The authors of this article have collectively implemented over 200 Employee Stock Ownership Plan ("ESOP") transactions and hundreds of estate plans featuring intergenerational transfers. In almost all of the ESOP transactions, the ESOP was used in lieu of a management buy-out or sale to a third-party. In almost all cases in which the ESOP was implemented, the primary objective of the current shareholders was not to pass the controlling interest of the business to family members but to monetize the equity position, immediately or over the course of the succeeding 5 to 10 years.
This article assumes a basic-to-advanced understanding of ESOPs. If the reader would like additional information on ESOPs we would encourage the reader to go to www.esopassociation.org for useful articles explaining the fundamentals of ESOPs from an ERISA and leveraged buy-out perspective. If there are additional questions or concerns regarding ESOPs, the authors of this article encourage you to call either for assistance. If desired, we encourage readers to seek additional educational workshop opportunities to further enhance their understanding of ESOPs.
The purpose of this article is to share with estate planning attorneys how an ESOP can potentially enhance an estate plan in which the goals of the client are to: pass a controlling interest in a family business to the next and/or 3rd generation and create liquid assets for beneficiaries that are not involved in the business. An ESOP could have the important, additional affect of binding the employees to the corporation and successor management team. Empirical studies have shown that productivity can go up and turn-over down in employee owned companies, especially when the ESOP is combined with a well conceived communications program.
Positioning the ESOP into the inter-generational estate plan
Both S Corps and C Corps are eligible to install ESOPs, but LLCs and partnerships are not. C Corps are capable of creating multiple classes of securities whereas S Corps are not, but S Corps may have voting and non-voting shares. For the client ultimately desiring to transfer control of the business to the next generation, a C Corp ESOP transaction carries some distinctive advantages relative to that of an S Corp transaction. The two primary advantages are: the ability to indefinitely defer or eliminate capital gain taxes under IRC Section 1042 and the ability to use Super Common Stock for the ESOP transaction which benefits multiple parties.
The use of Super Common stock in a C Corp transaction will:
• Allow the sellers to reap a legitimate valuation premium;
• Expedite tax deductions for the corporation under IRC Sec 404;
• Create larger employee benefits subsidized by the tax deductions enhancing employee loyalty; and
• Lower the value of the common stock to be sold or gifted to the family members.
Chronologically, the ESOP transaction would precede the sale and/or gift transactions. The ESOP transaction could be preceded by corporate transactions such as: an S Corp election revocation; AAA account distribution; recapitalization wherein the second class of stock is created; and a stock split.
The stock sold to the ESOP must be an "Employer Security" under the tax code. Simply stated, the security must have the highest dividend and voting rights.
Estate Planning Example
Consider a case where a family owns an S-Corp business worth $10,000,000 and there are four children. Further, assume that there is very little net worth outside of the business due to real estate depreciation and the need to use the operating cash flow of the business to fund growth. There are retirement accounts owned by the parents which are expected to be depleted prior to the parent's passing. Thirdly, assume that one son and one daughter are active in the management of the business and that the two other children are not involved in the business.
To further simplify this example, it is assumed that Mom and Dad are willing to give the entire $10,000,000 away during their life, relying on the assets in their retirement accounts and consulting fees/wages paid from the business pursuant to employment/consulting agreements to maintain their desired lifestyle.
The parents would like to achieve equal distribution to each child. The parents are open to gifting strategies and the creation of trusts and family partnerships.
Planning Strategy Without An ESOP
One strategy that is available assuming an ESOP is not implemented could be to take a bank loan at the corporation. The proceeds will be distributed to the parents and ultimately pass to the children not in the business. The business value, reduced by the bank loan, can be passed to the children active in the business at a discounted value. The cash generated by the parents could be distributed after the death of the parents to the two children that are not active in the business. There are two potential negative aspects of this strategy. First, there could be ordinary taxes on some or all of the strategy. Second, the company now burdened with a bank loan will have to pay it back with after tax dollars. On the positive side, 100% of the business ends up in the family and there has also been a diversification of the parent's net worth to the benefit of the children outside of the business.
Under the hypothetical ESOP strategy, the parents would revoke the S Corp election and recapitalize the company into two classes, Common Stock and Super Common. The Super Common Stock if structured correctly should carry a valuation premium to the common stock of 20-30%, hence the parents would sell less of the equity to gain the desired funds for net worth diversification. Further, if structured appropriately, all funds should be paid without the payment of any taxes. On top of that, the company will initially get cumulative tax deductions equal to the price of the ESOP transaction. In short the company pays the bank loan in pre-tax dollars instead of after tax dollars and receives an income tax deduction as a result of contributions to the ESOP which is a qualified retirement plan under ERISA.
Finally, the common stock is not only reduced in value from the loan to finance the ESOP transaction but also from the shift of dividend rights to the newly created Super Common Stock.
In summary, the ESOP transaction in this scenario would create millions of dollars in cumulative tax deductions to add to aggregate family wealth and will also lower the value of the common stock to be transferred to family members who will control the business going forward after Mom and Dad are no longer with them, mitigating gift and estate taxes and allowing more shares to be transferred during lifetime using advanced estate planning strategies such as sales to Grantor Deemed Owned Trusts and/or Grantor Retained Annuity Trusts. In addition, cash generated from the sale of the Super Common Stock to the ESOP can be used by Mom and Dad to equalize the estate distributions and perhaps part of the sales proceeds could be used for the purchase of substantial life insurance to provide for the other children not involved in the business estate and gift tax free. On the other hand, the family will have to share the equity with the employees and no longer maintain 100% ownership.
There is a need for modest formalization of corporate governance with the inception of an ESOP. However, under the hypothetical scenario the family maintains control of both day to day operations and strategic direction and decisions.
Which strategy is better? We fall back to the proverbial, "It depends".
In this article, we presented a new perspective for ESOPs. A perspective that ESOPs can be used to create more robust estate plans wherein the primary objective of the family is the transfer of equity control to successor generations.
What we are certainly not saying is that a strategy using an ESOP is always going to be the better one. Only that providing the family with the ESOP strategy gives the estate planner an interesting alternative. Further, since very few estate planning professionals currently understand the concept of using an ESOP to enhance an estate plan it also provides a competitive advantage to the estate planning practitioner open to the concept.
*Editor's Note: This article was originally published in the January 2011 issue of The WealthCounsel Quarterly, published by WealthCounsel.