A fine tool for succession planning

According to a 2010 study by Boston College's Center for Retirement Research, baby boomer business owners will be involved in what is predicted to be the largest collective transfer of wealth in U.S. history. Unfortunately, this transfer is occurring during a period in which capital gains rates have increased from 15 percent to 23.8 percent.

Oregon business owners bear the burden of having the third highest combined capital gains rate in the country at 31 percent. When a business is sold, the owner will generally pay capital gains tax on the difference between the price the owner is paid, or "basis" in the asset, and the sale price.

The question for many business owners is how to transfer ownership without the large tax liability. One option would be to hold onto the business until death. This would allow the owner's heirs to receive the assets with a step-up in basis.

For example, if a business owner capitalized the business with $10,000, which over time increased in value to $1 million, upon the owner's death, the owner's heirs will receive the shares with a stepped-up basis of $1 million. When the owner's heirs eventually sell the shares, they will be responsible for paying capital gains only on the difference between the $1 million value and the price the business is sold for. This results in close to $280,000 remaining with family members that would have otherwise been paid in taxes.

The main disadvantages of this option are that it requires the business owner to generally be involved with the business much longer than he or she would like, and it leaves the owner's family with the responsibility to sell the business with little to no direction.

Several other ownership transition choices include selling the company, merging with another company, selling internally via a management group or an employee stock ownership plan (ESOP) or a combination of the two, transferring the business to family, liquidating or going public. One of these options allows a business owner to sell a company in the present, and still allow his or her heirs to receive the assets with a step-up in basis. This may be facilitated with the sale of the business to an ESOP.

An ESOP is a qualified retirement plan that was created by Congress in 1974. It has a myriad of tax incentives for the seller of a business and the sponsoring company, and it also provides a great benefit to employees by providing them ownership equity. An ESOP can be sponsored by any C corporation or S corporation.

Under section 1042 of the Internal Revenue Code, a qualified seller of a C corporation who sells at least 30 percent of his or her business to an ESOP may make a "1042 election," which allows the seller to reinvest the proceeds in qualified replacement property (QRP) within 12 months of the transaction. Capital gains on the sale will be deferred until the QRP is sold, resulting in no immediate taxation to the seller.

If the seller desires liquidity, any portion of the QRP may be sold, with capital gains tax applying only to the sold QRP. Any remaining QRP still held by the seller at death is transferred to the seller's heirs with a step-up in basis, avoiding capital gains tax entirely.

The ESOP also provides tremendous tax advantages to the company. Any contributions to the ESOP for purposes of paying down the ESOP loan are deductible, resulting in the purchase of the company from the seller on a pre-tax basis.

It should be noted that S corporation ESOPs have additional tax advantages. An S corporation is a pass-through entity similar to a partnership or LLC. As such, any profits are allocated to the company owners, and they pay personal income tax on the gains. Since ESOPs are tax-exempt retirement plans, any percentage of profits allocated to the ESOP is tax-free, and provides the ESOP with additional cash flow to pay off amounts owed to the seller or to grow the business.

The ESOP approach also allows the business to stay intact. A sale to a competitor has the inherent risk that employees may be laid off, corporate culture will be diminished, and the character and strength of the business developed for years by the owner will be extinguished. An ESOP allows current management to continue to operate the business, and as the company grows, all of the employees may share in the future success through growth in their retirement accounts. Studies have shown that on average, ESOP participants receive 50 percent to 100 percent more in contributions than traditional 401(k) plan participants.

In addition to the tax benefits of an ESOP, a study by the National Center for Employee Ownership has shown that when employees are given a percentage of ownership through an ESOP, sales growth of a company increases by 2.4 percent on average.

An ESOP is a valuable business succession planning tool with significant tax benefits. As such, ESOPs should be considered by any closely held company considering succession planning and transition from an owner to future management.

Even so, an ESOP isn't the best solution for every organization because it is inherently complex, and as with any transition option, the owner, the employees and the company need to understand how it works and what to expect at every stage of the process from assessing feasibility to exploring and executing transaction alternatives. An ESOP can be the right tool for the owner and the company, but only after review of the options and determination whether it is a viable fit for strategic goals and personal legacy.


James Moser is a law clerk with Schwabe, Williamson & Wyatt in its ERISA, employment and business transitions groups. He is licensed to practice law only in California and Utah. He has a pending application for reciprocal admission in Oregon. Contact him at 503-796-2893 or jmoser@schwabe.com.

Published: Fri, Dec 26, 2014


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