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The pros and cons of ESOPs

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Despite the fact that the American Taxpayer Relief Act of 2012 saved most U.S. taxpayers from a doomsday “Taxmageddon,” it remains that, all other things being equal, most high income and small business clients will pay more in taxes in 2013 than they did in 2012. Small business clients looking to exit the business in the near future are looking for ways to reduce — or at least defer — the taxes they will incur should they sell their business interests outright. The ESOP strategy can work well for these clients by allowing them to indefinitely defer any taxable gain on the sale of their business. Advisors must be wary, however, because Department of Labor inquiries into these transactions have recently become more frequent and detailed than ever — just when the ESOP may have become more beneficial than ever.

ESOP basics

An employee stock ownership plan (ESOP) is a tax-preferred plan created by an employer-company that is designed to invest primarily in shares of that employer. An ESOP must meet certain employee coverage, nondiscrimination, and vesting requirements in order to qualify for favorable tax treatment.

The primary benefit of the ESOP structure is that it allows a current business owner to sell its business interests to the ESOP and defer taxation on that sale if the owner subsequently invests the proceeds in qualified replacement property — meaning the securities of a third-party company (or companies) that does not receive more than 25 percent of income from passive activities — within twelve months after the sale. The ESOP must then hold the business interests for at least three years following the purchase or pay a 10 percent penalty tax. This type of transaction is known as a Section 1042 transaction and can allow a selling business owner to defer taxable gain on the sale indefinitely.

A small business owner who wishes to retire but does not have immediate need for the capital that the sale would generate will find this type of transaction particularly valuable in 2013, now that taxes on capital gains rates for the highest earners have increased to 23.8 percent (20 percent capital gains, plus 3.8 percent investment income tax). By the time the owner liquidates his holdings in the qualified replacement property, he may have fallen into a much lower income tax bracket, triggering lower capital gains rates and possibly escaping the investment income tax altogether.

The small business ESOP trap

If the simplicity of the tax deferral that can be realized by an ESOP strategy sounds too good to be true, that is probably because it can be. Business owners face a serious problem if they sell interests to an ESOP that is later found to be overvalued — especially in light of rampant Department of Labor (DOL) inquiries — and some very high profile cases have put the issue in the spotlight.

The valuation problem is especially applicable to small business clients because it is unlikely that they have a ready market for their shares (because they probably are not publicly traded). The lack of trading activity makes it difficult to place a value on the interests, but other factors add to the problem.

For example, the retiring business owner who is more actively involved in the company’s affairs will impact the value of the overall business — and thus any business interests sold to an ESOP — when he leaves the company. The percentage of the business represented by the business interests sold in the small business context is likewise more important in valuation than it might be for a larger company.

Undervaluation of shares can lead to civil or even criminal prosecution following a DOL investigation. The DOL has brought lawsuits seeking over $100 million in repayments to ESOPs following findings of undervaluation in the past year.

The appraisal fix

In order to defend against a valuation challenge, the small business client should obtain a professional appraisal of the interests he intends to sell prior to their transfer into the ESOP. As with valuation of small business interests for estate tax purposes, the appraiser should be independent of the business.

The company’s financial history will be considered, along with the economic outlook (both generally and within the specific industry in which the business operates). A control premium — or minority discount — may be applied if the situation calls for it, and family ownership and other conflicts of interest can also be relevant.

Importantly, small business clients should note that the DOL intends to introduce a broadened fiduciary standard in the near future, and it is expected that this definition could bring independent appraisers under the fiduciary umbrella. This means that small business owners should expect even more careful scrutiny by these appraisers, who will have their own potential liability to protect against.


While structuring a 1042 transaction to defer taxes until your small business clients reach a lower income tax bracket at some point in retirement can provide a powerful tax-deferral incentive, it is important that these clients be advised of the new complexities that will be found in the process. Valuation has always been important, but now and in the coming months, it is more crucial than ever for clients and appraisers alike to take special care in the process or face potential DOL prosecution.

For previous coverage of small business succession planning in Advisor’s Journal, see Joint Life Policies—Planning Beyond Estate Liquidity.

For in-depth analysis of ESOPs generally, see Advisor’s Main Library: N—Employee Stock Ownership Plans.