ESOPs valuable tool for business succession plan

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Gary Powell is a member of the Tax & Estate Planning Practice Group in the Springfield office of Husch & Eppenberger LLC. He concentrates in the areas of business law, taxation and estate planning.|ret||ret||tab|

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Employee stock ownership plans have generally been thought of as an employee benefit plan or as a technique of corporate finance. In addition to these traditional uses, ESOPs also can be an integral part of the business succession plan of a business owner.|ret||ret||tab|

Before discussing the use of an ESOP in the estate and business succession plan of a business owner, it is helpful to consider some of the general tax attributes of ESOPs. |ret||ret||tab|

Contributions to an ESOP are deductible by the sponsoring employer (within applicable limits). Income earned by an ESOP is exempt from tax. |ret||ret||tab|

The participant in an ESOP is not required to recognize any taxable income in connection with allocations of employer contributions or earnings to their accounts until their benefits are withdrawn from the plan.|ret||ret||tab|

If the sponsoring employer is a C corporation, a sale of stock by a shareholder to the ESOP sponsored by the employer may qualify for a tax-free rollover of the sale proceeds under Section 1042 of the Internal Revenue Code, if the sale proceeds are invested in "qualified replacement property."|ret||ret||tab|

"Qualified replacement property" generally can be defined as stocks and bonds of United States operating companies. Also, immediately after the sale, the ESOP must own at least 30 percent of the total value of the common stock of the employer.|ret||ret||tab|

If the requirements of Section 1042 are satisfied, the selling shareholder may elect to defer all tax on the sale of his or her stock to the ESOP. |ret||ret||tab|

The seller takes as his or her tax basis in the qualified replacement property a basis equal to his or her former basis in the stock sold to the ESOP (which typically will be very low).|ret||ret||tab|

Thus, the seller needs to develop a strategy for the selection of a qualified replacement property portfolio and for extending the tax deferral. |ret||ret||tab|

A common investment strategy involves the purchase of long-term, floating-rate notes, typically referred to as "ESOP notes." ESOP notes can be monetized by borrowing against them, and buying and selling securities in a margin account. Thus, the taxpayer can reinvest the value of the ESOP sale proceeds in any way that he or she wishes. |ret||ret||tab|

The note-monetization technique enables a taxpayer to pursue an active investment strategy.|ret||ret||tab|

If the sponsoring employer is an S corporation, a tax-free rollover under Section 1042 is not available to the selling shareholder. On the other hand, there are significant tax benefits for S corporation ESOPs.|ret||ret||tab|

An S corporation is not subject to tax under the general S corporation rules. The income of the S corporation is passed through to its shareholders. |ret||ret||tab|

An ESOP is a tax-exempt entity. Thus, any income of an S corporation passed through to an ESOP is not subject to a shareholder-level tax. |ret||ret||tab|

In effect, the income will be deferred until the participants in the ESOP receive their benefits (and they may further defer their tax liability by rolling their benefits over into IRAs).|ret||ret||tab|

If the S corporation is owned 100 percent by an ESOP, this effectively means that no income tax is payable on the earnings of the S corporation until those earnings are ultimately distributed to the ESOP participants at their retirement. |ret||ret||tab|

The selling shareholder is still entitled to long-term capital gain treatment with respect to the sale of his or her stock to the S corporation ESOP.|ret||ret||tab|

A selling shareholder is not required to sell all of his or her stock to receive these tax benefits. |ret||ret||tab|

A tax-deferred sale of some of the stock of a business owner to an ESOP can be a useful estate-planning technique. |ret||ret||tab|

The diversification of wealth that the ESOP transaction offers can enable the business owner to solve other estate planning problems. By selling a portion of his or her shares to the ESOP, the business owner can create a source of estate liquidity on a tax-free basis, while at the same time retaining control of the business and continuing to manage it on a day-to-day basis.|ret||ret||tab|

ESOPs can be successfully coupled with other estate planning strategies. For example, the period following a sale of stock to an ESOP is an ideal time to make a gift of stock of the corporation to children and other family members because the value of the stock will be depressed by the ESOP indebtedness. |ret||ret||tab|

Thus, stock can be transferred to children and other family members at a discounted value. In addition, ESOPs can be combined with use of family limited partnerships or charitable remainder trusts to achieve favorable income and estate tax results.|ret||ret||tab|

In summary, the possible use of an ESOP should not be overlooked by the business owner in structuring a business succession plan as part of an overall estate plan.|ret||ret||tab|

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