Authored by Mark Lobb
Pre-ESOP Planning Estate and Asset Planning Considerations
There has been a recent increase in the number of business owners opting to use employee stock ownership plans (ESOP or ESOPs) as a succession tool. The National Center for Employee Ownership (NCEO) estimates that as of 2022 there are roughly 6,500 ESOPs covering almost 14 million participants. The NCEO reports that since 2014 an average of 254 new ESOPs have been created each year.
Why do business owners opt for transitioning ownership to an ESOP? There are many reasons a business owner may want to transition ownership into an ESOP, but normally the tax benefits eschewing to the owner with the ability to retain control during a transition period are at the top of the list.
What is the ESOP transition process? Companies set up an Employee Stock Ownership Trust (ESOT) for employees and either fund the company stock into the trust, fund the trust with cash to purchase the stock or have the trust borrow money to buy stock. The third method of having the trust borrow money to buy the stock is very common and that method is called a leveraged ESOP. At the close of the ESOP formation, the business owner normally ends up with cash, a promissory note or notes, and in some instances warrants.
If planned properly, the business owner pays very little in tax for the sale of the stock. The ESOP has federal and state income tax-exempt status which provides the company with both stability and an enhanced ability to pay off the note owed to the selling owner. The employees end up with a tax deferred retirement plan.
It is imperative for business owners to plan for the transition process in advance of selling the stock to the ESOT. The succession planning process must take into consideration tax optimization, estate planning and asset protection.
Utilization of irrevocable grantor trusts commonly solves estate and asset protection planning concerns. However, one technique often employed for ESOP tax planning purposes is to roll the sale proceeds from the sale to the ESOT into qualified replacement property (QRP). An exchange into QRP not only defers taxable gain on the sale to the ESOT, but if the QRP is held until the death of the selling business owner, those inheriting the QRP receive a step-up in basis to eliminate the tax on the sale. If the stock is transferred to an irrevocable grantor trust before the sale to the ESOT, the step-up in basis is lost to the next generation. Tax and estate tax modeling are important in the ESOP planning phase to determine if the use of irrevocable grantor trusts to eliminate estate tax is a beneficial planning tool.
If preserving a step-up in basis for the heirs of the selling business owner is not an issue, irrevocable grantor trusts can assist the business owner in eliminating estate tax. If the installment sale method is used to house the stock in the trust, certain discounting rules may provide an immediate estate tax reduction. There may be timing issues relative to the ability to receive any discounting on the value of the stock so planning early in the ESOP consideration stage is imperative. For more information on the benefits of irrevocable grantor trusts you can find the information here.
Conversely, if preserving the step-up in basis is desirable, there are many other types of trusts which can be used to fulfill estate planning and asset protection goals, such as “The Passage Trust”, (www.passagetrust.com). Although these trusts will not reduce the estate tax, if a business owner decides to defer tax until death, the step-up in basis will eliminate tax on the sale to the ESOT.
It may be that the business owner decides to defer some, but not all, of the tax on the sale until death. In this instance, financial planning is extremely important to carve out how much of the stock should be housed in an irrevocable grantor trust for asset protection and estate tax purposes and how much should be exchanged into QRP.
If a business owner completes an installment sale of the stock to an irrevocable grantor trust, although the stock will end up in an asset protected and estate efficient trust, the owner will have a promissory note in the owner’s name or the name of the owner’s revocable trust which provides no asset protection or estate tax efficiencies. Our firm has created a proprietary trust called “The Passage Trust” (www.passagetrust.com) to hold assets such as promissory notes and other intangible assets. Although a self-settled trust, the United States has several jurisdictions which afford self-settled trusts asset protection from creditors. Other trusts such as spousal lifetime access trusts (SLAT or SLATs) can also be used to protect the promissory note from creditors and provide estate tax efficiencies. SLATs and The Passage Trust are very different in design but both are effective planning tools for stock liquidation planning.
It is always important to have asset protection, estate and tax plans in place before a major liquidation event, but if your succession plan involves an ESOP, it is important to have everything organized and ready because the ESOP process can move quickly. Our firm has been engaged by hundreds of companies over the years for business transition planning; and in the area of ESOP structuring and implementation, we work with some of the top professionals in the country. If you would like to discuss pre-succession planning or ESOP structuring, feel free to contact me to start the process.
Meet the Authors:
Mark Lobb is a founder of the firm and the Managing Partner of Lobb & Plewe. He focuses on matters concerning middle market companies which are closely held and the owners of such companies.
Sean Tannenbaum is an associate in the firm. His focus is helping businesses and individuals protect their assets using innovative tax and estate planning tools.