Employee Stock Ownership Plans (ESOPs) offer successful business owners a means to diversify their risk while simultaneously rewarding loyal employees. An ESOP can be structured to allow the owner to cash out some or all equity in the company while still retaining operational control. The company itself may benefit from tax savings as well as access to a unique corporate financing strategy.

In order for the owner of a privately held corporation to sell his or her stock in the corporation to the corporation's ESOP without paying any taxes at the time of sale, the following conditions must be met:

If the seller complies with all these requirements, he or she has enhanced liquidity by converting an investment in a privately held corporation to publicly traded securities - without currently recognizing any taxes.

What Is Qualified Replacement Property?

In order for a security to qualify as Qualified Replacement Property, it must be a purchased security of a domestic operating corporation.

The Qualified Replacement Property must be acquired by purchase, not by gift, inheritance or otherwise, within a 15-month period beginning three months before the sale to the ESOP and within 12 months after the sale to the ESOP.
Domestic: The qualified Replacement Property must be securities of a corporation that is incorporated in the U.S. or any state thereof.
Operating Corporation: The Qualified Replacement Property must be securities of a corporation that uses more than 50% of its assets in the active conduct of a trade or business. Furthermore, the corporation cannot have passive income that exceeds 25% of its gross receipts for the year. Shares in mutual funds and real estate investment trusts (REITs) do not qualify as Qualified Replacement Property, although shares in certain financial institutions and insurance companies may.

 Tax Consequences

By reinvesting all proceeds in Qualified Replacement Property, the seller defers all gain on the sale and thus avoids paying any current tax. Any gain that the seller defers on the sale to the ESOP reduces his or her tax basis in the Qualified Replacement Property.

If the Qualified Replacement Property is sold, matures, or is redeemed by any call or sinking fund provision, the seller generally must recognize a capital gain or loss on the difference between the amount received and his or her tax basis in the Qualified Replacement Property. Alternatively, the seller can eliminate the taxable capital gain deferred in the Qualified Replacement Property by passing the securities through his or her estate. The result would be a 'step up' to fair market value in tax basis and the elimination of any capital gains the seller would have recognized on the sale of the Qualified Replacement Property.

As mentioned previously, the primary objective of the IRC §1042 ESOP Rollover is the current deferral of capital gains taxes and the increased income benefits of having 100% of the ESOP sales proceeds working on behalf of the investor. The portfolio containing the Qualified Replacement Property is not one to be traded, nor is it like a real estate exchange whereby real estate can be swapped on a tax-free basis for other real estate. For many investors, the portfolio is permanent.

However, if liquidity is needed, there are methods to create it without selling the Qualified Replacement Property and recognizing capital gains taxes.

Estate Planning Opportunities

Successful business owners are often faced with the challenge of transferring wealth to the next generation or to charitable interests and reducing, if not eliminating, estate taxes.

Generally, the ideal time to revisit and perhaps fine-tune a previous estate plan or initiate a new estate plan is either immediately following or within a year of completing an ESOP sale. For example, if an investor combines an IRC §1042 ESOP Rollover with an accelerated gifting program, it may be possible to save significant estate taxes.

As a result of a leveraged ESOP, a company's capital is restructured by virtue of the additional corporate debt. This modification of a company's balance sheet, combined with the simultaneous, though hopefully temporary, reduction in the remaining equity in the company or its share value, allows an investor who still has shares remaining in the company to make a gift of these 'reduced-value' shares to the next generation. If valuation discounts for lack of marketability and for minority interests are applied, value may be reduced even more.

This enables the investor to give more shares post-leveraged ESOP sale than what is possible pre-leveraged ESOP sale. And, of course, as the ESOP debt is reduced, the equity in the corporation typically increases, resulting in appreciation outside of an investor's estate.

The Benefits of a Charitable Remainder Trust

Another estate planning strategy with significant value involves transferring Qualified Replacement Property into a Charitable Remainder Trust (CRT). This can generate large charitable tax deductions. A taxpayer's gift of Qualified Replacement Property to a CRT generally will not generate taxable gain nor will it result in a recapture or recognition of gain relative to a taxpayer's IRC §1042 election.

In Closing

ESOP IRC § 1042 Rollover Strategies and Estate Planning Strategies are critical, complicated processes. Asset Strategy Retirement Plan Consultants is committed to helping our clients build a prudent and sound IRC § 1042 ESOP Rollover portfolio.

However, we do not provide tax or legal advice. You must consult with your tax and legal advisors prior to implementing any strategy. All information provided has been obtained from sources believed to be reliable. There is no guarantee of accuracy or completeness. All investment alternatives discussed are subject to change and availability. No assurance is given that proposed results will be achieved.