Selling Stock in a Closely Held Business to an ESOP

Excerpted from the introduction to Selling to an ESOP

Perhaps the most powerful tax and business succession planning tool available to shareholders of a closely held company is the ability to sell stock to a trust created pursuant to an employee stock ownership plan (ESOP) and defer or permanently avoid taxation on any gain resulting from the sale. The ESOP structure also is very powerful for the company from a tax and financial perspective because it provides for tax deductions to the company for the funds that are used to fund the purchase of company stock. An ESOP also can produce greater commitment and productivity from employees and, in turn, greater stock value, provided that employees understand how their work affects the stock value and are given an opportunity to have constructive input on their day-to-day efforts in the workplace. In order to generate these intangible benefits of broad-based employee ownership through an ESOP, employers must invest a substantial amount of time in fostering an “ownership culture” where employee owners are informed and educated about the company’s finances and may give input into decisions affecting the conduct of their jobs, which can lead to a general sense of responsibility for the success of the employer’s business plan, including a focus on limiting expenses, maximizing revenues, and increasing profits and value.

An example of the tax advantages available to selling shareholders and the company for a sale to an ESOP trust is instructive. A shareholder who owns stock worth $3,000,000 in a closely held company (for which stock he or she originally paid $200,000) will pay $658,000 in federal and state income taxes on the sale (assuming a combined federal and state tax rate of approximately 23.5%), meaning that he or she will net $2,342,000, at best, from the sale. In contrast, by selling his or her stock to an ESOP, he or she will pay no federal income taxes, and possibly no state income taxes, on the sale. The selling shareholder will net $3,000,000 on the sale, a tax savings of $658,000! This tax deferral (and, possibly, complete avoidance) is available, however, only if the following requirements are satisfied:

The selling shareholder must be either an individual, a trust, an estate, a partnership, or a limited liability company, and must have owned the company stock sold to the ESOP trust for at least three years.
The selling shareholder must not have received the stock from a qualified retirement plan (e.g., an ESOP or stock bonus plan), by exercising a stock option, or through an employee stock purchase program.
The sale must otherwise qualify for capital gains treatment but for the sale to the ESOP trust.
The stock sold to the ESOP trust must (in general) be voting common stock with the greatest voting and dividend rights of any class of common stock or preferred stock that is convertible into such voting common stock.
For the 12 months preceding the sale to the ESOP trust, the company that establishes the ESOP must have had no class of stock that was readily tradable on an established securities market.
After the sale, the ESOP trust must own at least 30% of the company that establishes the ESOP (on a fully diluted basis). Although not a requirement for the tax deferral, the company also must consent to the election of tax-deferred treatment, a 10% excise tax is imposed on the company for certain dispositions of stock by the ESOP within three years after the sale (and while the ESOP loan is outstanding, in certain circumstances), and a 50% excise tax is applied if certain prohibited persons (i.e., the selling shareholder and/or certain family members and/or more-than-25% shareholders) receive allocations of the company stock that the selling shareholder sold to the ESOP trust.
Within a 15-month period beginning three months before the sale to the ESOP trust and ending 12 months after the sale, the selling shareholder must reinvest the sale proceeds in qualified replacement securities (QRP) (common or preferred stock, bonds, and/or debt instruments) issued by publicly traded or closely held domestic corporations that use more than 50% of their assets in an active trade or business and whose passive investment income for the preceding year did not exceed 25% of their gross receipts. Municipal bonds are not eligible reinvestment vehicles, nor are certificates of deposit issued by banks or savings and loans, mutual funds, or securities issued by the U.S. Treasury.
The ESOP must be established in a C corporation, not an S corporation. (S corporation ESOPs do, however, have their own substantial tax advantages, discussed below.)

Many of these requirements are subject to legislative change and should be monitored carefully before the sale to an ESOP trust. In addition to these requirements for the tax deferral, the company stock purchased by the ESOP trust may not be allocated to the seller, certain members of his or her family, or any shareholder in the company that establishes the ESOP trust who owns more than 25% of any class of company stock (at any time during the one-year period ending on the date of the sale to the ESOP or the date on which “qualified securities” are allocated to ESOP participants). A prohibited allocation causes a 50% excise tax to be imposed on the company and adverse income tax consequences to the participant receiving the allocation.

Reinvesting the Proceeds in ESOP Notes and Other Securities

The tax deferral has one downside that many selling shareholders focus on: a subsequent sale of the QRP will trigger the tax that had been deferred by the sale to the ESOP trust. To address this problem, investment alternatives have been developed and carefully and repeatedly refined in recent years.

One of a number of commercially acceptable approaches to accomplishing the tax deferral involves investment in publicly registered debt securities, issued by highly rated companies such as Dupont, Merck, United Parcel Corporation, and Minnesota Mining & Manufacturing. Morgan Stanley Dean Witter, UBS, Solomon Smith Barney, Merrill Lynch, Wachovia Securities, and other investment advisory firms have helped bring to market a number of similar securities in recent years. These floating rate note debt securities often have a maturity of 35 to 50 or more years and bear a floating-rate coupon indexed to 30-day commercial paper, LIBOR, or some other floating-rate index. These securities also normally have call protection for 30 to 50 years. These debt securities can be margined (without recourse except with respect to the securities) up to 85% to 90% or more of their market value, if properly structured, allowing investors access to a substantial portion of their initial sale proceeds to create an actively managed portfolio without triggering any tax liability on the part of the selling shareholder, without limiting the selling shareholders’ reinvestment choices, and with a step-up in basis for the selling shareholders. The borrowing cost is usually the broker call loan rate (or, in recent years, a much better negotiated rate with institutional lenders such as DeutscheBank) plus a spread (in larger transactions, 45 to 80 basis points), which is greatly offset by the income earned on the floating rate note debt securities. When interest rates were substantially higher than they are today, these types of reinvestment transactions actually produced a positive spread of interest to the selling shareholders (i.e., the interest paid on the securities was greater than the borrowing cost). There are a number of traps for selling shareholders who do not properly structure their reinvestments in these securities, so caution and due diligence is warranted.

Variations of this reinvestment strategy involving the purchase of equity securities rather than floating rate debt securities also are now available. There are more investment and potential tax risks associated with this strategy; however, the potential rewards and investment returns are substantial, and the percentage of sale proceeds that must be committed to accomplish this tax deferral strategy is approximately 10%.

Careful planning of the reinvestment of the ESOP sale proceeds is extremely important. The business owner who sells his or her company to the employees through an ESOP can create liquidity today while deferring capital gains taxes potentially indefinitely (as described above). In the event of the selling shareholder’s death after the ESOP sale, his or her heirs will receive a stepped-up basis on the QRP, meaning the taxation on the sale of his or her business is avoided forever. With the help of a knowledgeable investment advisor, the selling shareholder also can design a well-diversified portfolio with the monies that are not used to purchase floating rate note debt securities and/or equities that can be rebalanced according to the changing fundamental and technical conditions of the capital markets. Gifting of QRP to a charitable remainder trust (CRT) is an alternative available to selling shareholders who want to establish an actively managed portfolio without the investment and other risks associated with the margined approaches to purchasing QRP rather than buying and holding QRP in a well-diversified portfolio. If a selling shareholder has donative intent, this planning alternative has some merit. The primary drawback of this strategy is that although the selling shareholder (and his or her family) may receive the income on the QRP transferred to the CRT during the selling shareholder’s lifetime, the principal will be transferred to the designated charities upon the selling shareholder’s death.

In addition to the tax advantages available to the selling shareholder in a C corporation ESOP transaction, there are significant tax deductions available to the company that sponsors the ESOP. This is fundamentally as important as the tax advantages for the selling shareholder, and maybe more so for many of the ESOP transactions that occur each year.

Steps to Setting Up an ESOP

Assuming this tax deferral/avoidance and the company tax deductions appeal to the owner of a closely held business, how does such an owner go about selling 30% or more of his or her company to an ESOP trust? The first step is a feasibility study, which tells the owner whether the characteristics of the company and his or her circumstances are such that he or she is a good candidate for a sale to an ESOP trust. This feasibility study may involve one or more conversations with a qualified employee ownership attorney or a full-blown written feasibility analysis prepared by an attorney and/or financial consultant.

If the circumstances are such that the ESOP alternative is feasible, the next key step is to obtain an independent professional valuation of the entire company and of the portion of the company that is being sold to the ESOP trust. A valuation by an independent appraiser is one of the requirements for a transaction between an ESOP trust and an owner of the company that establishes the ESOP. Under the Employee Retirement Income Security Act of 1974, as amended, and the Internal Revenue Code of 1986, as amended (the “Code”), the ESOP trust cannot pay more than fair market value for the company stock that it purchases from the selling shareholder. The independent appraisal is used by the ESOP fiduciary (a board of trustees, an administrative committee, or an institutional trustee) to ensure that the ESOP trust does not pay more than fair market value for the company stock, as determined as of the date of the sale. Based on existing case law and regulatory guidance, the ESOP fiduciary must conduct the proper due diligence to make this determination in good faith.

The ESOP plan document and the ESOP trust agreement must be designed and implemented as the valuation process progresses. If the company does not have adequate cash resources to finance the purchase of company stock by the ESOP trust, as is usually the case, the company must obtain a loan from a commercial lender or the ESOP must receive credit from the selling shareholder, and loan terms (e.g., interest rate, prepayment penalties, commitment fees, costs, restrictive covenants, and collateral) must be negotiated. In addition, a stock purchase agreement between the owner of the company and the ESOP trust must be negotiated and prepared.

The ESOP trust then typically borrows the money from the company, which, in turn, borrows from a commercial lender, or the ESOP receives credit from the selling shareholder to purchase the company stock. The ESOP trust uses these loan proceeds or credit to purchase company stock from the owner at no more than its fair market value, as determined by an independent appraiser and confirmed in good faith by the ESOP fiduciary as of the date of the purchase. The company’s debt to the commercial lender and the ESOP’s debt to the company are normally repaid over a five- to ten-year term (or even more) with tax-deductible contributions by the company to the ESOP trust. The company, the ESOP trust, and the selling shareholders should work together to obtain the best terms possible for such financing. Collateral, corporate governance, and personal guarantees (or the lack thereof) are often issues on which the parties may have differences that need to be resolved. Contributions used to repay ESOP loan principal are generally deductible up to an amount equal to 25% of the total compensation paid or accrued to all participating employees. (Please see the relevant discussion in this book’s chapter on contribution and allocation limits.) “Compensation” for this purpose includes wages that an employee elects to defer pursuant to a cash-or-deferred arrangement under a 401(k) plan. Furthermore, the 25% limit does not include salary reduction contributions to a 401(k) plan. In other words, an employer may contribute 25% of the total compensation paid or accrued to all participating employees in order for an ESOP to repay loan principal in addition to salary reduction contributions, provided that the annual addition limitation of $41,000 (as indexed for inflation) for individual ESOP participants is not exceeded.

In a C corporation ESOP, contributions to the ESOP trust that are used to pay the interest on the ESOP’s loan from the company are fully deductible, and they are not included in the 25% contribution limit.

In a C corporation, reasonable cash dividends on ESOP-trust held company stock also are deductible and not included in the 25% contribution limit if they are passed through directly to ESOP participants, used to repay a leveraged ESOP’s loan, or are reinvested in company stock at the direction of participants instead of being passed through to them. The timing of the dividend deduction differs depending upon whether the dividends are (1) paid or distributed to the ESOP participant, (2) reinvested in company stock, or (3) are used to repay a leveraged ESOP’s loan. With respect to dividends described in (1), the deduction is allowable in the C corporation’s taxable year in which the dividends are paid or distributed to an ESOP participant or his or her beneficiary. With respect to dividends described in (2), the law that makes these types of dividends deductible includes a technical error (a prior reference for the timing of the deduction for dividends described in (3) incorrectly refers to the dividends described in (2)) that does not make it clear when the deduction is allowable. Intuitively, the dividend should be allowable in the C corporation’s taxable year in which the dividends would have been distributed to ESOP participants and instead were reinvested in company stock at the direction of such participants. With respect to dividends described in (3), the deduction is allowable in the C corporation’s taxable year in which they are used to repay the leveraged ESOP’s loan.

In S corporations, distributions on ESOP-held company stock are not deductible; however, based upon a provision in the American Jobs Creation Act of 2004 that was signed into law on October 22, 2004, distributions on both allocated and unallocated shares of company stock held by the ESOP may be used to repay an ESOP loan. This new law is retroactively effective back to January 1, 1998. The exact details of such retroactivity will be worked out in the future through regulations and/or regulatory interpretations, etc. It appears that distributions of earnings to an S corporation ESOP may not be passed through to ESOP participants, based on an express denial of a private letter ruling request in 1999 (that would have allowed such pass-through distributions) and on a dearth of statutory and/or regulatory support in the Code. To the extent distributions of S corporation ESOP earnings are not or may not be used to repay an ESOP loan, they may be used for ESOP distribution purposes.

The ESOP as a Versatile Financial Tool

An ESOP is a versatile financial and motivational tool that can be used by a selling shareholder and a company to obtain significant tax benefits in selling a portion or all of his or her company. An ESOP also can be used in connection with the spinoff of a division or corporate expansion or as an acquisition planning tool; it can be given a special class of preferred stock to minimize equity dilution; and it can be combined with a 401(k) plan to attract employee equity into a company. For both financial and non-financial reasons, selling stock to an ESOP should be irresistible to many closely held companies and their shareholders.

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