Academic journal article Journal of Accountancy

Benefits of an Employee Stock Ownership Plan in Succession Planning: An ESOP Can Be Used to Finance an Owner's Exit from a Business and Has the Added Advantage of Tax Deferral on the Gain from the Sale of the Business

Academic journal article Journal of Accountancy

Benefits of an Employee Stock Ownership Plan in Succession Planning: An ESOP Can Be Used to Finance an Owner's Exit from a Business and Has the Added Advantage of Tax Deferral on the Gain from the Sale of the Business

Article excerpt

Employee stock ownership plans (ESOPs) provide numerous benefits for small business owners and their employees, many of which are realized while the owner is still actively engaged in the business. In addition, proper planning for the owner's exit from the business can result in sizable tax savings. Many owners take advantage of the opportunities under Sec. 1042, which permits nonrecognition (or, more accurately, deferral) of gain on the sale of stock to an ESOP (or a worker-owned cooperative) if the seller purchases qualifying replacement property. This benefit can be magnified by using either a charitable remainder trust (CRT) or a family limited partnership (FLP) along with additional trusts. Although the IRS has recently increased its scrutiny of FLPs, owning an active business through an FLP should bolster the position that the structure has the characteristics of what the IRS considers a "good" FLP.

INTRODUCTION TO ESOPs

At their most basic level, ESOPs are employee benefit plans that allow employees to take an ownership interest in the company. From a management perspective, this is a useful tool for aligning the employees' interests with the owner's. An ESOP allows the owner to cash out of the business all at once or little by little. By selling the business over time, the owner can transition control to the management team.

This strategy also permits the company to transfer control without borrowing large sums to purchase all of the owner's shares, which otherwise would force the company to become over-leveraged. The ESOP also creates a market for the owner to sell shares when a market may not otherwise exist. The owner can take advantage of the deferral provisions under Sec. 1042 by purchasing qualified replacement property. The gain is deferred until the newly purchased, potentially diversified portfolio is sold. While S corporation owners cannot take advantage of the deferral provisions under Sec. 1042, income attributable to the shares held by the ESOP are exempt from income taxation.

Employees receive an ownership interest in the company, and the ESOP benefits are not taxed until they receive a distribution. Employees can roll over the distribution proceeds into an IRA to continue to defer tax. If an employee does not roll over the distribution, the employer contribution is taxed as ordinary income, and any gain is taxed as capital gain.

In contrast to other retirement plans, the ESOP can borrow money to purchase shares to fund itself. Typically, the company borrows money from an external lender and then loans the money to the ESOP to purchase shares. The company then makes contributions to the ESOP to repay the loan. As the loan is repaid, the shares are released from a suspense account and allocated to the participants. Unlike other debt repayments, principal and interest payments for ESOP loans are tax-deductible under Sec. 4975. This tax treatment allows the ESOP to be financed with pretax dollars. Also, any dividends paid to service the loan are partially tax-deductible, up to 25% of employee compensation.

When an employee retires or leaves the company, the ESOP must repurchase the shares at the share value established by an independent third party. A major concern for ESOPs is having enough cash available to purchase shares when an employee retires or leaves the firm. To protect against a cash crunch in the event of a death, the company can purchase life insurance policies on the lives of the owner and key managers. Upon the death of one of these individuals, the company would receive the insurance proceeds tax-free, the company would then make a tax-deductible contribution of the proceeds to the ESOP, and the ESOP would purchase the shares. This strategy provides a double tax benefit for the insurance proceeds.

ESOPs IN SUCCESSION PLANNING

An ESOP provides substantial benefits while the owner continues to take an active role in the business. …

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