business builder ESOPs
ESOPs are way to tap wealth, maintain control
by Tim Johanson
EMPLOYEE STOCK OWNERS PLAN (ESOPs) are unique vehicles that offer a variety of advantages to certain business owners.
Most business owners have the majority of their wealth tied up in their companies. An ESOP gives them a chance to cash out some of their equity while rewarding loyal employees and retaining operational control.
The most common use of an ESOP is to sell all or part of an owner’s interest in a closely held company on a tax-advantaged basis.
This strategy provides four main benefits:
• The ESOP provides a ready market for the stock, where one might not otherwise exist.
• The transaction can be funded by the company with pre-tax dollars, as long as IRS guidelines are met.
• The selling shareholder may continue to be involved in both the management and operation of the company.
• The selling shareholder can benefit from significant income, estate and gift tax advantages.
The 8 percent club
An ESOP is a qualified, defined contribution employee benefit plan. Like any such plan, it is governed by the Employee Retirement Income Security Act (ERISA). As the name implies, its principal purpose is to allow employees to invest in the company’s stock.
About 8.5 million employees, representing 8 percent of the work force in the United States, own stock in their companies through ESOPs, according to the ESOP Association. Those companies – about 11,500 of them – range from small businesses to leading names in the airline and food service industries.
One of the major benefits of an ESOP is the ability of the selling shareholder to defer taxation on capital gains attributed to the sale of company stock to the ESOP.
This capital gain deferral is often referred to as a “1042 rollover.” Section 1042 of the Internal Revenue Code provides significant incentives to the owners of closely held companies to sell equity to employees through an ESOP rather than to liquidate the company or sell the shares to an outside party. That tax-deferral capability is a key motivating factor behind many ESOP transactions.
In order for the selling shareholder to reap the tax benefits of the 1042 rollover, many conditions must be met, including the following:
• The seller must have held the employer securities for at least three years prior to the sale.
• The employer securities must not have been acquired through options or other employee benefit plans.
• The ESOP must own at least 30 percent of the value of all shares in the company immediately following completion of the transaction, and it must continue to hold this amount for a minimum of three years after the transaction unless the company is sold.
• The price paid by the ESOP must be based on a valuation by a qualified, independent appraiser.
• The seller must reinvest the sale proceeds into qualified replacement property (QRP) during the period from three months before the sale to 12 months after its completion.
A way to diversify
The last point above, qualified replacement property or QRP, deserves elaboration. QRP is defined as securities of a domestic operating business, such as a U.S. domiciled company generating no more than 25 percent of its earnings from passive investments. Those securities can be stocks, bonds, warrants or debentures.
Investments such as government and municipal bonds, mutual funds, real estate investment trusts (REITs) and partnership interests do not fall under the definition of QRP.
The QRP provision creates an opportunity for business owners to purchase marketable securities, thereby achieving tax-free diversification into the public markets.
By reinvesting all proceeds of the ESOP sale in QRP, the investor defers all gain on the sale and avoids paying any current tax. Any gain the seller defers on the sale to the ESOP reduces the tax basis in the QRP.
When combined with a thoughtful gifting program, a sale to an ESOP can be a highly effective estate planning tool that provides financial security for the owner of a closely held company, retains operational control of the company within the family, and produces significant income and estate tax savings.
There are also a number of tax advantages that accrue to the company through the establishment of an ESOP, since interest and principal payments on an ESOP bank loan are generally fully tax deductible as well as contributions to the plan.
Not for everyone
An ESOP only makes sense if the economic benefits outweigh the costs incurred to set up and run the plan. Those costs can be considerable, so of course careful consideration and consultation with advisers must precede any such move.
In general, ESOPs are most effective for companies that have at least 25 employees, a minimum annual payroll of $1 million, are valued at more than $5 million, and are in a higher corporate tax bracket.
Most ESOPs are implemented in conjunction with an existing 401(k) retirement plan in order to maximize the benefit to employees.
Tapping the wealth accumulated over a lifetime of hard work while maintaining operational control creates a serious challenge for any owner. Establishing an ESOP is one tool to consider to accomplish these goals.
[contact] Tim Johanson works with the ESOP Advisory Group at UBS Financial Services Inc. in Minneapolis and holds a monthly lunch meeting on the topic: 612.371.4142; timothy.johanson@ubs.com; www.ubs.com
