The Virtues of Using ESOPs with Charitable Contributions

Business owners who want to generate liquidity for their ownership interests often look at selling to an employee stock ownership plan (ESOP) as the most attractive mechanism. While this is often the case, the contribution of stock to a charity, either directly or through a charitable remainder unitrust (CRUT), can be an attractive alternative or adjunct, especially for sellers who have charitable intentions. CRUTs can also be a cost-effective means to change some investments in portfolios for people who have reinvested the proceeds of the sale of their stock to an ESOP under the tax-deferral provisions of section 1042 of the Internal Revenue Code.

Direct Charitable Contributions with Subsequent Sale to an ESOP

The simplest approach is to contribute stock to a charitable organization (which includes all the obvious examples as well as universities and 501(c)(3) nonprofits). The seller can take a tax deduction for the appraised value of the gift. If this is for a minority interest in the company, as is usually the case, minority valuation discounts will probably apply. For most sellers, this will generate a tax savings of 30% or more of the difference between the original basis of the stock and its appraised value. The charity then can resell the stock to the ESOP.

Why not just sell to the ESOP and then make a charitable cash contribution? Or roll over the sale into replacement securities and contribute them? For one thing, unless the seller is ready to sell 30% of the company, the sale is taxable as a capital gain. For a $1 million stock transaction, there would be a tax deduction of over $200,000 for the gift of the proceeds remaining after taxes, about $700,000. However, by receiving the stock, the charity could get a $1 million, not $700,000, gift.

A gift of private company shares has other consequences as well. The shares bought by the ESOP from the charity can be allocated to accounts of family members and 25% shareholders who would otherwise be excluded under section 1042 rules. This can help transfer wealth to family members to help compensate for the charitable contribution. The stock is also now out of the taxable estate of the donor. Illiquid holdings can be taxed at 50% or higher in estate settlements.

Charitable Remainder Unitrusts

A more powerful income-generating mechanism is a CRUT. Under a CRUT, the donor gives company stock to a charity, which then sells the stock to the company's ESOP. The charity pays the seller an income on the investment proceeds until death, the death of a spouse, or a fixed period, at which point the charity can use the principal amount contributed. The CRUT can also be used by a seller to an ESOP who has reinvested in replacement securities, some of which are performing poorly. Rather than sell those poorly performing securities, and pay tax on gains from the original sale to the ESOP plus any gain on the sold replacement investments, the seller can contribute them to a CRUT, take a tax deduction, and use the income and tax-deduction proceeds for living expenses or reinvestment.

The tax deduction to a CRUT is more complicated than a straight charitable contribution. The deduction is based on the net present value of the gift. It is reduced based on the donor's age, the percentage payout from the trust, maximum annual deduction contributions, and other factors. Generally, the deduction can be carried forward for five years. The table below gives approximate deductions for a $100,000 transfer for a married couple.

Some Pros and Cons

The effect of this contribution can be illustrated by the table below:

The after-tax income with the CRUT is further supplemented by an additional income tax deduction for up to five years.

The advantage here is obvious. A $1,000,000 property that had been yielding no income now is yielding $53,600, or about $17,000 per year more than if the property were sold. For a non-dividend paying stock in a private company, this offers the owner an attractive start on diversification of stock holdings with minimal personal and corporate taxation. The disadvantage is obvious too: the property now belongs to the charity. The donor can, however, take part of the savings from the contribution of stock and create a wealth replacement trust by buying life insurance. The policy proceeds are not subject to taxation.

Donors need to realize that lack of marketability discounts may apply, although proper design can usually avoid this. While the CRUT will not replace tax-deferred sales to ESOPs, for certain people, especially those who would make a charitable contribution anyway, they are very attractive vehicles. This is a technically complex area, however, and requires consultation with specialized counsel.