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A versatile business exit and estateplanning tool

If you own a closely held business, a significant portion of your wealth may be tied up in it. So, to prepare for retirement and provide for your loved ones,you need an exit plan. One option, if your business is a corporation, is to establish an employee stock ownership plan (ESOP).

These plans allow you to provide valuable employee benefits, generate significant tax savings for yourself and the company, and create a market for your stock. In addition,you canbetter meet your liquidity needs while remaining in control of the business.

Defining an ESOP

An ESOP is a qualified retirement plan, similar to a 401(k) plan, that invests primarily in your company’s stock. ESOPs must comply with the same rules and regulations as other qualified plans, and they’re subject to similar contribution limits and other requirements.

One requirement that’s unique to ESOPs is the need to have the stock valued annually by an independent appraiser. Also, by definition, ESOPs are available only to corporations. Both C corporations and S corporations are eligible, but the two entity types are subject to different rules.

In a typical ESOP arrangement, the company makes tax-deductible cash contributions to the plan, which uses those funds to acquire some or allof the current owners’ stock. Alternatively, with a “leveraged ESOP,” the plan borrows the money needed to buy the stock and the company makes tax-deductible contributions to cover the loan payments.

As with other qualified plans, ESOP participants enjoy tax-deferred earnings.They pay no tax until they receive benefits, in the form of cash or stock, when they retire or leave the company. Participants who receive closely held stock have a “put option” to sell it back to the company at fair market value during a limited time window.

Explaining the benefits

ESOPs offer many benefits for owners, companies and employees alike. Benefits for owners include:

• Liquidity and diversification. An ESOP creates a market for your stock. By selling some or allof your stock to the plan, you can achieve greater liquidity and diversification, enhancing your financial security and estateplanning flexibility. Acquiring a wider variety of nonbusiness assets can make it easier to share your wealth with loved ones, especially those who aren’t interested in participating in the business.
• Tax advantages. If your company is a C corporation and the ESOP acquires at least 30% of its stock, it’s possible to defer capital gains on the sale of your stock by reinvesting the proceeds in qualified replacement securities. You can even avoid capital gains tax permanently by holding the replacement securities for life.
• Unlike certain other exit strategies, an ESOP allows you to tap your equity in the company without immediately giving up management control. You can continue to act as a corporate officer and, if you serve as the ESOP’s trustee, you’ll retain the right to vote the trust’s shares on most corporate decisions.

The companycan benefit because its contributions to the plan are tax deductible. With a leveraged ESOP, the company essentially deducts both interest and principal on the loan. And, of course, both the company and its employees gain from the creation of an attractive employee benefit, one that provides a powerful incentive for employees to stay with the company and contribute to its success.

Exploring S corporation ESOPs

There are pros and cons to establishing an ESOP for an S corporation. A disadvantage is that S corporation owners, unlike their C corporation counterparts, cannot defer gain on the sale of their shares.

But as pass-through entities, S corporations have abig tax advantage: Because ESOPs are tax-exempt, corporate income passed through to the plan as an owner of S corporation shares avoids federaland often state income taxes. That means an S corporation that’s 100% ESOP-owned avoids income tax altogether.

Considering the costs

An ESOP can be a powerful estateplanning tool for closely held business owners, but it’s important to consider the costs. In addition to the usual costs associated with setting up and maintaining a qualified plan, there are also annual stock valuation costs. Employees’ put options also create potential repurchase liabilities for the company.

Typically, companies prepare for this liability by setting aside reserves or purchasing key person life insurance. Contact usfor additional information.

Sidebar: An added ESOP benefit for employees: Net unrealized appreciation

Employees who participate in an employee stock ownership plan (ESOP) may be able to take advantage of the net unrealized appreciation (NUA) rules. Typically, distributions from a traditional qualified plan are taxable as ordinary income. But, depending on the ESOP’s provisions, the NUA rules may allow employees to elect to defer tax on the appreciation in value of employer stock until those shares are sold, and then pay tax on that appreciation at more favorable long-term capital gains rates.

To qualify, an employee must take a lump sum distribution of his or her entire ESOP account because ofa “triggering event,” such as separation from employment, disability or reaching age 59½. Employer stock held in the account must be distributed in kind (that is, as actual stock rather than its cash value). If the NUA rules are followed, the employee pays ordinary income tax on the stock’s cost basisbut defers capital gains tax on the stock’s appreciation in value until it’s sold.

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