Is a substantial portion of your net worth tied up in your closely held business? Even if you plan to stay involved with the company for many years, it’s critical to have an exit strategy.
An employee stock ownership plan (ESOP) is one tool that offers a tax-efficient way to share equity with employees. It can also help you address issues such as a lack of liquidity and enable you to provide for family members who don’t work in the business.
ABCs of ESOPs
An ESOP is a qualified retirement plan, similar to a 401(k) plan. But instead of investing in a selection of stocks, bonds and mutual funds, an ESOP invests primarily in the company’s own stock. ESOPs are subject to the same rules and restrictions as qualified plans, including contribution limits, minimum coverage requirements and nondiscrimination testing. They also require an annual stock valuation by an independent appraiser.
Typically, companies make tax-deductible cash contributions to the ESOP, which uses the funds to acquire stock from the current owners. This doesn’t necessarily mean giving up control, though. The owners’ shares are held in a trust, and the trustees — usually officers or other insiders — vote the shares (except on mergers or other major issues). A “leveraged ESOP,” which borrows the funds used to acquire stock, offers the greatest tax benefits. The company’s contributions cover the loan payments, essentially permitting it to deduct both interest and principal.
An ESOP’s earnings are tax-deferred: Participants don’t recognize taxable income until they receive benefits — in the form of stock or cash — when they leave the company, die or become disabled. In closely held companies, employees who receive stock can sell it back to the company at fair market value for a period of time. This creates a potentially significant “repurchase obligation,” which the company should prepare for by setting aside reserves or purchasing key man life insurance.
Fund retirement and provide for family
If a large portion of your wealth is tied up in a closely held business, lack of liquidity can create challenges as you approach retirement. Short of selling the business, how do you fund your retirement and provide for your family?
By selling some or all of your shares to an ESOP, you convert your shares into liquid assets. Plus, if the ESOP owns 30% or more of the company’s outstanding common stock immediately after the sale, and certain other requirements are met, you can defer or even eliminate capital gains taxes. How? You do so by reinvesting the proceeds in qualified replacement property (QRP) — which includes most securities issued by U.S. public companies — within the required period, which stretches from the three months prior to the ESOP purchase to one year after the date of the purchase.
QRP provides a source of retirement income and allows you to defer your gain until you sell or otherwise dispose of the QRP. From an estate planning perspective, a simple but effective strategy is to hold the QRP for life. Your heirs receive a stepped-up basis in the assets, eliminating capital gains permanently.
If you want more investment flexibility, you can pay the capital gains tax upfront and invest the proceeds as you see fit. Or you can invest the proceeds in qualifying floating-rate long-term bonds as QRP. You avoid capital gains, but can borrow against the bonds and invest the loan proceeds in other assets. In addition, you can use a QRP to fund a charitable remainder trust (CRT). Not only does a CRT provide you with a current charitable income tax deduction and an income stream for life, but it can dispose of QRP without triggering tax liability.
If estate taxes are a concern, you can remove QRP from your estate, without triggering capital gains, by giving it to your children or other family members. These gifts are subject to gift and generation-skipping transfer taxes, but you can minimize those taxes using traditional estate planning tools, such as grantor retained annuity trusts (GRATs).
An ESOP can be an effective strategy when some of your children are active in the business and some aren’t. For example, you might sell a portion of your stock to an ESOP and use the proceeds to provide for children outside the business, and give the remaining stock to children in the business. Ideally, gifted stock would be sufficient to keep control of the business in the family.
Right for you?
While the basics have been discussed here, keep in mind that, perhaps more than with most tax strategies, there is a lot of nuance with respect to ESOPs. Certain businesses aren’t eligible, and for others there are steps to be taken in advance of the ESOP to maximize the tax benefits. Please contact our Family Wealth and Individual Tax Group for more details.