Employee Stock Ownership Plans (ESOPs) can wield great financial power and benefits when applied properly to real-life needs and concerns within today's corporate environment. From reducing employee benefit costs to purchasing capital goods, these tools help make companies' financial planning easier and more accurate. Six strategies are particularly beneficial.
One – Exit Strategy
What happens when a corporate founder and major shareholder decides that it is time to liquefy his or her investment, retire, and pursue other interests? These other interests cost money-and, of course, the founder and CEO of the company does not intend to curtail a heretofore pleasant lifestyle. Now it's time for exit strategies. How can the owner sell all or part of his or her holdings while remaining in control and avoiding current taxation? Sounds like a tall order, right? Consider the following parameters.
| Fair Market Value of Company |
$5,000,000 |
| Shares Issued and Outstanding |
10,000 |
| Value Per Share |
$500 |
| Percent Owned by Selling Shareholder |
100% |
| Cost Basis in Stock |
00.00 |
| Corporate Marginal Tax Rate |
34% |
| Personal Marginal Tax Rate of Shareholder |
31% |
| Annual Net Free Cash Flow of Company |
$450,000 |
| Sales and Profit Trends |
Up |
Selling Shareholder Benefits
Let's see how, by applying the above figures, an employee stock ownership plan can be used effectively to buy out the major shareholder to the benefit of both the shareholder and the remaining management. Assuming all rules are followed correctly, the shareholder can sell his or her holdings to a company sponsored ESOP and avoid current income tax on the gain.
Under Sec. 1042 of the Internal Revenue Code, income tax is deferred on such transactions if (1) at least 30% of all classes of stock were sold to the ESOP, and (2) the proceeds of the sale were reinvested in qualified replacement property, defined as the stocks and bonds of American operating companies. The deferral will last as long as the qualified replacement property is retained by the seller. Proper planning assumes that the qualified replacement property will be held until the seller's death. Should that be the case, income tax on the original transaction is deferred permanently. Furthermore, there is a step up in the stock's basis when the seller dies.
Assuming the above scenario, the selling shareholder would defer capital gains tax on the sale of $5 million of closely held stock to the ESOP. Applying the taxpayer's marginal tax rate of 31% to the $5 million taxable gain, the tax savings under Sec. 1042 would amount to $1,550,000.
In addition to receiving this outstanding benefit, the seller would be enjoying dividends from the reinvested proceeds of the sale. Assuming a 7% return, annual dividends would amount to $108,500. These proceeds are, of course, taxed in the year received.
Corporate and Lender Benefits
On the corporate side of the transaction, more benefits accrue. Under Sec. 133 of the Internal Revenue Code, properly constituted ESOP loans offer an attractive tax preference to the lender. Assuming at least 50% of all classes of stock-or 50% of the total value of all classes of stock-were sold to the ESOP, then the bank or another qualified lender is required to report only 50% of the interest income received from an ESOP loan for tax purposes.
This tax preference to the lender allows for an unusually profitable loan. As a result, a company is sometimes able to negotiate a below-prime-rate loan. The best, however, is yet to come. All principal and interest on an ESOP loan are tax deductible to the corporation. Accordingly, the corporation (or, more correctly, the management team) is able to acquire the company from the selling shareholder for $0.66 on the dollar.
Benefits such as these make exit strategy planning an exciting process for both seller and buyer. The benefits gained through tax savings are unbeatable.
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