November 1, 2001

Effective Business Succession Planning: Part I


By Brad Eriksen

Fall 2001

In the previous articles, we addressed the necessity of proper succession planning to assure the continued viability of a business in the event of the death, withdrawal or retirement of an owner. We noted that the first step in any well-structured succession plan is a buy-sell agreement among the current owners of the business. In this column we investigate two “tax-advantaged” tools available to owners to sell or transfer their business and minimize the federal income tax consequences from the sale. The first tool is an Employee Stock Ownership Plan (ESOP). The second is a Charitable Remainder Trust (CRT).


An ESOP is a qualified retirement plan, not unlike a profit sharing plan, with the added feature that it is permitted to own shares of stock of the sponsoring employer. Generally, the prohibited transaction rules of ERISA preclude a qualified retirement plan from owning shares of the sponsoring employer. An exception is made for plans set up to meet the special requirements of an ESOP. With this additional flexibility come additional responsibilities, such as annual appraisals and employee participation in company governances. As with any qualified retirement plan, there are many technical requirements for implementing and administering an ESOP. Care must be taken to properly establish and operate the ESOP and to obtain a favorable determination letter from the IRS as to the quailed status of the plan.

Use of an ESOP for succession planning provides two tax favorable treatments. First, an ESOP allows for funding the purchase of the departing shareholder’s shares with pretax dollars. Second, if the selling shareholder rolls over the sales proceeds into qualified securities (generally securities traded on any United States stock exchange), the selling shareholder can defer recognition of the gain on the sale.

Leveraged ESOP

In a leveraged ESOP, the ESOP borrows the money necessary to purchase the stock of the departing shareholder. The sponsoring employer makes tax-deductible contributions to the ESOP over a period of years in order to make the loan payments. As contributions are made and the loan balance reduced, shares of stock owned by the ESOP are allocated to the retirement accounts of the employee participants.

Unleveraged ESOP

In an unleveraged ESOP, the sponsoring employee makes contributions to the plan in advance of the purchase of the departing shareholder’s shares. The contributions may be invested in stocks, bonds, or mutual funds pending the buyout of the departing shareholder. When the time comes for the buyout, the investments are liquidated and used to pay for the stock. The shares of stock purchased by the ESOP are again allocated to the retirement accounts of the participating employees.


A charitable remainder trust (“CRT”) may also help eliminate the income tax consequences of selling a successful business. Prior to any sale, and as a part of the owner’s general estate planning, the owner forms a CRT and transfers ownership of the company stock to the CRT. The business is then sold by the CRT, with the sales proceeds going into the trust. Because of the charitable nature of the trust, the sale by the CRT does not result in gain recognized or capital gains tax paid. The CRT then invests the sales proceeds and provides an income stream to the income beneficiary (generally the grantor of the trust). Since the sales proceeds are not reduced by capital gains taxes, the entire sales proceeds may be invested and provide the owner with a larger income stream than if the owner sold the business outside of the CRT and paid taxes on the gains recognized.

A CRT provides that at the end of the trust term, the remaining assets in the trust are disbursed to the charitable organization identified in the charitable remainder trust.

While both an ESOP and a CRT can effectively defer or eliminate capital gains tax upon sale of the business, they are not necessarily a proper succession planning tool for all businesses and business owners. In the next article, we will explore other succession planning tools that, while not necessarily tax-advantaged, may be appropriate for many business owners.

Click here for Part II | Click here for Part III

Tags: Business

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