Tax Planning with ESOPs
The confluence of three rules creates wonderful opportunities for business tax planning.
The Three Rules
- S Corporation Taxation: An S corporation is not subject to income taxation because its income must be reported by its stockholders. (There is an exception in the case of a C corporation which converts to S status.)
- ESOP Qualification: A qualified retirement plan designed to invest primarily in the employer’s stock and which meets certain requirements can achieve status as an Employee Stock Ownership Plan (“ESOP”). ESOPs are permitted to engage in certain transactions that are prohibited for other plans, such as borrowing from the employer or purchasing stock of the employer.
- UBTI Exemption: Normally, exempt organizations must pay tax on unrelated business taxable income (UBTI). However, the Internal Revenue Code (amended in 1998) provides an exemption from UBTI tax for an ESOP owning stock in an S corporation. The portion of income attributable to such an ESOP is exempt from income tax. This arrangement is called a SESOP (S ESOP). If the SESOP owns all of the outstanding stock, the corporation is effectively exempt from income tax.
Corporate Benefits
Corporate employers can take deductions for contributions of stock to an ESOP. Such a noncash deduction improves cash flow. ESOPs also incentivize employees to behave more like owners, encouraging accountability and productivity.
Tax-Free Rollover Opportunities
Stockholders can qualify for a tax-free rollover of gain on the sale of stock to an ESOP if certain requirements are met:
- The ESOP must own at least 30% of the outstanding stock of the corporation after the sale.
- The sale proceeds must be reinvested in stock of an operating U.S. corporation (e.g., IBM).
- Rules prohibit the ESOP from allocating purchased stock to the seller, related parties, or large stockholders.
Classic Example
Stockholders can exit tax-free by selling to the ESOP, with the corporation effectively paying the purchase price via deductible contributions. For example:
- The ESOP borrows the stock purchase price from a bank.
- The loan is guaranteed by the corporation and the selling stockholder.
- The ESOP buys the stock with the loan proceeds.
- The corporation makes deductible contributions to the ESOP, which are used to repay the loan.
Buying or Selling a Business
ESOPs provide a tax-efficient way to buy or sell a business to a third party. A suitor can even use his or her own retirement money:
- The corporation establishes an ESOP.
- The suitor rolls over IRA or 401(k) funds into the ESOP.
- The ESOP buys stock, with the majority allocated to the suitor’s ESOP account.
Small Business Benefits
Tax planning with ESOPs is especially useful for small businesses with asset protection concerns, such as physician practices. The professional association (P.A.) can be converted to an Inc. or LLC. The corporate guarantee of the ESOP loan can be secured by receivables and other assets. The proceeds are received by physician-stockholders at capital gain rates, while the loan is repaid with deductible contributions. This approach allows physicians to capture stock value efficiently, rather than selling at artificially low values on termination.
