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.

ESOP basics

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 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.

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 in 2013 and beyond, now that taxes on capital gains rates for the highest earners have increased to 23.8 percent (20 percent capital gains plus a new 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.

Further, and importantly for many small business clients, an ESOP that owns all of the company’s business interests is permitted to elect to operate as an S corporation. Business owners who make this election are therefore able to escape taxation at the corporate level entirely.

Potential ESOP contenders

It is particularly important that a business establishing an ESOP be profitable, as the business will have to generate sufficient revenues to repay the business owner or lender that financed the transaction. Relatedly, because the business owner’s continued participation can be key to ensuring this financial success, it is often important that the small business owner be willing to remain active for a certain period of time after the ESOP is established.

Further, it is important that the company have a strong management team in place to continue the business after the original business owner has retired completely. Typically, ESOPs are most effective for companies that are closely held.

As with any business strategy, the costs of establishing and managing an ESOP should be considered when determining whether an ESOP is right for each particular small business client. While each client’s situation is unique, as a general rule business owners with less than $1 million in annual profits will not usually be good candidates for an ESOP strategy.

Conclusion

While an ESOP strategy may not be the answer for every small business client’s business succession dilemma, for those high-income clients looking to gradually exit the business, the tax deferral makes the option a potentially valuable tool for many.

For previous coverage of business succession planning in Advisor’s Journal, see Estate Planning Strategies Designed for the C Corporation.

For in-depth analysis of ESOPs in Advisor’s Main Library, see I—ESOPS and Thrift Plans.

Your questions and comments are always welcome. Please contact the Panel of Experts.