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.