The Advantages Of An ESOP As An Exit Strategy

When it comes to business succession planning, an employer stock ownership plan (ESOP) offers an exit strategy that is par excellence.

An ESOP offers a multitude of tax advantages for the company, its owners, and its employees. In addition, an ESOP is the only employee benefit plan that is permitted to borrow money to achieve its objective–that is, to purchase company stock. (See sidebar.)

A properly designed ESOP sale can enable a business owner to make a tax-free exchange of his or her business interest for a diversified investment portfolio of qualified securities.

If the ESOP owns at least 30% of the company, an owner can sell his or her appreciated stock to the plan and defer capital gains taxation indefinitely, perhaps permanently, pursuant to the deferral provisions of Code Section 1042.

The fair market value realized from a stock sale to the ESOP by existing shareholders can be reinvested into a diversified portfolio of domestic, qualifying, income-producing securities within 12 months after the date of redemption. Capital gains will then only be realized upon the subsequent sale of the purchased securities.

Gifting those newly purchased securities to a charitable remainder trust can not only generate an income payable over the joint lifetimes of the donor and spouse, but can also generate a current charitable income tax deduction. And, appreciated asset sales within the tax-exempt charitable trust would permanently avoid a capital gains tax.

The use of a charitable gift annuity may even be more tax efficient since the annuity’s applicable exclusion ratio enables a portion of the income stream to be a tax-free return of the annuitant’s investment.

There are even more tax advantages available to an ESOP when the tax deferral provisions of Section 1042 are used with a Family Limited Partnership (FLP). First, the employee shareowner funds his FLP with a minority interest of his company stock and takes back general and limited partnership interests in the FLP.

Second, the FLP, not the employee, sells the corporate stock to the ESOP. Capital gains taxation is avoided under Section 1042 if the FLP reinvests the monies from the stock sale into a qualified portfolio.

FLP assets and the future appreciation of those assets are removed from the employee’s estate to the extent that the employee has gifted most of his FLP partnership interests to a third party, like an irrevocable life insurance trust (ILIT).

Now the trust, in its capacity as a limited partner, would receive its pro-rata share of FLP income to pay the life insurance premiums. The gift of limited partnership minority and limited marketability interests may be appropriately discounted to perhaps fall within the applicable gift annual exclusion amount to avoid any gift tax transfers to the trust.

Additional gift valuation discounting can be achieved if gifts of FLP interests are made to a grantor retained annuity trust (GRAT). Such gifts not only qualify for the partnership minority/limited marketability discounts but also for the grantor retained income interest discount. The ILIT previously mentioned can serve as the beneficiary of the GRAT discounted remainder interest.

Life insurance can play a big part in any ESOP plan. ESOPs need instant liquidity to purchase the stock allocated to the accounts of ESOP participants upon their death. There is perhaps no more cost and tax effective way to fund an ESOP or corporate stock redemption plan than with life insurance.

ESOPs can purchase life insurance on key owners using tax deductible corporate contributions. The insured employee does not pay taxes on the economic benefits of the life insurance policy owned by the ESOP as normally occurs with pension plan life insurance.

The corporate sponsor of the ESOP may have the ultimate obligation to purchase the stock allocated or owned by employee participants under a standard “put” option granted in the plan agreement. Corporate owned life insurance on key employees can ensure that sufficient liquidity is always available.

At the death of a stockholder, the employer receives the income tax free insurance proceeds to execute its buy-back obligation. The company can then make tax-deductible contributions of the purchased stock to the ESOP to achieve a double tax benefit. Any alternative minimum tax consequences incurred could be neutralized.

The prospective ESOP candidate should be a profitable, growing corporation with good successor management. Adequate cash flows and eligible payroll need to be evaluated.

Look for these characteristics for a bona fide prospect:

  1. an owner in his 50s or 60s who wants to sell corporate stock tax-free to diversify his portfolio;
  2. an owner who wants to repay loyalty and improve the productivity of his employees;
  3. a corporation that wants to redeem the stock of a minority shareowner with tax deductible dollars;
  4. a corporate owner who wants to transfer control of the corporation to his heirs or managers; and
  5. a corporation that would like to convert its profit sharing plan into an ESOP and use pre-existing assets to enhance the corporate capital account for business expansion or other purposes.

The advantages of corporate ESOP planning are only limited by one’s own creativity. It can be an incomparable exit planning strategy for closely held business owners.

John S. Budihas, CLU, ChFC, CFP is a business, estate and trust planning consultant for Hartford Life in Sarasota, Fla. He can be reached via e-mail at john.budihas

@hartfordlife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, March 4, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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