Employee stock ownership plans (ESOPs) can serve a number of purposes for your small business clients, providing a powerful motivator for employees and simultaneously reducing corporate taxes. In today’s market, however, the most important function of an ESOP may actually solve one of your retiring small business client’s most pressing problems—how to exit the business upon retirement. This business succession strategy can actually allow a small business client to gradually transition into retirement through a sale of the business to his employees while deferring recognition of any gain on the sale far into the future.
An ESOP is essentially a trust created by the small business owner. The small business owner who wishes to exit the business sells his business interests to the ESOP, which may finance the purchase through a traditional financial institution or a loan made by the small business owner himself. An ESOP must meet certain employee coverage, nondiscrimination and vesting requirements in order to qualify for favorable tax treatment.
The business owner is entitled to defer taxation on the 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% of its 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% penalty tax.
A Tax Advantaged Plan
The primary benefit of the ESOP structure is that it allows a current business owner to sell his business interests to the ESOP and defer taxation on the gain that the transaction would otherwise generate. 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 now that taxes on capital gains rates for the highest earners have increased to 23.8% (20% capital gains plus a new 3.8% 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.