One of the more difficult challenges facing a small business owner is the formulation of a viable and economically beneficial exit strategy at retirement. Typically, the main goals of such an exit strategy are to identify a qualified buyer and ultimately receive fair compensation for the business, which would, in turn, translate into a desirable retirement income. The creative combination of an employee stock ownership plan (ESOP) and a charitable remainder trust (CRT) can be an effective method of meeting both goals.
First Things First
ESOPs are defined contribution plans and are subject to the same guidelines imposed on 401(k) and profit-sharing plans. However, ESOPs are designed to invest primarily in the stock of the business in which the employees work. As such, an ESOP gives all employees a vested interest in the profitability of the company—as the company’s fortunes increase, so does the value of each employee-shareholder’s stock.
An ESOP basically functions as a private marketplace, enabling retiring employees to recognize a retirement benefit by selling their shares to the ESOP. For example, an ESOP can be used to buy out the interest of a retiring owner, providing an alternative to selling the business (or an owner’s share of the business) to an outsider.
Typically, the ESOP borrows from a commercial lender and uses the funds to purchase the shares of the withdrawing shareholder. The corporation will normally be entitled to tax deductions for both the principal and the interest on the loan, because the loan is repaid out of future contributions to the ESOP.
Another significant benefit is that long-term capital gain on the sale can effectively be deferred under Internal Revenue Code Section 1042 if the ESOP holds at least 30% of the company stock after the sale and the seller reinvests the proceeds into qualified replacement property (generally defined as securities of U.S. domestic-operating corporations other than the corporation that issued the securities involved in the transaction). This must take place within a “qualified period” (beginning three months prior to the date of the sale and ending twelve months after the sale), and the ESOP must have no publicly-traded stock outstanding. However, non-recognition of gain is only allowed if the owner-shareholder has held the shares for at least three years prior to the sale to the ESOP and did not receive the shares from a plan described in Sec. 401(a). The individual choosing
this treatment will need to file an election no later
than the due date (including extensions) of the individual’s income tax return for the year in
which the sale occurs.
Restrictions. . .Solutions
While a retiring owner can liquidate his or her interest in the business on a tax-advantaged basis using a Sec. 1042 transaction, he or she should be aware of some limitations. From an investment perspective, the definition of qualified replacement property may be restrictive—it does not include mutual funds, real estate investment trusts (REITs), or U.S. government and municipal bonds. A portion of the gain may be recognized, i.e., to the extent that the amount realized on the sale exceeds the cost of the securities purchased to replace the stock sold to the ESOP.
In addition, the deferral of taxation ends once the qualified replacement property is sold. Thus, active management of the qualified replacement property portfolio is not possible without incurring capital
When considering these factors, some estate planners have come to view qualified replacement property assets as ideal for funding a charitable remainder trust (CRT). Funding a CRT reduces
estate taxes and provides an immediate income tax deduction for a charitable contribution as well. Since the CRT is a tax-exempt entity, it can sell the funding assets without capital gains consequences. It can then reinvest the proceeds with the ultimate goal
of the donor (in this case, the selling shareholder)
being the receipt of a steady income stream from
the trust assets.
Moreover, there may be additional flexibility if the CRT is designed as a unitrust, as opposed to an annuity trust, because a unitrust can accept additional contributions on specified terms and conditions, while an annuity trust cannot. Since a Sec. 1042 transaction can occur in stages—provided at least 30% of the corporation’s stock is owned by the ESOP after the initial transaction—the opportunity exists for selling shares of the business and funding the unitrust in stages.
An Intriguing Combination
An owner planning for withdrawal from his or her business (such as retirement) faces a variety of challenges that impact both the business and the owner’s estate. While an ESOP assures ownership will remain within the company, the ESOP/CRT combination can be a powerful business liquidation/estate maximization strategy, regardless
of the owner’s charitable intent or motivation. However, as is the case with all advance planning,
a thorough review of the owner’s long-term goals
and objectives is essential to determine an appropriate course of action.