Consider The ESOP

No succession or estate-planning strategy is complete unless you’ve evaluated whether it’d be smart to use an employee stock ownership plan

By Louis H. Diamond

In business succession and estate planning involving a closely held business, employee stock ownership plans (ESOPs) should be one of the prime planning alternatives considered.

Unfortunately, they rarely are.

That’s probably because ESOPs are very complicated. The tax-oriented inducements incorporated into the law are tantalizing. But, to ensure that they’re not abused, they’re designed to be finite and restrictive. Many rules are involved; deviation from the letter of these laws can result in dire consequences. Still, Congress, the Department of Treasury and the Internal Revenue Service have provided guidance, and even safe harbors, that enable us to swim in these rough-but-rewarding waters.

Also, ESOPs are good for the companies themselves. Studies have shown that when a meaningful ESOP program has been implemented and properly explained to employees, ESOP companies outperform their non-ESOP counterparts.1


An ESOP is a form of qualified deferred compensation plan that blends retirement planning with employee ownership. Actually, “ownership” is a bit of a misnomer. Stock ownership is relegated to a trust controlled by either an internal or external trustee, or a combination of the two, with the latter stepping in should a conflict arise. The trustee is appointed by the board of directors, and the beneficiaries of the trust are the company’s employees.

The underlying purpose of ESOPs is to create a correlation between how well the company does with how well its employees do. ESOPs’ existence can be credited to Senator Russell B. Long, D-La., who chaired the Senate Finance Committee for 15 years and Louis Kelso, a lawyer and economist from San Francisco, who advised him. Through Sen. Long, the concept of employee ownership gained popularity in Congress and was incorporated within our overall qualified deferred compensation system: the Employee Retirement Income Security Act of 1974 (ERISA). Interestingly, while a part of ERISA, ESOPs frequently violate the edicts encompassed within it. Exceptions enable ESOPs to accomplish many goals that would otherwise be unattainable. These exceptions bestow upon ESOPs an ensemble of tax benefits designed to induce private industry to extend to employees the financial benefits inherent in ownership.


These ESOP inducements can enhance both business succession and estate planning. You just have to know what to look for, and how to make it work.

  • Rolling gains over tax-free — Internal Revenue Code Section 1042 enables qualified stockholders of a C corporation to sell their company stock to an ESOP and defer, or even avoid, paying a tax on the gain realized from this transaction. Instead, that gain is “rolled over” into investments referred to as qualified replacement property (QRP). QRP is a broad category consisting principally of stocks, bonds or notes of active U.S. corporations — usually, those that are publicly traded on our major stock exchanges. This is analogous to the manner in which taxation of gain from the sale of business property (usually real estate) can be deferred by investing the proceeds from that sale into analogous business property (IRC Section 1031). In both instances, the recognition of that gain can be indefinitely postponed until the time the owner permanently disposes of the business property, or the gain can be avoided if the replacement property is held until the owner’s death. In the meantime, this QRP is, as we say, “locked up” because its disposition triggers the deferred tax on the gain.

This QRP can, however, be the key to creating liquidity by using it as collateral on loans pursuant to a procedure known as “monetizing.” This is how it works:

    1. The seller of stock to an ESOP for, say, $10 million takes the proceeds of that sale and, within one year, invests it in a specially designed long-term (for example, 40-year) note, the interest on which is reset quarterly to reflect the then-prevailing rate of interest (usually LIBOR).
    2. These notes, which qualify as QRP, are issued by AA/AAA companies like JP Morgan, UPS and Proctor & Gamble, with the expectation that, by negating interest rate risk in the underlying securities by means of quarterly interest rate resets, they will always be worth face value. Lenders such as Deutsche Bank and UBS have been willing to lend 90 percent (and sometimes even more) with these floating rate notes (FRNs) as collateral, thereby enabling sellers to free-up 90 percent of their sale price by tying up the remaining 10 percent. But in this recession, other makers of FRNs (such as AIG, Wachovia and National City) have been hit hard, so their notes may not hold their full value and could even precipitate margin calls. Accordingly, the current status of the monetizing procedure is in flux and should be checked before implementing this investment scenario.

The attraction of Section 1042 diminished when the tax on long-term capital gain (LTCG) was reduced from 20 percent to 15 percent. But it’ll regain importance if, as many expect, the tax on LTCG is restored to 20 percent.

  • Even at 15 percent, Section 1042 transactions remain in vogue and can produce major benefits. (See “Sale to ESOP vs. Non-ESOP,” this page.) That’s because Section 1042 enables stockholders of closely held businesses to: realize more from a sale of their stock, diversify to prepare for retirement and even earmark funds to provide inheritance for non-involved children, while reducing the tax bite of passing a family business on to the next generation.


Sale to ESOP vs. Non-ESOP

Selling company stock to a corporation’s employee stock ownership plan produces dramatic tax savings

If a corporation’s founding stockholders sell some of the firm’s stock to an ESOP for $7 million, they’ll save a total of $4.2 million in taxes, compared to what they’d get by selling the stock to a non-ESOP alternative.

After-Tax Benefits to Seller After-Tax Cost to Company
ESOP Alternative $7,000,000 $4,200,000*
Non-ESOP Alternative $5,600,000* $7,000,000
Differential $ 1,400,000 $2,800,000
Total Tax Savings Using ESOP $4,200,000

*The $4.2 million is based on $7 million contributed to the ESOP and deducted by the corporation, reduced by a 40 percent tax deduction (34 percent federal tax rate, 6 percent state tax rate). The $5.6 million is based on the $7 million sales proceeds, reduced by a 20 percent long-term capital gain tax (15 percent federal rate, 5 percent state rate).

Louis H. Diamond


Section 1042 does have complications and limitations in addition to its lock-in effect that may make it less than the optimal method of deferring tax. But, alternatives are available that can produce other benefits with the potential to achieve tax savings that may even exceed the benefit derivable through Section 1042.

  • Participating in the allocation of stock within the ESOP — Under 1042, the seller, family members, and other 25 percent stockholders cannot participate in the allocation of the stock the ESOP purchased from the seller. But, absent a 1042 election, these people, in their capacity as company employees, are entitled to participate in the ESOP and receive in their account a pro-rata portion of the stock purchased from the seller. Then, depending upon the nature and extent of the company’s payroll, their entitlement as ESOP participants could, in and of itself, exceed the taxes incurred in connection with the stock sale involved.
  • Channeling the sale of stock through a charitable remainder trust (CRT) — Here, the question immediately arises as to how something as far afield as a CRT can work to the advantage of a stockholder of an ESOP corporation who, in effect, channels his “sale” of stock to the ESOP through a CRT. This scenario goes along these lines: The stockholder forms a CRT by contributing to it some of his company stock,2 reserving from it an annuity that the CRT pays him usually using income it generates, but, depending upon the form of CRT utilized, can include a return of principal if earnings are insufficient to pay the reserved annuity.

Let’s look at the tax ramifications of this transaction. At inception, the stockholder forming the CRT gets an actuarially calculated charitable deduction that varies based upon the stockholder’s age, the magnitude of the reserved annuity and the type of CRT being utilized. That stock is then no longer part of the seller’s taxable estate.

On the company side, it deducts the cost of funding the ESOP that purchases the stock contributed to the CRT by the “selling” stockholder, who gets his “sales price” in the form of the annuity he reserves from the CRT. (See “Channeling a Stock Sale Through a CRT,” p. 24.) Normally, under the Section 1042 alternative, if the QRP is “disposed of” before the death of the selling stockholder, the deferred gain attributable to the QRP disposed of must be recognized so that that portion of the deferred tax would be triggered and tax will become due. But, by routing this transaction through a CRT pursuant to an exception to the normal “disposition” rule,3 the selling stockholder, in his capacity as CRT trustee, retains the ability to buy and sell the investments owned by the CRT without triggering any tax, thereby avoiding the 1042 “lock-up” effect.



See how it works

In our example, let’s say a 65-year-old man contributes 10 percent of stock in his 100 percent-owned company with an appraised value of $1 million to a charitable remainder trust (CRT), subject to a retained annuity of $50,000 per year. The CRT then sells that stock for $1 million to the company’s employee stock ownership plan (ESOP).*

What Happens Contribution Amount Tax Savings Net Investment Contribution Reduced by Tax Saving Retained Annuity Yield
The seller contributes company stock worth $1,000,000 $1,000,000 $50,000 5.0%
This transaction produces income tax deductions for the seller of $403,180, which saves tax of 40% (federal 35%; state 5%) = $161,272 $161,272 $832,728 50,000 6.0
It also excludes from his taxable estate $1,000,000, producing estate tax savings of $450,000, the present value of which assuming life expectancy of 21 years is $236,246 236,246 602,482 50,000 8.3
Meanwhile, the company deducts ESOP contribution of $1,000,000 × 90% (100% – 10% ) × 40% federal and state tax, which saves the grantor $360,000 $360,000 $242,482 $50,000 20.6%

* These calculations, and other contained in this article, were derived with the computerized help of NumberCruncher, created by Leimberg & LeClair, Inc.,
Louis H. Diamond


When using this tax-saving vehicle in situations where the selling stockholder is married and the annuity due from the CRT is joint and survivor, I usually recommend that a portion of the tax savings be placed into an irrevocable trust and used to purchase last-to-die life insurance covering both spouses. In that way, upon the death of the last of the two when the CRT terminates and its assets are conveyed to the named charity, the insurance proceeds will provide surviving beneficiaries with an estate tax-free substitute for their lost inheritance. This completes a logical tax-reducing circle, and entitles the stockholder involved to bask in the sunlight of being a benevolent philanthropist.

  • Accessing larger ESOP contribution deductions — When no more than one-third of employer contributions to an ESOP goes to highly compensated employees (those earning more than $110,000 (subject to cost-of-living adjustments) per year), C corporations can exclude interest from the calculation of the first 25 percent of the defined contribution plan covered compensation deduction limitation, raising it to well beyond 25 percent (say 40 percent when considerable interest-bearing leverage is involved). Then, subject to limitations contained in IRC Section 415,4 a second 25 percent of covered compensation deduction is available so long as the second, but not the first, 25 percent contribution is used by the ESOP to pay down stock acquisition indebtedness.

Depending upon the facts, which may be adjusted to comply with this provision, deductible contributions made by the company to an ESOP can substantially exceed that attainable through any other type of defined contribution plan (for example, a 401(k) plan).

Then, money freed up through these tax savings can be applied to hasten repayment of stock acquisition indebtedness. Banks understand this and are willing to lend more to an ESOP company than to another that does not share its tax-avoidance capacity. And, when at least a portion of that debt is a seller take-back note, the whole ESOP sale transaction becomes more feasible.

  • Deducting dividends paid by a C corporation on ESOP stock — Reasonable dividends paid by a C corporation on stock acquired by its ESOP can be deductible, although they are subject to the alternative minimum tax (AMT). This is the only instance in which our tax system allows companies to deduct dividends paid to a shareholder. In turn, the company has available even larger plan infusion potential that can be used to gain a tax deduction for money placed into its ESOP, then either used to pay stock acquisition debt or passed through the ESOP to its employee participants.
  • Getting long-term capital gain rather than ordinary income — Distributions from ESOPs to plan participants can be made eligible for LTCG, rather than ordinary income (OI), tax on net unrealized appreciation (NUA). This means that, to the extent that the value of company stock in a participant’s ESOP account exceeds its tax basis to the ESOP, LTCG rather than OI, tax will apply when the stock is distributed and then sold back either to the company or its ESOP. Considering the fact that the company got a tax deduction for placing that stock in its ESOP with no current offsetting income tax payable at that time by the ESOP’s participants (frequently including the seller, family and 25 percent stockholders), for them to get LTCG, rather than OI, tax on the gain they ultimately realize produces a particularly advantageous end result.
  • Having the employer purchase stock with ESOP funds laterally transferred from other qualified plans — It’s common in planning situations involving business owners who’re ready to phase down and out of their businesses to consider selling to employees. The idea is quite appealing and logical, but usually goes nowhere because, with very few exceptions, the employees have no money to pay the purchase price. But under ERISA, participants can laterally transfer money due them from one qualified plan, including a transferee IRA, into their account in another qualified plan. So, for instance, monies in a plan participant’s account in a 401(k) plan transferred to that participant’s account in an ESOP can be used to purchase company stock solely for that participant’s ESOP account that is not shared with the accounts of other ESOP participants. As you may imagine, this is not easily done, and even involves Securities and Exchange Commission and state blue sky laws. But with careful planning, particularly advantageous results can be attained.

I have successfully consummated two such transactions: In one, employees bought their company by moving $27 million of $110 million they had in other plans into a newly formed ESOP that, using those transferred funds as equity and borrowing the rest, completed a $130 million purchase. Employees in another transaction used the same format to complete a $2 million purchase. In both instances, these then 100 percent employee-owned companies prospered. It’s important to know what can be accomplished and what, if any, ramifications might arise. Then, all involved can decide whether the benefits attainable by means of lateral transfers are worth the complexities they entail. In my experience, when the money is substantial, they frequently are.

Avoid Tax

Since 1998, ESOPs have been allowed to be stockholders in an S corporation and thereby delay any tax on their share (all when the S corporation is owned 100 percent by its ESOP) of the S corporation’s taxable income until distributions are made to participants. Moreover, the ESOP’s share of the corporation’s active business income is not subject to the unrelated business income tax (UBIT), which taxes at the top corporate rate (now 35 percent) the net income that tax-exempt entities realize from the conduct of active businesses unrelated to their tax-exempt purpose. This infusion of non-taxed income available to pay creditors enables ESOP-owned corporations to qualify for extended credit from banks and primary lenders at reasonable rates, as opposed to analogous funds obtained from mezzanine lenders or venture capitalists.

Obviously, being able to operate tax-free can produce dramatic results. For instance, the annual production of $1 million of net income per year by an ESOP-owned S corporation compounded at 12 percent for 10 years will grow to over $18 million. The same income production by a taxable C corporation will result in the reduction of that growth from 12 percent to 7.2 percent (12 percent less a 40 percent tax) and accumulate to less than $8 million.

This kind of S corporation growth, coupled with readily supportable synthetic equity (for example, warrants, options, stock appreciation rights, phantom stock) and the seller’s participation in the S corporation’s ESOP, should induce more business owners to adopt and sell stock to ESOPs.

Family Businesses

For purposes of this discussion, a family business is one owned and operated by a person, usually still married, who has children who may, or may not, be actively involved in the business. While it’s common for family businesses to have some non-family stock and “synthetic equity” holders, in the eyes of the parent, control is usually as important as outright ownership. When an ESOP is involved, the control factor is particularly important because, some, or all, ownership is in a trust (the employee stock ownership trust), the trustee of which is appointed by the board of directors.

As usual, fact situations vary greatly and, as planners, we must adapt accordingly. Fortunately, the ESOP world is quite flexible and the underlying facts can almost always be adjusted to achieve the business owner’s objectives.

There are now a wealth of outstanding professionals who engage in “cutting edge” estate planning that, for instance, removes high-worth assets from taxable estates, minimizes (largely through discounts) the value assigned to gifted assets — including interests in businesses (usually by making them minority, illiquid and non-marketable). Nevertheless, quite frequently, those cutting edges can be made considerably sharper by either coupling, or replacing them with ESOPs. While the presentation and analysis of a litany of examples is not here feasible, perhaps a brief introduction to a few typical scenarios and lead-ins on how ESOPs can provide optimal answers might whet your appetite for details:

  • Situation 1: A father has a profitable, but illiquid company and two adult children; a son who works in the business and a daughter who does not.

First dilemma — How can the father treat both children equally knowing that leaving each 50 percent of the business will result in acrimony?

Second dilemma — How can the father turn the business over to his son yet still extract money to fund a retirement for himself and his wife, while equalizing the share given to his daughter?

Some suggestions:

    1. Recapitalize by having the father exchange half of his common stock for “super common stock” (common stock with a limited dividend preference) to offset an unwanted discount. Sell the super common stock to the ESOP in exchange for take-back debt, elect 1042 and monetize; live off of the income from the QRP while preserving principal for the daughter. The business can then deduct the cost of repaying the debt.
    2. Place remaining common stock into a limited partnership and start making discounted gifts of minority limited partnership interests to the son.
  • Situation 2: What if there are no children in the business, nor will there ever be? There are three options:
  • Situation 3: A father has management that wants equity, and a young son who works in the business.
    1. The father sells his business to an ESOP — 30 percent (the 1042 minimum) to start, then more after take-back debt has been paid and value restored. Or,
    2. The father sells 100 percent of the business to an ESOP and elects 1042, but maintains control until his take-back debt has been paid.
    3. After the ESOP becomes owner of the business, it elects S corporation status effective for its fiscal year beginning after the sale and becomes tax-deferred (or avoided, by either retaining QRP until death or monetizing). The business uses untaxed earnings to pay the father’s take-back debt.
  1. The business adopts an ESOP and extends employees the right to transfer funds from a 401(k) plan to the ESOP to purchase some stock from the father (experience discloses that few employees beyond management choose to go this route when it’s available).
  2. If needed, provide selected managers “incentive stock options” to purchase stock from the father at the price paid by ESOP.
  3. The father and management train the son to guide the business in the future.


Of course, before incorporating an ESOP into a business succession or estate plan, you should consider what are seen by some to be the downside to ESOPs.

  • Repurchase obligation — Remember that somewhere down the line there will come a time when ESOP participants leave the company or, even while still employed, become entitled to compel diversification of up to 25 percent of the company stock in their account (after they’ve served 10 years and attained age 55), and then another 25 percent (at age 60). When that time comes, those ESOP participants will be entitled either to be paid an amount equal to the appraised value of the shares subject to diversification that have been allocated to their ESOP account, or have that percentage of their account invested in at least three other investment choices (mutual funds, for example) that have different degrees of risk.

This obligation should be anticipated and planned for. Fortunately, the law provides considerable flexibility.

First, no participant distributions need be made to anyone other than retirees until all indebtedness incurred by the ESOP to acquire the stock that gave rise to these distributions has been paid. Then, upon retirement, death or disability, the company can phase out payments over five years, starting with the year following the triggering event.

If an employee leaves the company for reasons other than retirement, death or disability, the start of distributions can be delayed for an additional five years. This rule provides the company considerable time within which to plan for that demand upon its resources.

Moreover, it’s important to understand that, if the company’s value diminishes, so does its payment obligation, because that obligation keys off the value of the company’s stock at the time the payment becomes due. So maturing ESOP payment obligations should not become crippling as have defined benefit pension plans that have hobbled U.S. automakers. Still, it’s a good idea to create and maintain a sinking fund (including, perhaps, key-man life insurance) to cover this future liability.

  • Cost to implement and maintain — ESOPs are not cheap. Set-up costs covering legal, valuation and accounting services normally run $50,000 to $75,000, but can go much higher depending upon the scope of the project. Of course, these costs are deductible. They also should be dwarfed by the tax savings they produce. All this should be quantified by a feasibility study before deciding to go forward. Thereafter, absent special circumstances (for example, an acquisition), annual maintenance costs, including testing to assure that no mistakes occur, should be relatively modest: probably $10,000 to $15,000 a year and that too is deductible.


Of course every situation involving ownership of closely held businesses is different and necessitates different approaches. And of course, planning alternatives abound. Some are good, yet many, if not most, will fall far short of desired goals. That’s why it’s so critical to do a comparison of all alternatives — a feasibility study — that, to the greatest extent possible, penetrates through the esoteric and hyperbole. Such a feasibility study should include a thorough analysis of the present, embellished by projections about the future. It should include meaningful and well thought out assumptions. Preconceived notions about ESOPs should be ditched. For instance, without a thoughtful analysis of the financial consequences of a gift of company stock to a CRT, who could have imagined that such a step could produce a reward-to-cost yield of over 20 percent per year? Indeed, a feasibility study should probably be implemented as part of any business succession or estate plan for a wealthy business owner.

Indeed, it’s important when constructing any estate and business succession plan, to explore every option, including the ESOP. It may be that an ESOP doesn’t suit the goals at hand. But without at least considering this device, it’s hard to justify that an adequate study has been done.

— For their help with this article, the author thanks Luis Granados, partner in the Washington office of McDermott, Will & Emery, and Ronald Gilbert of ESOP Services, Inc. in Scottsville, Va.

Louis H. Diamond is the managing member of Diamond ESOP Advisors PLLC in Washington


  1. See “Employee Ownership and Corporate Performance,” Chapter 2, Smiley, Gilbert, Binns, Ludwig, Rosen, Employee Stock Ownership Plans, The Beyster Institute at the Rady School of Management, University of California, San Diego.
  2. There is an alternative way that a transaction such as this can be structured. The stockholder could first sell his stock to the employee stock ownership plan (ESOP) pursuant to Internal Revenue Code Section 1042. He then uses the proceeds to purchase qualified replacement property, which can be contributed to a charitable remainder trust (CRT), subject, of course, to its obligation to pay the annuity. The end result should be comparable, except that not every stockholder is eligible to use Section 1042, and not all stock or corporations qualify under the Section. Only C corporations are eligible in either instance (IRC Section 1042(c)(1)(A)). Also, CRTs do not qualify as eligible owners of S corporation stock. But in an analogous situation in which S corporation stock was transferred to an individual retirement account (also an ineligible S corporation shareholder) that immediately had that stock redeemed by the corporation, the Internal Revenue Service has held that this momentary ownership by an ineligible stockholder would not cause a termination of the corporation’s S status. (See Private Letter Ruling 200122034). Then, in Revenue Procedure 2004-14, the IRS confirmed this position and extended it to cover an immediate sale of that stock to an ESOP. The reasoning used by the IRS in these pronouncements should equally apply in the “S to CRT to ESOP” scenario, and I believe that, if asked, the IRS would so rule. But, it probably would not be wise to have an S corporation stockholder engage in this transaction without first obtaining a ruling from the IRS. In any event, the path should be clear for a C corporation (or an unincorporated entity, for example, a proprietorship, partnership or limited liability company that incorporates as a C corporation), to undertake this procedure, then, if desired, subsequently elect S corporation status. And, it also would be feasible for an S corporation to terminate that status, and, for the five taxable years that must pass for it to be eligible to re-elect S corporation status, shelter its otherwise taxable income by means of large ESOP contributions that are principally used to pay stock acquisition debt. But, a feasibility study that supports the conclusion that this will work, should precede the utilization of this S corporation termination alternative.
  3. IRC Section 1042(e)(3)(C)).

No contribution is deductible or permitted that produces a per-person defined contribution plan allocation in excess of the lesser of 100 percent of compensation or $49,000 (subject to cost of living increases).