From the August 2003 issue of Investment Advisor • Subscribe!

August 1, 2003

Moving Out

For your business-owning clients, an ESOP might be just the answer to their succession planning prayers

One of the biggest issues for business-owning clients is how to get out of that business some of the sweat equity they've put into it. The problem arises when a business-owner client works for years to develop wealth by building up his business. Then when he is ready to get out of the business, he can discover that his wealth is locked up in an illiquid--albeit valuable--asset: his business. How is he going to cash in on that value? One way is to set up an employee stock ownership plan, or ESOP. Used correctly, an ESOP can provide substantial advantages over other business succession alternatives. Here's how ESOPs work, and when they are appropriate.

There are currently about 11,000 ESOPs and similar plans covering over 8.5 million employees in both publicly traded and closely held companies of every size in the U.S. An ESOP is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the employer company. ESOPs are qualified in that, in return for meeting certain rules designed to protect the interests of plan participants, ESOP sponsors can make tax-deductible contributions to fund the participants' retirement. ESOPs are defined contribution plans in that the employer makes yearly contributions that accumulate to produce a benefit that is not defined in advance. Rather, what the plan participant receives is based on the growth of the assets in the plan: for the ESOP, it's the value of the employer's stock.

ESOPs and the Closely Held Business

The ESOP is often used as a way to monetize all or part of an owner's interest in a closely held company. The owner may sell in whole, in part, or in stages over a period of years so he can gradually ease out of the company--a particularly important consideration for sellers with management responsibilities. With a C corporation, the selling owner may defer taxation on the gain on the sale by using a Section 1042 rollover.

The ESOP is very valuable in an exit-planning situation for an owner in helping access his wealth for the following reasons:

1. It creates a ready market for the closely held business;

2. It provides the ability to diversify the closely held business or concentrated business interest on a tax-incentive basis;

3. It provides liquidity during the owner's life and liquidity at his death;

4. If used appropriately by knowledgeable people, it can enhance the effectiveness of other wealth-planning techniques.

By investing primarily in the employees' own company shares rather than in the securities of other companies, the ESOP also gives employees a vested interest in the business: the better the company does, the greater the rewards for the employees participating in the plan. Moreover, the other interest the ESOP serves is the remaining, or what's called "leave-behind," ownership. It gives these employees the ability to buy the company over time with company profits.

With all this going for it, the ESOP is almost like the tonic that the traveling salesman used to hawk as a miracle cure--it was good for iron-poor blood, for the gout, for depression, for everything. But the magic elixir was snake oil. In the same way, the ESOP approach should always be analyzed in light of other ways that the owner can satisfy his departure objectives. Initial public offerings, leveraged recapitalizations, a sale to a strategic buyer (i.e., an outside buyer), or a transfer to insiders (possibly key employees or family members) must all be considered as well.

While going public, i.e., the IPO route, may sound impressive, it can be costly and the owner is going to have to jump through many regulatory and financial hoops. How about leveraged recapitalization? If the company is doing well and has built substantial equity, it can borrow money, but then has to find a way to get the borrowed money to the owner without triggering an additional tax burden. And a transfer to insiders may not yield properly timed cash flow to facilitate the owner's desired exit.

While these other approaches may be more suitable in some cases, the departing owner is likely to find that the ESOP is a very attractive alternative. In certain circumstances, an owner with a concentrated equity position in his business can sell his position, buy a broadly diversified portfolio of securities with the proceeds, and still not pay any capital gains tax.

The ESOP as Exit Strategy

While three types of ESOPs can be used in exit planning--the conventional, the leveraged, and the seller-financed ESOP--the most appealing strategy is the leveraged ESOP.

In a conventional ESOP, the owner is bought out over time. Each year the employer makes tax-deductible contributions to the ESOP based on the overall payroll of the participating employees. These yearly contributions are then used to purchase shares from the departing owner in bits and pieces based upon the contributions that are made in that year. Once they purchase these shares, the shares are allocated to the participants' accounts. The successor ownership then buys out the participants as they retire.

Although this is done on a tax incentive basis, the departing owner almost always would prefer to get his money up front. "I worked hard for 20 or 30 years," the thinking goes, "I'm ready to go and I want my money now." But "leave-behind" owners (typically family or key employees) who buy the business often don't have that kind of money up front and would prefer to buy it over time.

If a leveraged ESOP is used, the ESOP borrows the money to acquire the exiting shareholder's stock in a lump sum up front. These shares are then put into a suspense account in the ESOP as the security for the loan. Each year as tax-deductible contributions are made to the ESOP based on the payroll of participating employees, these contributions can then be used to pay off the loan. As the loan is paid down, the securities that were purchased from the exiting shareholder are now freed up and put into each employee's account. In addition, there is potential for gain deferral under IRC Section 1042. To do so, however, the departing owner must meet various criteria, including the purchase of "qualified replacement property" within a 15-month period extending three months before the sale to the ESOP until 12 months after the sale. Qualified replacement property includes stocks, bonds, and debentures of domestic operating companies (i.e., publicly traded securities). The owner typically buys the property with the money from the sale. Gain on the sale of his company stock is delayed until the qualified replacement property is disposed of.

The seller-financed ESOP is a little more esoteric because it's not as easy to get the deferral of the gain on the sale of the shares by the departing or exiting shareholder. In the seller-financed ESOP, the seller, in essence, lends the money to purchase his shares, letting the ESOP buy him out over time. There are two reasons he would do this: one, the seller gets paid the interest rather than the bank; and two, there are lower transaction costs when it's a seller-financed ESOP. The annual tax-deductible contributions made to the ESOP are used to extinguish the loan.

If done the right way, the seller can still qualify for a gain deferral under IRC Section 1042. The most problematic of the IRC Section 1042 criteria that must be met is the purchase of qualified replacement property within the time period required. So if the seller lets the employees buy him out over time, where is he going to get the money to buy the replacement securities?

He can get it from one of two places. There's nothing in Section 1042 that requires that the money from the sale of the shares must be the money used to buy replacement securities, so if he has some other money squirreled away, he can use that to purchase the securities (though that's not usually the case). Otherwise, the seller can buy a long-term (30-year) floating rate debenture--sometimes known as an ESOP bond. Financial institutions will lend up to 90% of the cash needed to buy replacement securities on the ESOP bonds. The owner can use this leverage to purchase the requisite amount of replacement securities, paying off the margin debt as he receives his payments from the ESOP.

Is Section 1042 a Silver Bullet?

At about this point, you're probably wondering what the catch is. When anyone looks at an ESOP and the benefits of IRC Section 1042, it seems like a no-brainer. As is usually the case, let the buyer beware. First, the qualified replacement securities take the cost basis and tack on the holding period of the old securities.

Take the following example: Joe started a company with $1,000. He's owned the business for 20 years and he sells it to the ESOP for $10 million. He buys a basket of replacement securities that are publicly traded. The $10 million of stock that Joe sold had a basis of $1,000, so this basket of securities, even if he paid $10 million for it, gets a basis carried over at $1,000. What he has done is deferred the day of reckoning until he sells all or a portion of that basket of securities. And the holding period for all these securities includes, or "tacks on," 20 years, the length of time he held the business before he sold it to the ESOP. Still, that's a tremendous benefit.

Second, with the leveraged or seller-financed ESOP, the owner has effectively gone from a concentrated, illiquid position that has gained a lot of value over time, sold it to employees who want to own the company after he leaves, and bought a broadly diversified basket of securities that spreads out his risk. The downside is that if he does nothing further when he sells those replacement securities, he will have to pay the gain on the securities over the original cost basis of the business.

Benefits of Put Options:

The value of the ESOP shares is tied to the business. As the employees make the business grow, they benefit from that increase in value. Their only problem is the same one that the exiting owner just solved: Where are they going to sell their ownership? If the company is not publicly traded when an employee retires, that employee has to have what's called a "put option" where the employee can go back to the company and say, "Those shares are valued at X amount. You have to buy me out of the shares at that price." That's a very powerful position for the employee to have, and is thus one that often concerns "leave behind" ownership since the business must come up with the cash to buy them out despite the fact that the buyout increases their ownership. This funding requirement is on top of the normal cash needs of the business.

While the company can transact this buyout either immediately or over a period of time not greater than five years, the concern highlights the need to review the demographics of the participating employees before you put the ESOP in place to avoid a "run on the bank" at their retirement.

The Stumbling Blocks

The cost to put an ESOP in place generally ranges from a minimum of $20,000 to $50,000 for a closely held business. An appraisal, which is also required in the setup phase, can run anywhere from an additional $8,000 to $15,000. Subsequently, annual appraisals are required at about 50% percent of the cost of the setup appraisal. There is also the cost of filing annual tax returns for the ESOP.

But there are other stumbling blocks to ESOPs as well. One of the major drawbacks are unreasonable expectations on the part of the selling shareholder; most notably perceptions concerning the worth of the business. Unsupported statements such as: "My business is worth $10 million, easy" pave the way for disappointment. When owners start running the numbers on the feasibility of the ESOP, they may find they're not going to get as much as they thought. But that's really no different than selling it on the open market--expectations must be tempered and supportable. Moreover, perceptions about the tax benefits of IRC Section 1042 are overblown. It's often the case that departing shareholders perceive the benefits as a permanent avoidance of tax rather than deferral.

The second big stumbling block is the lack of adequate advance planning. How does the ESOP fit into the overall succession or exit strategy? Will it be the vehicle through which all the shares are transferred or will gifts, bequests, or intrafamily sales also be involved? What will the replacement property consist of and how will it fit into the owner's asset allocation strategy? How and when will the departing owner cash in on the value of the qualified replacement property? The ESOP must be integrated into an overall plan that addresses a range of questions that produce details on the timing of the plan and the owner's overall intentions (see Before You Leave sidebar). Remember, the ESOP can't be an island unto itself; it must fit into the overall departure plan of the owner.

The ESOP Advantages

Following are some of the more sophisticated ways that a knowledgeable and experienced planner can utilize the advantages of the ESOP for liquidity, as an exit strategy, for the purposes of diversification, or for estate planning.

Shadow Replacement Securities. Some owners want to totally leave the business and sell everything; others will only want to monetize a portion of their interest. As long as the ESOP owns at least 30% of the business after the owner's sale (the minimum threshold for benefits under IRC Section 1042), no gain is recognized on the sale. Either way, the shadow replacement security strategy gives the owner the ability to sell on a tax-deferred basis and get liquidity that he can use for anything without triggering the tax.

The seller purchases the qualified replacement securities--in this case, a single long-term (20 to 30 years) floating rate debenture--and then borrows against the debenture, as much as 90%. There is very low exposure to a margin call because the debenture is long-term and will have a fairly constant value due to its floating interest rate. Remember, if he disposes of the securities, he has to pay the tax. In this case, borrowing is not equal to a disposition because he still owns the security. Tax deferral is maintained, while liquidity is available.

Enhanced Basis Step-Up

The enhanced basis step-up takes the shadow replacement technique one step further. The owner may want to gift the qualified replacement securities using one of a number of planning techniques (e.g., a GRAT), and have their value and post-transfer increase in value escape the estate tax and gift tax. It's true that he can get a great estate and gift tax result, but when the recipient sells the securities, he usually has a big capital gain because he receives the property with a nominal carry-over basis.

The seller can buy a floating rate debenture as his shadow replacement security and borrow against it; then, he can buy items for gifting that he thinks have potential to increase in value after gifting them. The advantage is the property that he's gifting doesn't have carry-over basis; it has full cost basis, which is normally much higher than that of the qualified replacement security. He uses the same tax incentive strategies to depress the gift tax value. Later on, when the recipient sells these securities, the capital gain is smaller.

The FLP ESOP. The FLP combines the income tax deferral of IRC Section 1042 with estate planning benefits. A FLP allows the donor to gift limited partnership interests to members of his family. The value of the gift is not full dollar-for-dollar pro-rata of the underlying assets; it's discounted because limited partnership interests are illiquid by nature of the agreement, have no say in management, and cannot be freely transferred.

Thus, the IRS is willing to decrease the value of the gift because of the lack of control, lack of marketability, and lack of transferability. The extent of the adjustment continues to be the source of controversy between the IRS and taxpayers (as does the IRS's latest attack on the efficacy of the FLP as an estate planning vehicle). Depending on the specific facts of the case, the valuation adjustments can range anywhere from 10% to 50% of partnership's underlying assets. Thus an owner can gift a partnership interest at 60 cents on the dollar instead of 100 cents.

Generally, it works like this: An owner sets up a family limited partnership and contributes a portion of his interest in his closely held company, which itself is discounted due to the nature of the business, into the FLP. He creates an additional discount because he wrapped it into a partnership interest. Next, he gifts FLP interests to his family. Thereafter, the FLP elects to sell shares of the business to the ESOP in a sale that qualifies to defer the gain on the sale and buys replacement securities. The owner has in essence transferred a nice basket of diversified securities to his family in a very tax efficient manner.

Leveraging Wealth. An owner's exit plan often includes more than just a tax favorable sale to an ESOP. Other strategies--like outright gifts, gifts to a grantor retained annuity trust, or sales to an intentionally defective trust--are often part of a well-designed plan as well. When combined with a sale to a leveraged ESOP designed to qualify for the benefits of IRC Section 1042, these techniques become even more attractive.

Remember, participating employees have a put option on the shares sold to the ESOP that are allocated to their account and the company is obligated to buy back the shares. In addition, the company typically guarantees the loan for the leveraged ESOP because the ESOP has no assets and the financial institution must have collateral for its loan. Now, the value of the company goes down because of the put rights that the company has to satisfy, and because the company has guaranteed the loan on the ESOP.

Because the value of the company has gone down, the shares that haven't been sold to the ESOP that the owner wants to use in other wealth transfer strategies are devalued, enhancing his ability to transfer them to his family. The seller fully expects the loan to be paid off and for the company to be able to meet the put right. When that happens, the value of the shares that the owner has gifted or otherwise transferred goes up in value. In addition, the company has hopefully expanded and increased in profitability, so there has been a post-gift explosion in value on the "devalued" shares he gifted. Coupled with the departing owner's ability to use the shadow replacement securities technique, the ESOP can be a real home run.

To conclude, it's fair to say that proper use of the ESOP can not only unlock but also magnify wealth accumulated in a closely held business. It creates a market for the business, provides tax incentive diversification of a valuable (but illiquid) ownership interest, and enhances the benefits of other planning strategies. Despite these obvious advantages, it's not the magic elixir for all that ails a business owner who wants to stop being an owner. Its costs, intricacies, and impact on other planning strategies suggest thoughtful analysis before proceeding.

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