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05 Nov Tip Tuesday

Posted at 15:41h in Firm News, Uncategorized by

This week, enjoy an article on Business Transactions Brian wrote for the WealthCounsel Quarterly that was published May 23, 2024.

Business Transitions with Employee Stock Ownership Plans

05/23/24 | WealthCounsel Quarterly | Brian Eagle

Transferring a family business can be one of the trickiest aspects of estate planning. There are multiple challenges for a family to deal with, especially when some members of the family work in the business and others do not. One of the often-overlooked planning strategies to discuss with families is the establishment of an employee stock ownership plan (ESOP). An ESOP is an employee benefit plan in which ownership of a corporation’s[1] stock is transferred to a trust, allowing the employees to take an ownership interest in the company and providing tax advantages to the employees and selling shareholders.[2]

ESOPs are ideal for business owners with 20 or more employees and at least $750,000 in earnings before interest, taxes, depreciation, and amortization (EBITDA) who desire to do any or all of the following:

  • transition their business to their family
  • sell minority interests owned by family members not working in the business
  • keep their business in the community where it is currently located
  • reward employees
  • diversify their portfolio
  • reduce or eliminate estate taxes
  • equalize distributions for children working in the company and children not working in the company
  • potentially create an income-tax-free business entity.

ESOPs may be used to strategically transfer the business to family members or from family members who own a minority interest in a company. The transferring business owner establishes an ESOP to purchase a partial interest in the business for the benefit of the employees, with the remaining interest being owned by the initial owners (e.g., the parents) or other family members (e.g., the children). When the transaction is complete, the ESOP then allocates its ownership of the equity of the company to the participants (i.e., eligible employees) over time as the company makes contributions to the ESOP. The ESOP may obtain the cash to purchase shares through an internal loan from the company. To accomplish the internal loan, the company arranges for financing to be provided by a bank or may negotiate with the selling owners/shareholders for seller promissory notes. The company then loans the funds obtained to the ESOP in exchange for a promissory note between the ESOP and the company. The company makes annual tax-deductible contributions[3] to the ESOP; the ESOP immediately uses these contributions to repay the loan. The ESOP uses the proceeds of the internal loan to purchase the selling shareholder’s interests in the company.

ESOP Story 1: Transferring the Business to Family

Meet Bob, age 70, and his wife Mary, age 68. They have three sons, all of whom are in their forties and are active in leading their business. James is in charge of accounting, Mike is in charge of sales, and Kevin is in charge of operations. Bob has complete confidence in their ability to manage the company without him. Bob and Mary have two daughters who are not involved in the business. The company, JKM Industries, founded by Bob 40 years ago, manufactures and sells boosters and compressors in the oil and gas industries worldwide and has 50 employees. Bob and his family know that the company’s success is directly attributable to its ability to equip its employees for success. At the end of the prior year, the company had $40 million in sales and a net profit of $4 million and was recently valued at approximately $25 million.

Bob and Mary are concerned that increased government spending will lead to tax increases in the future. Due to the 2018 reduction in the income tax rates for C corporations, they are considering changing their company’s current tax election as an S corporation to a C corporation. Bob and Mary are ready to transfer the business to their sons but want to provide for all their children equally. In addition, they are concerned about the potential estate tax liability because their estate is valued at approximately $40 million (including the $25 million value of the business).

Using an ESOP after Death—No Lifetime Planning

Bob and Mary suddenly pass away before planning for their business succession. At their deaths, their estate will pay approximately $5 million in estate taxes if their deaths occurred before 2026, and approximately $10 million if their deaths occurred during or after 2026.[4] This amount may also increase because future appreciation of the value of the business will continue to accrue in their taxable estate before their deaths. Bob’s and Mary’s estate plan provides that all of their children will share in their estate equally after their home is sold and the estate pays the estate taxes. Each of the five children will receive a 20 percent interest in the business ($5 million each) and approximately $2 million in cash/marketable securities before 2026 and approximately $1 million during and after 2026. After Bob’s and Mary’s deaths, the family can still use an ESOP to purchase the daughters’ shares. Implementing an ESOP would lead to the following outcomes:

  • The daughters are provided with liquidity and cash flow not otherwise available.
  • The company is provided with a tax deduction over time equal to the purchase price, reducing the cash necessary for the purchase by 25 percent and effectively reducing the purchase price.[5]
  • The employees are rewarded for their service and the cashflow equips them for retirement.
  • The company culture is maintained.
  • A vehicle is established for the sons to sell their 60 percent stake in the business to the ESOP in the future, potentially creating a fully tax-free entity upon the sale.

Using an ESOP as Part of Lifetime Planning

Bob and Mary decide to be proactive with their planning before their deaths. After meeting with their attorney, accountant, and financial advisors, Bob and Mary decide to implement the following plan:

  • The corporation’s tax election is converted from an S corporation to a C corporation.[6]
  • They create an ESOP and sell 40 percent of their interest in the company to the ESOP using bank or seller financing.
  • Upon the sale to the ESOP, they elect according to I.R.C. § 1042(a)[7] to eliminate capital gains taxes on $10 million in realized gains, saving approximately $2.5 million.
  • The company is valued an estimated $15 million after the implementation of the ESOP (a value of approximately $25 million before the ESOP transaction less the transaction debt of $10 million obtained to finance the ESOP transaction.) This represents a 40 percent reduction in the value of the company, with $6 million (40 percent) of the value allocated to the ESOP and $9 million (60 percent) allocated to Bob and Mary.
    • After the reduction in the value of the company related to the financing of the ESOP transaction, valuation discounts for lack of control and lack of marketability estimated at 30 percent can be applied to the $9 million remaining interest owned by Bob and Mary.
    • As a result, the 60 percent interest in the business owned by Bob and Mary (after the financing and discounts due to the ESOP transaction) has a gift or estate tax value of approximately $6.3 million compared to a gift or estate tax value of $15 million before the ESOP transaction.
  • Bob and Mary give the remaining 60 percent interest to their sons in equal shares at a gift tax value of $2.1 million for each son ($6.3 million valuation divided among three sons).
    • The future appreciation of the business is now in the sons’ estates.
    • Bob and Mary have reduced the value of their estate by giving their sons the 60 percent interest in the company. Their interest was originally valued at approximately $15 million but now has a gift tax value of approximately $6.3 million (a 58 percent discount).
  • Bob and Mary modify their existing estate plan to provide that the first $10 million be shared equally between their daughters (because the sons received the gifted shares), with the balance being shared equally by all of their children.
  • Bob and Mary may consider implementing a wealth replacement trust or irrevocable life insurance trust with a second-to-die policy that has a death benefit of $5 million to reduce the cost of the remaining estate taxes, provide for their daughters, and achieve further equalization of the amounts each child will inherit.
  • Bob’s and Mary’s planning provides the following benefits:
    • Bob and Mary can diversify their net worth by selling 40 percent of their interest in the company to the ESOP without incurring capital gains tax.
    • The plan saves approximately $3.5 million in gift and estate taxes.
    • A wealth replacement trust or irrevocable life insurance trust and charitable planning options are used to further reduce or eliminate the remaining estate taxes, estimated at approximately $1.6 million before 2026 and $6.9 million during and after 2026.
    • The plan enables all future appreciation of the business to be excluded from Bob’s and Mary’s estate, resulting in additional estate tax savings as the company continues to grow.
    • Employees are rewarded for their service and equipped for retirement.
    • Bob and Mary leave a legacy of a thriving company and maintain its culture.
    • The plan establishes a vehicle for the sons to sell their interests in the business in the future to the ESOP, potentially creating a fully tax-free entity upon such sale. The potential tax benefits are discussed below.

If a client desires to transfer the business itself to their family, consider implementing an ESOP as a potential solution to meet the client’s goals. ESOPs provide significant income, gift, and estate tax savings. It may also be the solution to address your client’s interfamily challenges when the client has some family members who work in the business and other family members who do not.

ESOP Story 2: Saving Taxes and Transaction Fees with an ESOP—Creating a Fully Tax-Free Entity

If a client has no family members working in the business, they should consider an ESOP to create a fully tax-free entity and transfer the value of the business to their family after their death.

Meet Jimmy. Jimmy has been happily married for over 30 years and has three wonderful children. Jimmy owns a company that manufactures precision wire-based materials such as wires, cables, composites, and assemblies for use in medical and industrial applications. After 30 years in the business, Jimmy wants to retire. None of Jimmy’s children are interested in working in the business.

Jimmy recently discussed selling his company with an investment banker. The investment banker suggested conducting a private equity auction to create a competitive bidding process for the company to maximize the purchase price. The company’s estimated value is $20 million. The company has been operating as an S corporation and the tax basis is only $3 million. His accountant has also indicated that, in the event of an asset sale, depreciation recapture is estimated at $10 million.[8]

Jimmy has enjoyed the benefit of a best-in-class, five-member, senior management team. However, Jimmy is concerned about what will happen to his senior management team and employees in the event of the sale of the company to a third party. The average age of his senior management team is 50 years old. He has asked for and received the loyalty of his senior management team over the years, many of whom started working for the  company immediately after college. After attending a National Center of Employee Ownership webinar,[9] Jimmy decides to explore using an ESOP to purchase his shares in the company before moving forward with an investment banker to sell the company to a third party. After further investigation, Jimmy decides to implement the ESOP. Before implementing the ESOP, the company converts from an S corporation to a C corporation. Jimmy’s decision was based on the benefits of an ESOP compared to a sale to a third party:

  • By converting to a C corporation before the transaction, Jimmy obtains tax deferral and potential elimination of capital gain by qualifying for an election under I.R.C. § 1042[10], which saves approximately $6 million in income and capital gains taxes.
  • Jimmy saves approximately $800,000 in investment banking and business brokerage fees (fees for the sale to a third party could be 5 to 7 percent of the value of the company, potentially exceeding $1 million).
  • The ESOP creates the necessary cash flow for him to implement advanced estate planning strategies and support his favorite charitable projects.
  • Jimmy can now leave a lasting legacy in his community, provide for his executives and employees, and enhance the likelihood that his business will continue to operate successfully in the future.
  • The ESOP also allows for annual tax deductions to the company for ESOP loan payments,[11] reducing or potentially eliminating federal income taxes after the ESOP transaction.
  • A plan is created stating that five years after the ESOP transaction, the company will convert back to an S corporation, thus creating a fully federal income tax-free entity.[12]
  • The ESOP creates a “We Can” attitude versus an “Us and Them” attitude among employees.
  • Using the ESOP, Jimmy has provided employees with increased retirement plan contributions and an equity interest without requiring the employees to make additional contributions.
  • The company now has a competitive advantage in employee retention and recruiting by offering employees a benefit not offered by other employers in the community.
  • Employees can maintain positions and remain employed.
  • It allows Jimmy, together with senior management, to maintain control.
  • The ESOP provides senior management with additional long-term, deferred-equity, incentive compensation.

Eliminating Taxes on a Business Sale: the Power of I.R.C. § 1042

For Jimmy to obtain tax deferral and perhaps elimination of capital gains on the sale, he must make an I.R.C. § 1042 election. This election is available only for C corporation ESOPs if the following statutory requirements are met:

  • After the sale, the ESOP must own at least 30 percent of outstanding stock.[13]
  • The selling shareholder(s) must have owned the shares for the last three years.[14]
  • The selling shareholder must purchase qualified replacement property (QRP)[15] within 15 months of the ESOP sale (three months before and 12 months after).[16]
  • The company must consent to I.R.C. § 1042 treatment.[17]

The following tax advantages are provided by the election:

  • Sellers to ESOPs are allowed to defer or potentially eliminate capital gains.
  • If the requirements of I.R.C. § 1042 are met, there is no realized gain on the sale of the shares.
  • Gain is recognized if and when the QRP is sold.
  • If the QRP is not sold before Jimmy’s death, Jimmy’s spouse will receive a step up in basis in the QRP to the fair market value on Jimmy’s death, thus eliminating any pre-death unrealized gains (including unrealized gains from the sale of shares to the ESOP) on the sale of the QRP after Jimmy’s death.

As noted, the selling shareholder must purchase QRP within the specified time frame.

QRP is

  • securities (stocks) of domestic (US) operating corporations, and
  • bonds (debt) of domestic (US) operating corporations.[18]

QRP is not 

  • US government agency bonds,
  • municipal bonds,
  • mutual funds,
  • exchange-traded funds,
  • real estate investment trusts,
  • securities of a foreign corporation, or
  • seller financing notes.

In Jimmy’s case, with no family to transfer the business to, the ESOP is an excellent alternative when compared to selling to management or an outside, third-party, strategic, financial, or private equity purchaser.

Conclusion

ESOPs are much more than a retirement plan for employees. They can be an advantageous strategy for many owners of closely held corporations to transfer ownership of their businesses to the next generation or to employees, providing both tax advantages and a vehicle for the successful continuation of the business after the owners’ departure.

_____________________________

[1] Employee stock ownership plans (ESOPs) may only be established by corporations. See K.H. Co., LLC Employee Stock Ownership Plan v. C.I.R., T.C. Memo. 2014-31, 107 T.C.M. (CCH) 1168 (2014) (plan ceased to be a qualified ESOP when corporation became a limited liability company; it “was a partnership for tax purposes and did not have any stock, it did not have any qualifying employer securities for purposes of sections 409(l) and 4975(e)(7) and (8) in which the plan could invest. Therefore, petitioner failed to operate as an ESOP pursuant to its terms when K.H. Co. became its employer, sponsor, and administrator.”). But see I.R.S. Priv. Ltr. Rul. 2015-38-021 (Sept. 18, 2015) (IRS ruling that the membership units of an LLC will be considered as qualified employer securities under the Internal Revenue Code).

[2] See I.R.C. § 4975(7) (“The term ‘employee stock ownership plan’ means a defined contribution plan—(A) which is a stock bonus plan which is qualified, or a stock bonus and a money purchase plan both of which are qualified under section 401(a), and which are designed to invest primarily in qualifying employer securities; and (B) which is otherwise defined in regulations prescribed by the Secretary.”); see I.R.C. § 1042(a) and § 1042(h), as amended and added by Pub. L. No. 117-328, Div. T, § 114, § 409 (qualifications for tax credit employee stock ownership plans).

[3] See I.R.C. § 404(a)(9)(A) (employers permitted to deduct contributions to an ESOP of up to 25 percent of eligible compensation) and I.R.C. § 404(a)(9)(B) (all contributions used to repay interest on an ESOP loan are deductible to the employer). Note that the interest deductions are not available to S corporations pursuant to I.R.C. § 404(a)(9)(C). Both C and S corporations can deduct contributions of up to 25 percent of the eligible payroll in an ESOP to repay an ESOP loan; C corporations must base this calculation only on the amount of principal paid, while S corporations must count interest as well.

[4] The current federal gift and estate tax exemption amount will expire and return to the pre-2018 level on December 31, 2025.

[5] See  I.R.C. § 404(a)(9)(A).

[6] See I.R.C. § 404(a)(9)(C) and I.R.C. § 1042.

[7] See I.R.C. § 1042(a)(1) (“If . . . (1) the taxpayer or executor elects in such form as the Secretary may prescribe the application of this section with respect to any sale of qualified securities, . . . then the gain (if any) on such sale which would be recognized as long-term capital gain shall be recognized only to the extent that the amount realized on such sale exceeds the cost to the taxpayer of such qualified replacement property.”). Under I.R.C. § 1042, if certain circumstances are satisfied, the selling shareholder will pay no tax at the time of sale on all or part of realized gain when the stock of a closely held C corporation is sold under circumstances in which the sale would otherwise be considered long-term capital gain. See section titled “Eliminating Taxes on a Business Sale—the Power of I.R.C. § 1042.” Note that the SECURE 2.0 Act amended I.R.C. § 1042 to provide S corporation shareholders a tax deferral opportunity, but it is available only for sales to an ESOP after December 31, 2027, and for 10 percent of the sales proceeds received by the shareholder from the ESOP. I.R.C. § 1042(a) and § 1042(h), as amended and added by Pub. L. No. 117-328, Div. T, § 114.

[8] See generally I.R.S. Pub. 544, Sales and Other Dispositions of Assets (Feb. 2022), https://www.irs.gov/pub/irs-pdf/p544.pdf, for general information about depreciation recapture. “If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if otherwise nontaxable) as ordinary income.” Id. at 27.

[9] National Ctr. for Employee Ownership, https://www.nceo.org/ (last visited Jan. 24, 2024).

[10] I.R.C. § 1042(a)(1). As stated in note 7, under I.R.C. § 1042, if certain circumstances are satisfied, the selling shareholder will pay no tax at the time of sale on all or part of realized gain when the stock of a closely held C corporation is sold under circumstances in which (i) the sale would otherwise be considered long-term capital gain and (ii) there is a step-up in basis on the death of the selling shareholder on qualified replacement property to the extent that such property is held until death. I.R.C. § 1042(c)(1)(4).

[11] See I.R.C. § 404(a)(9)(B) (all contributions used to repay interest on an ESOP loan are deductible to the employer).

[12] Unlike a C corporation, which is subject to double taxation at the federal level, an S corporation is a pass-through entity and generally is not required to pay federal corporate income tax. Rather, S corporation shareholders must pay income tax on their share of the S corporation’s income. Note that certain requirements must be met for a corporation to be an S corporation pursuant to I.R.C. § 1361(b)(1)(A). An S corporation that is owned 100 percent by an ESOP is thus generally exempt from federal income tax at both the corporate and shareholder level, as it is not required to make distributions to its shareholders so they can pay tax on their share of the S corporation’s taxable income. Note that under I.R.C. § 1374, for the five-year period following its conversion to S corporation status, the corporation will be subject to a built-in gains tax on the disposition of any asset that it held on the day of its S corporation election.

​[13] I.R.C. § 1042(b)(2).

[14] I.R.C. § 1042(b)(4).

[15] I.R.C. § 1042(a).

[16] I.R.C. § 1042(c)(3).

[17] I.R.C. § 1042(b)(3).

[18] See I.R.C. § 1042(c)(4).

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