ESOPs as a Tool in Business Succession Planning

With all of the tax-saving avenues discussed, ESOPs are ideally suited to be used in the design of a business succession plan.  For instance, the ability to sell tax-free using 1042 coupled with monetizing, and the facility to combine ESOP with Subchapter S, thereby creating a tax-exempt entity, constitute luscious : “food for thought” to a tax planner who knows, or has access to, the intricacies of ESOP.

As you know, there is now a wealth of outstanding professionals who engage in “cutting edge” estate planning that, for instance, removes high-worth assets from taxable estates, minimizes 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 coupling them with planning using ESOPs.  To illustrate, let’s focus on a few common business succession planning problems facing many, if not most, family business owners:

  • 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 retirement for himself and his wife, while equalizing the share given to their 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, continue to run the business, and live off of the income from it and the interest on debt while preserving proceeds of the take-back note for the daughter.  The business can then deduct the cost of repaying the debt by channeling it through to the ESOP in the form of deductible contributions.
  2. Place the remaining common stock into a limited partnership or LLC and start making discounted gifts of minority interests to the son.
  • Situation 2: What if there are no children in the business, nor will there ever be?  Here are three options:
  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.
  2. The father sells 100 percent of the business to an ESOP and elects 1042, but maintains control at least 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 then uses its untaxed earnings to pay the father’s take-back debt.
  • Situation 3: A father has management that wants equity, and a young son who works in the business.
  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, even though it is made available to them, few employees beyond management choose to go this route).
  2. Where needed, provide selected managers “incentive stock options” to purchase stock from either the father or the corporation that owns the business, at an appropriate price.
  3. The father and management train the son to guide the business in the future.

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