Many owners of closely held businesses already leverage employee stock ownership plan (ESOP) transactions to meet their liquidity and business succession needs, but they do not realize ESOPs also offer numerous benefits as an estate planning tool, including reduced taxes, flexible gifting and accurate valuation.
In an ESOP transaction, the shareholder sells stock to the plan as opposed to a third-party buyer, who would likely want to buy assets. The practical result is that the selling shareholder pays capital gains taxes on the proceeds rather than a blended rate of capital gains taxes and ordinary income taxes, representing average savings of more than 10%.
In addition, according to Section 1042 of the Internal Revenue Code, in many situations, the shareholder may defer all taxes in the sale of shares to the ESOP. For example, in the event the selling shareholder transfers the basis in their closely held company to qualified replacement property (QRP), they can defer any tax on the sale’s proceeds or, often, avoid it altogether. If the shareholder passes the qualified replacement property through to their estate, their heirs will inherit these securities at a stepped-up basis, and the tax from the sale of the company to the ESOP will be avoided altogether.
The sale of company stock to an ESOP presents an immediate, advantageous way to institute a gifting plan. A large number of closely held businesses are capitalized primarily by equity and carry very little long-term debt on their books, meaning they are well-suited to use ESOPs for gifting.
Typically, in the sale of company stock to an ESOP, the company takes on additional leverage to finance the transaction. Whether this leverage is provided by a bank or the selling shareholder, the company’s post-transaction balance sheet usually displays a significantly different capital structure than it did pre-transaction. The additional debt depresses the equity value of the company, making the ESOP an excellent tool to gift shares to future generations.
Due to federal limitations on the amount of value that an individual can gift tax-free to future generations, many business owners gift minority stakes of their closely held businesses to their heirs annually. The value of these gifts can be further depressed through the use of discounts, which are applied to minority positions. Applying reasonable assumptions of the amount of debt a company would incur as part of an ESOP transaction, as well as the discounts that should be applied to a minority stake, allows the shareholder to make gifts at a value that is substantially below the stock’s initial, pre-ESOP market value.
The Department of Labor requires that ESOP-owned companies undergo an annual appraisal to determine their market value. An ESOP’s established equity price makes it far less likely that the Internal Revenue Service will attempt to have its own independent appraiser assign a value to shareholders’ companies, a process that can lead to unforeseen estate taxes.
Furthermore, because the plan serves as a ready buyer, a deceased shareholder’s heirs are not forced to sell their shares at a distressed price.
ESOPs are much more than just a tool to address businesses’ liquidity and succession needs. They also provide estate planning opportunities for business owners who understand how to reap the plans’ ancillary benefits.