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The Almost ESOP Small-Business Succession Strategy

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While business succession planning poses a challenge to any retiring small business owner, the challenge is magnified in the small business context where the owner may not have the funds to implement a traditional succession plan.

(See Business Succession Planning and the Buy-Sell Agreement.)

These small business clients need creative solutions in order to successfully transition the business to key employees who have been selected to take over following the owner’s retirement. 

The concept of an employee stock ownership plan (ESOP) strategy may be appealing to the small business owner, but in a very small business the plan may simply be too expensive to adopt and administer. On the other hand, an ESOP alternative that uses a modified defined benefit plan structure may provide a more viable option for an existing small business owner who is both trying to transition the company and minimize current tax liability.

About ESOPs

An ESOP is essentially a trust created by a small business owner. An owner who wishes to exit the business sells his or her business interests to the ESOP, which may finance the purchase through a traditional financial institution or funds provided by the small business owner. 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 income from passive activities—within 12 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. That means, of course, that as a succession strategy advance planning will be required.

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. 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.

If the owner is willing to transfer the shares to a key employee for little to no consideration, the share transfer will likely be treated as compensation, so that it will become subject to income and employment taxes at its fair market value—making the traditional ESOP strategy unappealing for some clients.

A Modified ESOP Approach

Instead of establishing a traditional ESOP, the employer can form a defined benefit plan that serves to benefit only the business owner (instead of all employees, or a group of key employees). Excluding even key employees from the plan will eliminate some of the difficulties in passing IRS nondiscrimination testing, and will simplify plan administration.

While the plan can be funded with compensation that would otherwise be paid to the owner, the key employee (or employees) who will inherit the business can also fund the plan by foregoing compensation or bonuses that the employee would otherwise receive (essentially pre-paying for their purchase of the company over time). In this case, the parties would likely enter into an agreement providing that the employees have the right to purchase the business at a certain time in the future.

At the end of the period, the business owner will sell the shares to the key employees (the terms of the sale should be governed by the agreement) and can then withdraw the pension funds in a lump sum. In order to minimize current taxation, the retiring owner should plan to transfer those funds directly into an IRA so that no immediate tax issue arises.


Small business owners who are looking toward retirement are particularly in need of creative advice and strategies that can help them transition a successful business to the next generation. For the client who wishes to completely retire from the business, this modified ESOP/defined benefit plan strategy can provide a viable solution.

See these addtional blog posts by Professors Bloink and Byrnes:

Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.