By Brad Eriksen
From the Jordan Ramis Archives
Proper succession planning ensures the continued viability of a business if the owner dies, withdraws, or retires. The first step in a succession plan is a buy-sell agreement among the current owners. (See Article November 2001.) This column describes two available tools for selling or transferring a business that minimize federal income tax consequences: (1) An Employee Stock Ownership Plan (ESOP), and (2) a Charitable Remainder Trust (CRT).
An ESOP is a qualified retirement plan, like a profit-sharing plan. Generally, ERISA precludes a qualified retirement plan from owning shares of the sponsoring employer. However, 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 governance. 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 qualified status of the plan.
Using an ESOP for succession planning provides two tax favorable treatments. First, it allows for the owner's shares to be purchased with pretax dollars. Second, if the owner rolls over the sales proceeds into qualified securities (generally securities traded on any United States stock exchange), recognition of the gain on the sale may be deferred.
In a leveraged ESOP, the ESOP borrows the money necessary to purchase the owner's stock. The sponsoring employer makes tax-deductible contributions to the ESOP over a period of years to make the loan payments. As contributions are made and the loan balance reduced, shares owned by the ESOP are allocated to the retirement accounts of the employee participants.
In an unleveraged ESOP, the sponsoring employee makes contributions to the plan in advance of the purchase of the owner's shares. The contributions are invested in stocks, bonds, or mutual funds pending the buyout of the owner. At the time of 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 sale, 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, no gain is recognized, and no capital gains tax is paid. The CRT invests the sales proceeds and provides an income stream to the income beneficiary (generally the grantor of the trust). Because the sales proceeds are not reduced by capital gains taxes, all sales proceeds are invested and provide the owner with a larger income stream than if the business is sold outside of the CRT.
At the end of the trust term, the remaining assets in the trust are disbursed to an identified charitable organization.
While both an ESOP and a CRT can effectively defer or eliminate capital gains tax upon sale of the business, they are not necessarily appropriate for all businesses. The next article in this series will explore other succession planning tools that may be appropriate for many businesses.