From the July 2009 issue of Wealth Manager Web • Subscribe!

Heading for the Exit

The much sought-after clients who make up the high-net-worth segment have attained that status in a variety of ways. Corporate executives, fortunate heirs and entrepreneurs tend to be well represented among a wealthy clientele. Although these individuals inhabit the same social stratum due to their net worth, their needs can vary greatly. But it is the entrepreneur who tends to require the greatest level of specialized planning--a multipronged approach to wealth management that focuses equally on personal and business planning. During the life cycle of planning for this kind of client, personal and business planning will continuously overlap, but there is one point where this overlap is most evident, and that is in the client's business exit strategy.

As you know, owners of closely-held businesses are voracious in the pursuit of improvement and growth in their businesses. At times, this lifelong commitment causes clients to neglect the very goals they have worked so hard to achieve. The dream of one day selling a profitable enterprise is continuously interrupted by concerns about inventory, accounts receivables, shrinking margins and liabilities.

With so much to worry about in the present, how can a business owner justify the thought of leaving the operation and setting sail into a well-deserved retirement? This is where a wealth manager can offer invaluable guidance that not only provides a blueprint for financial success, but also relieves them of the stress that can accompany an exit from their life's work.

One of the more challenging and certainly the most important factors surrounding the sale of a business is securing a buyer. But what if you could help your clients secure a buyer by creating one for them? It may sound strange, but it's possible through the implementation of an employee stock ownership plan (ESOP).

Simply stated, an ESOP is a qualified defined contribution plan that is funded primarily with the stock of the employer. As with other types of qualified plans, a trust is established to hold the assets of the ESOP participants. Separate subtrusts or subaccounts are maintained for each participant. The employer contributes to these accounts with cash or employer securities. If they are funded with cash, the ESOP trustee then uses that cash to purchase stock. Ownership of an employer's contribution does not immediately vest in the employee, however. A vesting schedule assures the employer that contributions are not immediately sold or removed from the plan.

Tax benefits
The incentive to establish an ESOP generally lies in the tax benefits associated with such a plan. The following provides a brief overview of some of those benefits:

To begin with, the ESOP is a qualified plan. Contributions made to it on behalf of the employee participants are tax deductible to the employer. This characteristic of an ESOP allows the business owner to receive immediate tax deductions while simultaneously using current cash flows to fund the purchase of his or her business. Tax benefits can be further enhanced if the ESOP is a leveraged plan that borrows money to purchase the employer stock. The interest associated with such an arrangement may be deductible as well.

Contributions made on behalf of employee participants are not included in current income, and all earnings are tax deferred until distributions are made from the plan. Employees may make a net unrealized appreciation election, which can further enhance the tax benefits.

Of course, these tax benefits are common to all qualified plans, so what is the advantage of an ESOP over and above a 401(k) or profit-sharing plan? Typically, when business owners sell stock, they must pay long-term capital gains. Because owners of closely held businesses generally have a low basis in their stock, this tax can be a significant expense.

However, under Section 1042 of the Internal Revenue Code (IRC), it can be continuously deferred if the proceeds of the sale are reinvested in qualified replacement property (QRP), which--in very general terms--can be described as domestic U.S. securities.

Several conditions are placed on the purchase of the QRP as a means of deferring taxes. Although almost any business entity may establish an ESOP, only business owners of C-corporation stock derive this benefit from the purchase of QRP. The stock must have been held by the owner for at least three years prior to its sale to the ESOP. Another requirement for QRP treatment is that the ESOP must own at least 30% of the company immediately following the sale.

The QRP can not only provide for continued tax deferral on the sale of company stock to the ESOP, but if the QRP is held until the business owner's death, the stock will pass to the owner's heirs with a step-up in basis. What would otherwise have been a large capital gain in the hands of the original business owner now costs the heirs nothing in taxes.

Although the thought of completely avoiding the capital-gains tax associated with the QRP is attractive, the client may require the QRP capital to provide for his or her retirement needs. Managing the QRP to provide sufficient income through dividends becomes a welcome strategy for increasing cash flow to the client while continuing tax deferral.

If liquidation of the QRP becomes necessary, you may consider other planning techniques--such as a charitable remainder trust--to provide income to the client, as well as a current income-tax deduction. This scenario may be especially attractive to those clients who envisage philanthropy as a primary focus of their retirement.

Increasing loyalty
Most discussion of ESOPs focuses on their tax benefits, and rightly so, but there is another benefit that business owners covet as well. While many owners struggle to motivate and retain employees, those who establish an ESOP instantly convert their rank-and-file employees into proprietors, whose invigorated effort will only spur the growth of the company and increase the value of its stock.

Call in the experts
When considering an ESOP as an option for your business-owner clients, be sure to consult with professionals who are well versed in the ESOP arena. ESOPs are deeply intertwined within the Employee Retirement Income Security Act (ERISA) and the IRC.

An attorney and a CPA are essential to the establishment of an ESOP, but do not neglect the later stages of the ESOP lifecycle either. To truly provide your business-owner clients with a successful ESOP, you must keep the plan in compliance under both the IRC and ERISA and vet the administrators charged with the plan's day-to-day operation.

ESOPs are complex, and the plans do take time to establish, fund and maintain. In many cases, a business owner may not have the time or the patience to initiate an ESOP when an outright sale provides immediate liquidity and a quick exit.

Although an ESOP certainly is not an option for every business owner, it is a topic worth discussing with your business-owner clients.

Gavin Morrissey, JD ( is the director of advanced planning at Commonwealth Financial Network in San Diego.

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