From September 16, 2009

Bail Yourself Out with an Employee Stock Ownership Plan

 

Are you facing a cash crunch because most of your wealth is tied up in your company? If the current economic slowdown continues, your personal assets could be depleted over time.

 

Of course, you could sell a portion of the company and reinvest the funds elsewhere. But this may cause you to lose control of the business. And the sale might generate a huge tax bill.

 

Strategy: Create an Employee Stock Ownership Plan (ESOP). Sell some or all of your shares in the company to a separate entity that becomes the offi­cial "owner" of the business.

 

This technique enables you to rein­vest in a diversified portfolio, retain control of the business and avoid taxes indefinitely-all in one fell swoop.

 

Balance all the factors

 

Be aware that ESOPs aren't right for everyone, and they come with a price tag. It's important to conduct a feasi­bility study to see whether it makes sense to go ahead. To protect the deal from an IRS challenge, obtain a formal valuation from an independent expert in the field. You may find the pros out­weigh the cons if the bulk of your net worth is locked up in highly appreci­ated shares of the company.

 

Moreover, after the ESOP is in place, you can continue to run the op­eration as before. Employees don't vote to select board members, and you don't need to provide employees with the company's financial data. One re­quirement: Let each participant vote the shares allocated to his or her ac­count for certain transactions, such as mergers and liquidation.

 

Big tax break: If you own a C cor­poration and hold the shares for at least three years, you can defer capital gains tax on the sale of stock to an ESOP. That tax deferral kicks in if the ESOP owns at least 30% of the com­pany after the purchase.

 

Where does the ESOP get the money to pay for the company shares? It can borrow the money from the company, the same money the company borrowed from a third-party lender.

 

To sweeten the deal, the tax code provides spe­cial treatment for leveraged ESOPs (see box below).

When it repays the loan's principal, the C corp can make deductible contributions up to 25% of the covered participants' compensation. Plus, it can deduct contributions used to repay loan inter­est.

 

Note that an ESOP will work only if the com­pany generates adequate cash flow and shows enough financial strength to obtain a loan from the third-party lender. In these circumstances, it's a good source of diversification and liquidity.

Tip: This is not a do-it-yourself proposition. Have your tax pro explain the details.
 

 

Example: Put an ESOP to work

Your business is valued at $3 million. You sell one-third of the shares to an ESOP for $1 million, retaining control of the business. Assuming you have no basis in the stock, the capital gains tax would be $150,000 (15% of $1 million).

 

Good news: You can defer the tax by pur­chasing qualified replacement property (QRP) within 12 months after the sale. QRP includes stocks and bonds issued by U.S. companies.

 

You could invest the $1 million in sales pro­ceeds in a diversified portfolio of stocks and bonds. No tax would be due. But disposing of the QRP would trigger tax.

 

Better approach: Avoid short-term bonds. Invest in a variety of dividend-paying stocks. You can hold some of the QRP until death, maintaining deferral of the capital gains tax.

 

Bottom line: You generate cash flow and your fortunes aren't tied entirely to the fate of the business.