Innovative Uses of ESOPs In Estate Planning For Business Owners

Table of Contents

I. Introduction

II. What Is An ESOP?

A. Employee Stock Ownership Plans (ESOPs) are "Qualified Deferred Compensation Plans," accordingly:

1. Written Plan.
2. Primarily in Employer Securities.
3. Exclusive Benefit
4. Coverage and Vesting
5. Discrimination
6. Top Heavy
7. Fiduciary Responsibility

B. ESOPs are "Defined Contribution Plans"; accordingly:

1. Deductible Funding Limits.
2.Permissible Annual Additions.

III. What Can ESOPs Do That Other Qualified Plans Can't?

A. General.

1. Trust Investment in Employer Securities Exception.
2. Prohibited Transaction Exemption.
3. Increased Contribution Limit--Forfeiture, Interest and principal.
4. Deferral of Tax on Net Unrealized Appreciation Until Sale.

B. The ESOP Loan .

1. Requirements of an ESOP loan.

a. Use of loan proceeds.
b. Limited liability as to ESOP.
c. Release of collateral to be allocated among participant accounts.

2. ESOP Loan Format.

a. Lender-to-ESOP loan.
b. Mirror, Back-to-Back or Tiered Loans.

3. The ESOP Loan--Should it be Used?

a. Yes--Where the Best Interests of Employees are Foremost in Mind.
b. No--Where the Owners of the ESOP Sponsor Want Maximum "Bang for their Buck."

C. Tax-Free Rollover of Gain (IRC Section 1042 and 4978).

1. IRC Section 1042's Genesis.
2. General Rule.

a. Immediately after the sale the ESOP holds:
b. Within a 15-month period beginning 3 months prior to the date of sale "qualified replacement property" (QRP) is purchased by the seller.

3. Requirements to Effectuate a 1042 Election.

a. Election by the seller.
b. Consent by the employer to 10% premature disposition tax.
c. Consent by employer to 50% prohibited allocation tax.
d. Notarized Statement of Purchase.

4. Qualified Securities Defined.

a. Best common
b. Domestic corporation.
c. Three year holding period.
d. Received pursuant to another plan.
e. Long-term capital gain eligibility.

5. Qualified Replacement Property.

a. "Securities" i.e.,
b. Disqualifying Passive Income.
c. Underwriters.
d. Mutual Funds.

6. Deferred Gain as Basis Adjustment to QRP.

7. Partial Recognition of Gain.

a. Example:

8. Ineligible Sellers.

a. C corporation sellers.
b. Sponsoring employer with publicly traded stock.

9. Prohibited Allocations.

a. "Prohibited Group" defined.
b. de Minimis rule.
c. Permanent exclusion for 25% shareholders.
d. 10 year nonallocation period for others.
e. Consequences of prohibited allocations.

10. Tax on Dispositions of QRP.

a. Asset disposition by QRP corporation. b. Gain recognition exceptions.

D. Deduction of ESOP Dividends (IRC Section 404(k)).

1. Statutory Provisions.

a. Dividends paid to ESOP participants.
b. Dividends used to repay ESOP loan.
c. Dividends as an "evasion" of taxes.

2. Important Points.

a. Scope of dividend deduction.
b. Plan year vs. taxable year.
c. Procedure for determining distribution of dividends on ESOP stock.
d. What is a "dividend"?
e. ESOP dividends and the Alternative Minimum Tax (AMT).
f. Accounting treatment of ESOP dividends.

IV. Are ESOPs Subject To Special Limitations And Requirements?

A. Comparable Plans

B. Social Security Integration

C. Participant Entitlement to Demand Distribution of Employer Stock

D. Special Distribution Obligations

E. Independent Appraisal

F. Voting ESOP Shares

1. Allocated Shares
2. Unallocated Shares.
3. Tender Offers.

G. Distribution of ESOP Benefits.

1. Retirement, Disability or Death
2. Other Termination of Employment
3. Financed Securities Exception
4. ERISA Requirements Control
5. Period of Payment
6. Effective Date

H. Put Option

1. Stock that is not "Readily Tradeable". 2. Put Option Period
3. Special Exception for Banks
4. Special S Corporation ESOP (SESOP) Exception
5. No Other Repurchase Rights Permitted

I. Payment

1. Total Distributions
2. Adequate Security Required for Deferred Payments
3. Put Options on Installment Payments 4. Effective Date
5. Applicability to Stock Bonus Plans

V. Can S Corporations Adopt ESOPs?

A. Background

B. Up-side Potential

1. SESOP's share of its sponsor's income is not currently taxed

a SESOP not subject to UBIT

2. SESOPs Can Distribute Cash Rather than Employer Stock

3. SESOPs Can Now Engage in an ESOP Loan

C. SESOP Areas of Concern, and Analysis as to their Significance

1. Loss of 1042 Rollover Entitlement

a. Lower capital gain rates
b. Reduced gain due to higher basis
c. 1042 has built-in burdens
d. The best of both worlds.

2. Loss of Access to Expanded Contribution Limitations

3. S Corporation's Inability to Deduct SESOP Dividends

a. Use of S corporation distributions to pay an ESOP loan

4. Distribution of S Corporation Earnings to Stockholders

5. C to S Conversion Problems

a. Built-in Gains on conversion from C to S status
b. LIFO recapture
c. Loss of fringe benefits

D. Judicious Use of Stock Options and Restricted Stock

E. SESOPs and Large Corporations
F. Squeezing into S Qualification

G. The Ultimate--a SESOP--Owned Company

VI. What Stock Valuation Requirements Apply To ESOPs?

A. Requirement of Annual Appraisal

B. Appraisal Guidelines

C. Interplay Between Value and Stock Design

D. The ESOP Loan as a Factor in the Appraisal

1. The Farnum Case
2. The Eyler Case
3. The IRS
4. DOD/DCAA
5. Proper Rationale

E. Choice of Appraiser

F. SESOP and Valuation

VII. What About Dilution?

VIII. How Do ESOPs Differ From Eligible Individual Account Plans (EIAPs), And Which Is Best?

A. Eligible Individual Account Plans ("EIAPs")

B. Comparison of EIAP to ESOP

1. Contribution and Allocation Limits
2. Access to Leveraged Loan
3. EIAP, including ESOP, exemption from ERISA requirements applicable to other plans
4. EIAP Exemption from ESOP ERISA Requirements
5. Non-Voting and Other Specially Designed Stock
6. Flexibility

C. Fiduciary Considerations

D. Periodic Review and Amendment

IX. Can An ESOP Be Coupled With A Charitable Remainder Trust?

A. Gift of Company Stock to a CRT Followed by Sale to ESOP

1. ESOP Sale Routed through a CRT versus a 1042 sale

a. 1042 limitations do not apply
b. Charitable deduction

2. A 1042 sale followed by a gift of QRP to a CRT

B. Use of a Wealth Replacement Trust to Protect the Inheritance of Future Generations

X. What Typical Estate Planning Problems Can Be Solved With ESOPs?

A. Planning for Retirement

B. Realizing Maximum Value on Sale of the Business through ESOP

C. Providing for Surviving Spouse and Children

D. Treating Children Equally

1. Some Children in Business, Others Not
2. All Children Work in the Business
3. No Children Work in the Business

E. Rewarding and Motivating Loyal Employees
F. Prepare for Repurchase Liability

For a copy of the entire article, please contact author Louis H. Diamond

Buchanan Ingersoll's Tax Group advises publicly held and private business entities, affluent individuals and families, and key executives in a full range of tax, employee benefits and dispute resolution matters at federal, state and local levels. We also counsel clients in the areas of wealth preservation and business succession planning. For more information, contact Tax Group Chairman Francis A. Muracca, II, at 412-562-3950 or by email at muraccafa@bipc.com.