they are tax-deductible up to 25 percent of the annual compensation of the employees who participate in the plan. Any contributions made to pay off interest on the loan are fully deductible to your company.

In addition, dividends paid on ESOP-held stock are a deductible expense if they are used to reduce the ESOP loan or are distributed directly to employees. These dividends are not counted against the 25 percent benefit ceiling.

Your employees will appreciate the fact that they are not taxed on any aspect on an ESOP company contributions or account gains until they withdraw their vested funds upon leaving the company or retiring. Even then, a distribution can be rolled over into an IRA to continue to defer taxes.

Why consider an ESOP?

Most business owners are interested in ESOPs as a way to transfer ownership. They can be an attractive way for a business owner to phase out of a business gradually, gaining liquidity from the business' assets, yet retain some control in the business in the process.

With an ESOP, for example, you could gradually exit from your business, perhaps selling 30 percent of the business to your employees in the first stage and your remaining interest in a second ESOP transaction five or so years later.

Here are some other reasons you might consider instituting an ESOP:

?You need financing for business growth. You may be able to finance the expansion of your business, make acquisitions or fund other business needs at a lower cost than through other forms of debt.

?You want liquidity for your business assets. Selling shares in your business converts your equity in the company to a more liquid investment, while at the same time allowing you to maintain control of your business.

One of many alternatives.

If you are hoping to provide for your company's future or convert your equity to a more liquid investment, you might want to discuss your objectives with your business adviser.

An ESOP is just one of many alternatives. You might better meet your particular objectives by selling your business to other existing owners or to a third party, for example.

A business adviser could help you determine the feasibility of an ESOP by analyzing your company's value, employee compensation and debt capacity.

He or she could also help you find financing for the ESOP transaction and coordinate the activities of the ESOP advisers, including employee benefits consultants, attorneys or independent valuation experts.

While you might be interested in minimizing taxes through an ESOP, a financial consultant can help you determine what other factors should guide your thinking, such as your age, tax profile, investment goals and risk tolerance.

A business adviser can help you make the most of this opportunity by invest-

ing the proceeds from the transaction in a portfolio of securities that best suits

your individual financial goals and objectives.

(John Qua is senior vice president and director, business financial services, for Merrill Lynch.)

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