ESOPSTRATEGY

CONSIDER ESOPS IN

LEGACY PLANNING FOR

BUSINESS OWNERS

Selling a closely held business to anESOP can provide bus inesscontinuity, along with liquidity andtax savings for the shareholder.

KELLY O. FINNELL ANDANDREW T. HOLMES

An Employee Stock OwnershipPlan (ESOP) is a dynamic planningstrategy that can serve many pur-poses. Most commonly, an ESOP isused by a business owner as a li-quidity and ownership successionplanning strategy whereby a com-pany creates an ESOP and trust towhich the owner sells all or a por-tion of his or her stock in a lever-aged transaction. In this type oftransaction, the ESOP also serves a

tool of corporate finance, allowing acompany to finance a leveragedbuyout on a pre-tax basis.1 AnESOP also can create numerous es-tate, gift, and charitable planningopportunities, although in the au-thors’ experience, these opportuni-ties are underused. This articlepresents a case study that illustratesthe benefits of integrating estate,gift, and charitable planning into anESOP transaction.

Background

An ESOP is a qualified retirementplan and must comply with the re-quirements of Section 401(a). AnESOP is distinctive, however, inthat it:

• Must invest primarily in thestock of the sponsoring employer.2

• Is permitted to borrow money(i.e., a “leveraged ESOP”).3

• Can engage in transactions witha party-in-interest (i.e., the ESOPcan purchase stock from the spon-soring company’s shareholders).4

ESOPs used in ownership succes-sion planning typically are lever-aged. An exemption to the prohib-ited transaction rule, which preventsqualified retirement plans from bor-rowing money from their sponsoringemployers, allows loans to ESOPsprovided the loans satisfy certainstatutory requirements.5

An ESOP can provide multipletax benefits for the company andthe selling shareholder, the precisenature of which may vary depend-ing on whether the corporation istaxed as a C or S corporation:

• The company may deduct itsannual contributions to the ESOP.

• A C corporation may deductdividends it pays on ESOP shares.

• Under Section 1042, a share-holder who sells C corporationstock to an ESOP may reinvest theproceeds received from the ESOPsale in “qualified replacement prop-erty” without immediately payingincome tax on those proceeds.

• A 100% ESOP-owned S corpo-ration can essentially operate as atax-exempt entity.

Case study scenario

Jim and Joyce Smith, each age 70,have been married for 47 years. Jimis the founder, CEO, and sole share-holder of ABC Inc., a successfuldistribution company taxed as an Scorporation. The Smiths have twochildren: Bob, age 45, who is activein the management of the companyand Mary, age 42, who is a physi-cian and not involved in the com-pany. Jim has received a salary andbonus from the company of $1 mil-lion and S corporation distributionsof $4 million for the past 15 years.Based on input from his advisorteam, Jim believes that the com-pany’s equity value is $40 million.Jim and Joyce own assets outsidethe company worth $20 million.

Over the past five years, Jim hasbeen considering ownership succes-sion and liquidity strategies. Likemost successful business owners,Jim receives many calls from in-vestment bankers who tell him theywould like to represent him in asale of the company to a private eq-uity group (PEG).

A few years ago, Jim hired an in-vestment banker to prepare and dis-tribute a confidential informationmemorandum and arrange meetings

1 For additional information, see Finnell andHolmes, “Consider ESOPs as an Estate PlanComponent for Business Owners,” 41 ETPL3 (September 2014).

2 Section 4975(e)(7)(A).3 Section 4975(d)(3).

4 Section 4975(c)(1).5 Section 4975(a); Reg. 54.4975-7(b)(2).

Kelly O. Finnell, J.D., CLU, AIF, is the president of Executive Financial Services, Inc., in Memphis, Tennessee. He is also the author of The ESOP Coach: Using ESOPs in Ownership Succession Planning and can be contacted at kfin@execfin.com.

Andrew T. Holmes, LL.M., serves as vice president and shareholder. He has assisted on numerous complex ESOP transactions. He can be contacted at aholmes@execfin.com.

with potential PEG purchasers. AsJim learned about the risks that areinherent in sales to a third-partysuch as a PEG, this strategy becameless attractive. Jim realized thatmany of the key provisions of apurchase agreement such as repre-sentations, warranties, indemnifica-tions, and escrows can result in asubstantial amount of the supposedproceeds never being paid or beingclawed back. More importantly, herealized that he began this processwithout first considering goals forhimself, his employees, the com-pany, and his family.

The Smiths’ goals focused oncreating a legacy of financial secur-ity for their children and grandchil-dren, as well as a sense of signifi-c a n c e r e s u l t i n g f r o m t h eestablishment of a charitable trust tosupport their community, church,alma mater, and other worthycauses. Jim and Joyce also soughtan equitable way to divide their as-sets between their children, a pro-cess that can be challenging for bus-iness owners. Like many businessowners, two-thirds of the Smiths’net worth was tied up in the com-pany. Therefore, if they left thecompany to Bob (the active child),Mary would be disadvantaged. Onthe other hand, leaving Mary a 50%interest in the company that Bob

managed would present a host ofchallenges.

Based on discussions with theirteam of professional advisors, Jimand Joyce decided the answer totheir planning challenges was forthe company to establish an ESOPthat would purchase 100% of Jim’sstock.

Planned transaction. Section 1042provides a tax deferral to sharehold-ers who sell C corporation stock toan ESOP. Therefore, the companyrevoked its Subchapter S electionprior to the ESOP transaction in or-der to give Jim the option to electthe tax-favored treatment under thatCode section.

The company financed the ESOPtransaction with a $20 million se-nior bank loan, fully amortized overfive years, and a $20 million subor-dinated seller note. Jim will receive$20 million in cash at closing (fromthe senior bank loan) and he will re-ceive payments of interest at therate of 6% on the seller note untilthe senior bank loan is fully paid, atwhich time the seller note will befully amortized over three years (orrefinanced with a new bank loan).The seller note also has detachablewarrants equal to 25% of the com-pany’s fully-diluted equity. Thecombination of a 6% interest rateand detachable warrants for 25% ofthe company’s fully-diluted equityprovides an all-in return on theseller note consistent with returnsfor commercial subordinated debt.

Post-transaction position. Immedi-ately after the transaction, Jim andJoyce’s assets include the $20 mil-lion of investable assets they hadprior to the transaction, plus $20million of cash they received atclosing and a $20 million seller notewith detachable warrants. The plan-ning process often ends when theESOP transaction closes; however,Jim and Joyce’s advisors recognized

this was just the first step in theprocess.

Jim elected Section 1042 taxtreatment on his cash proceeds, andhis financial advisor helped him se-lect a diversified portfolio of in-come-producing stocks and bondsthat satisfied the “qualified replace-ment property” (QRP) requirementsof that Code section. Jim purchasedthose assets solely in his name sothat at his death, the beneficiaries ofhis estate would receive a stepped-up basis in those assets, convertinga tax deferral into a tax forgivenessthat saves $4.76 million of federallong-term capital gains tax ($20million × 23.8%).

Charitable giving. Jim and Joycealso had charitable planning goals inaddition to tax, liquidity, and own-ership succession planning goals.Ultimately, the Smiths sought tomake a charitable gift equal to 50%of the value of Jim’s stock. TheSmiths considered the followingthree planning alternatives toachieve their charitable planninggoals.

Jim first considered making a giftof half of his ABC stock to a char-ity or charitable trust prior to theESOP transaction and then have thecharity sell that stock to the ESOP.This approach would result in Jimavoiding paying long-term capitalgains tax when the stock is sold be-cause it will be sold by the charityrather than by Jim. He also wouldreceive an income tax deduction forthe value of the gift, subject to In-ternal Revenue Code limitations.This planning option had to accountfor the impact of a discount for lackof control (i.e., a minority interestdiscount) that is applied when deter-mining the value of the charitableincome tax deduction. Because Jimconsidered making a gift of a non-controlling interest (i.e., not morethan 50%) in the company’s stock,the value of the gift would be sub-

While the PEG could promise abig payday, Jim had spent the last40 years creating and nurturing acertain company culture that he didnot want to hand over to a PEGwhose mission is to maximize re-turns for its investors. It is possiblethat the best interests of the PEGand its investors may be at oddswith the best interests of the com-pany’s employees and its customers.Therefore, Jim terminated the third-party sale process and spent timewith Joyce considering their goalsand other liquidity options.

ject to the minority interest dis-count. Assuming a 20% discount,the value of the gift would be $16million rather than $20 million.

The second alternative Jim con-sidered was making a charitable giftof the $20 million cash proceeds hereceived at closing. Because Jimpreferred to avoid paying tax on hiscapital gain, he would invest his$20 million cash in QRP and thenmake a charitable gift of the QRP.This gift would not be subject to theminority interest discount, which re-sults in the value of the gift being$20 million rather than $16 million(as the option above).

Based on his planning goals andwith the advice of his advisors, Jimmade a gift of the $20 million sellernote (but retained the detachablewarrants) to a charitable remaindertrust (CRT), naming a donor-ad-vised fund (DAF) established at hislocal community foundation as theremainder beneficiary. Jim’s familywas given the ability to direct grantsfrom the DAF to qualifying chari-ties each year. Jim and Joyce cre-ated a separate document that de-scribed their family values andinstructed their children andgrandchildren to meet semiannuallyto discuss and direct the disburse-ment of the grants to charities thatsupported those values. Jim andJoyce felt that this was a key com-ponent in helping perpetuate theirvalues and legacy over succeedinggenerations. The value of the CRTgift (the remainder interest) was$12.26 million, resulting in incometax savings of $4.9 million (40%).

The calculation of the value ofthe CRT gift is based on Jim retain-ing a 6% income interest ($1.2 mil-lion annually) for eight years. Jimand Joyce gifted this $1.2 millionCRT payment each of the eightyears to a dynasty trust, which pur-

chased $20 million of survivorshiplife insurance. Because the total pre-mium of $9.6 million was less thantheir combined lifetime gift tax ex-clusion of $10.9 million, no gift taxwas due on the gift, and the $20million life insurance proceedswould pass outside their estate, sav-ing an additional $8 million in es-tate taxes (40%).

The gift of the seller note is a“disposition of an installment obli-gation,” resulting in a taxable gainequal to the difference betweenJim’s basis in the seller note and thefair market value of the installmentobligation. Therefore, the result willbe the same as if Jim had electednot to report the seller note underthe installment method. He will re-port a long-term capital gain on thedisposition of the note in the year ofthe gift to the CRT. For some tax-payers, this mismatch of tax beingdue in year one but cash being re-ceived in subsequent years couldcreate a financial hardship. Fortu-nately for Jim, he and Joyce havean investment account with $20 mil-lion of liquid assets and Jim re-ceived $20 million in cash at clos-ing f rom the ESOP. (Whencalculating Jim and Joyce’s assetsafter the transaction, the $4.9 mil-lion long-term capital gains tax Jimpaid on the gift of the note to theCRT has been subtracted.6 )

Company’s future. Jim made a giftof the retained warrants to his son,Bob, who became the president andchairman of the board of the com-pany. The warrants will provide apowerful equity incentive for Bob tocontinue to grow the company. Thestrike price of the warrants is basedon the company’s post-transactiondrop in value. A 5% organic com-pany growth rate, coupled with thedeleveraging of the ESOP debt, will

produce a value of $15.8 million ofthe warrants in eight years. The gifttax value of the warrants, which isbased on the Black Scholes optionpricing model, is $2.22 per share for333,333 shares, or $739,999.

The amount of this gift plus thetotal amount of the annual gifts tothe dynasty trust ($10.34 million) isless than the $10.98 million gift taxexclusion for 2017.

Overall impact. The charts in Ex-hibit 1 illustrates Jim and Joyce’sassets before and after implementingthe ESOP transaction and planningstrategy.

In the process of achieving theirfinancial and legacy goals, Jim,Joyce, and the company togetherhave saved $48.6 million in federaltaxes, consisting of the following:

• Section 1042 income tax sav-ings (23.8% of $20 million)—$4.76million.

• Income tax deduction for $20million gift of seller note to CRT(40% of $12.26 million remainderinterest—$4.90 million.

• Estate tax savings on $20 mil-lion dynasty trust (40%) — $8.00million.

• Gift tax savings on warrants(40% of [$15.8 million future valueless $740,000 value of gift]) —$6.02 million.

• Present value of company taxsavings over first ten years afterESOP transaction—$24.92 million.

Using an ESOP transaction aspart of an overall estate and gift taxplanning strategy can allow businessowners to maximize their legacywhile minimizing taxes. Throughthe skilled advice of their advisorteam, Jim and Joyce have used anESOP transaction as more than a li-quidity and ownership succession

6 See Section 453(e)(1)(B) regarding disposi-tions of installment obligations.

planning strategy; they haveachieved their comprehensive plan-ning goals.

The company’s employees willcontinue to work in a culture they

have come to know and thriveunder, and will not be subject to thewhims of a PEG whose primary fo-cus is maximizing returns for its in-vestors. The liquidity created by thetransaction will allow Jim and Joyceto treat each of their children fairlywithout having to deal with thechallenges inherent in leaving com-pany stock to an inactive child. Bobwill serve as the company’s CEOafter the transaction, and the war-rants will provide him a very gener-ous financial incentive to continueto grow the company.

Conclusion

While cashing in on one’s lifeworkis a worthy goal, doing so whilebuilding a legacy that will last forgenerations represents a higher call-ing for many business owners. Jimand Joyce have created enduringlegacies for their family, company,and community. For their family,they have provided financial secur-ity for their children, grandchildren,and succeeding generations. They

also have defined and created a sys-tem to reinforce their family’s val-ues through semi-annual familymeetings.

For the company, they have cre-ated a liquidity event while protect-ing their employees from the risksinherent in a sale to a third party,such as downsizing and relocation.The ESOP also will provide theiremployees an equity-based incentiveto increase employee productivityand enhance their employees’ finan-cial security. For their community,they have created a $20 milliontrust that will make grants to worthycauses.

Section 1042 provides a tax deferralto shareholders who sell C corpora-tion stock to an ESOP.

While cashing in on one’s lifework isa worthy goal, doing so while build-ing a legacy that will last for genera-tions represents a higher calling formany business owners.

Exhibit 1

Jim and Joyce will be financiallysecure for life. Jim will continue toreceive an annual salary of $1 mil-lion from the company after theESOP transaction, but since he is nolonger a shareholder of ABC, hewill no longer receive annual distri-butions of $4 million; however, as-suming their $35.1 million invest-ment account produces an annualreturn of 5%, Jim and Joyce willhave an annual income of $2.75million per year. This income willbe sheltered from tax for 4.45 yearsby the income tax deductions of$12.26 million generated by theCRT gift. The $20 million life in-surance-funded CRT will provide afinancial legacy for their commu-nity, church, alma mater, and otherworthy causes and will serve as aplatform to perpetuate Jim andJoyce’s values.

Executive Financial Services, Inc.

Kelly O. Finnell, J.D., CLU, AIF®

President kfin@execfin.com

901.259.7979

Founded EFS in 1981

Publications:

• The ESOP Coach: Using ESOPs in Ownership Succession Planning, available on Amazon

• Co-author, “Consider ESOPs as an Estate Plan Component,” Estate Planning, September 2014

Andrew T. Holmes, LL.M., QKA Vice President & Shareholder

aholmes@execfin.com 901.259.7900

Joined EFS in 2010

Publications & Speaking Engagements:

• Co-author, “Consider ESOPs as an Estate Plan Component,” Estate Planning,

September 2014

• National Center for Employee Ownership (NCEO)

• Business Enterprise Institute (BEI)

• National Business Institute (NBI)

• National Association of Certified Valuators and Analysts (NACVA)

Education Washington University in St. Louis School of

Law, LL.M. in Taxation Mississippi College School of Law, J.D.

University of Tennessee, B.S. in Accounting

Professional Credentials Qualified 401(k) Administrator (QKA),

American Society of Pension Professionals & Actuaries (ASPPA)

Frequent Conference Speaker

• Great Plains Federal Tax Institute

• Alabama Federal Tax Institute

• Heart of America Federal Tax Institute

• National Center for Employee Ownership

(NCEO)

• Business Enterprise Institute (BEI)

• National Business Institute (NBI)

• National Association of Certified Valuators and Analysts (NACVA)

• Education

• University of Memphis Cecil C. Humphreys School of Law, J.D.

• University of Memphis, B.A., Magna Cum Laude