The succession strategy to defer taxes

A 50% increase in capital gains tax rates makes this a good time to consider an ESOP

Apr 16, 2014 @ 1:40 pm

By Carl Grassi

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In the six-year period ending in 2012, taxpayers were reluctant to structure transactions to defer taxes because tax rates were very low (especially on capital gains).

Why defer taxes if rates are only going to increase? As of last year, the highest tax rate on most capital gains rose to 23.8% (which includes the additional tax on investment income).

This rate is more than 50% higher than rates were in 2012. Many observers think it is very unlikely that these rates will be going up anytime soon. This may, therefore, be a good time to once again consider techniques for deferring taxes, especially on significant transactions such as the sale of a company.

Driven in part by the current tax rate structure, many business owners are considering employee stock ownership plans (ESOPs) as part of their succession plan.

The basic mechanics of an ESOP are relatively straightforward. The company forms an ESOP, which is essentially a qualified retirement plan. It is similar in many ways to a 401(k) or profit sharing plan, except that its primary asset is stock of the sponsoring company.

The ESOP contracts to purchase stock of the company from one or more selling shareholders at a price determined by a qualified appraisal. In order to effectuate the purchase, the company often will borrow the necessary funds from a qualified lender (i.e., a bank or other lending institution).

This is called a “leveraged” ESOP. The company immediately lends this money to the ESOP, and the ESOP uses the money to pay the purchase price to the shareholders for the acquired shares.

There are many benefits to using an ESOP to acquire shares in a closely-held company. First, the ESOP essentially creates a market for a minority interest in the company. While many ESOPs are formed to purchase at least a 30% interest in the sponsoring company to take advantage of the tax deferral described below, there is no minimum percentage that the ESOP can purchase.

Selling a minority interest in the company to an ESOP can allow the current shareholders to maintain control of the business and remain employed by the company.

There can also be significant tax benefits to the shareholders. If the company is a C corporation, as long as the ESOP owns 30% or more of the company shares after the acquisition, the selling shareholders can generally defer the income tax on the gain from the sale of the stock.

Provided the proceeds received by the selling shareholders are rolled over into “qualified replacement property,” no tax is due on the sale of the shares to the ESOP. Selling shareholders can transfer the qualified replacement property by gift or upon death without triggering the deferred gain.

This allows a business owner to diversify his or her investment in the closely-held business without triggering any gain, and completely eliminating the gain if the qualified replacement property is held until the shareholder's death.

There are also benefits to the company. From a tax standpoint, the company will get a tax deduction for the interest paid to the lender and for an amount equal to the principal payments, generally not in excess of 25% of the eligible compensation of ESOP participants.

Another reason to consider an ESOP is to create a stock-based retirement plan for employees to replace or supplement existing plans.

Many business owners like the idea of employees thinking of themselves as owners of the company, but do not like the idea of giving employees voting rights, holding shareholder meetings, and entering into shareholder agreements with the employees to buy back the stock upon termination of employment.

An ESOP can eliminate many of these concerns because, like other types of qualified plans, ESOPs provide the employees with a beneficial ownership interest in the equity of the company but generally without the voting and other rights of a shareholder.

An ESOP will not work in every situation. Having a sufficient number of employees with relatively low turnover is important. Most companies implement an ESOP with borrowed money, meaning the company needs to have sufficient capacity for additional debt.

Also, the costs of setting up and maintaining an ESOP are not insignificant, and an experienced team of legal and financial professionals is critical to the successful adoption and operation of an ESOP. Despite these concerns, an ESOP should be a part of the discussion for any business owner considering succession planning.

Grassi is president of Cleveland-based law firm McDonald Hopkins LLC.


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