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FINANCIAL PLANNING FOR THE BUSINESS OWNER AND THE BUSINESS

Michael R. Holzman and Christopher T. Horner1

Congress and the Obama administration recently enacted legislation

that creates new taxes and increases existing tax rates. Business owners

who have spent their lives accumulating wealth within their businesses

must carefully consider how recent legislative changes will a"ect the

wealth diversi#cation and business succession strategies they formulated

in recent years. Tax e$ciency should be at the forefront of these business

owners’ minds.

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EMPLOYEE STOCK OWNERSHIP PLANS

This article discusses the tax bene"ts a#orded to business owners

and their businesses by a sale to an employee stock ownership plan

(“ESOP”). This article is intended for shareholders, directors, executives,

and professionals.

The bene"ts a#orded to business owners by a sale to an ESOP are

numerous and include:

1. The business owner may diversify wealth that has

accumulated within the business by selling any portion of the capital

stock of the business to an ESOP;

2. The ESOP may pay up to fair market value for the portion of

capital stock sold by the business owner;

3. The business owner may defer the recognition of the long-

term capital gain realized in connection with the sale to the ESOP, and,

with proper planning, the business owner may eliminate the long-

term capital gain tax liability;

4. The business owner may retain control of the business for so

long as desired--even after the sale of all of the capital stock of the

business; and

5. The business owner may receive an equity-like return on

investment even after selling all of the capital stock of the business.

A sale to an ESOP a#ords the business bene"ts, too, including:

1. The business may make tax-deductible contributions to the

ESOP and pay tax-deductible dividends on the shares of capital stock

held by the ESOP to reduce or even eliminate taxable income and thus

enhance the cash $ow and debt capacity of the business;

2. The business may operate exempt from federal (and most

state) corporate income taxes if it is taxable as an S corporation and

wholly-owned by its ESOP;

3. The business may o#er its employees a competitive, tax-

deferred retirement bene"t, the value of which is directly correlated

with the e#orts of the employees and the success of their employer. A

signi"cant portion of this tax-deferred retirement bene"t may even be

taxed at favorable long-term capital gains rates as opposed to ordinary

income rates associated with all other quali"ed retirement plans.

Employee Stock Ownership Plans. An ESOP is a tax-quali"ed

retirement plan that is designed to invest primarily in the capital stock

of its corporate sponsor. An ESOP is unique among all other quali"ed

retirement plans because, unlike other quali"ed retirement plans, an

ESOP can borrow money from its corporate sponsor and purchase

shares of the corporate sponsor from shareholders. Such transactions

with any other quali"ed retirement plan would constitute a prohibited

transaction and jeopardize the quali"ed status of the plan and give

rise to a penalty tax. Over 11,000 ESOPs currently exist and span nearly

every industry of the American economy.

Leveraged ESOP Transactions. Business owners frequently sell all

or a portion of their equity to an ESOP through a “leveraged ESOP

transaction.” The transaction is “leveraged” because the ESOP "nances

the purchase of shares of stock by borrowing funds from its corporate

sponsor. The following example illustrates one of several leveraged

ESOP transaction structures:

1. The board of directors of the company resolves to sponsor

an ESOP. One component of an ESOP is an employee stock ownership

trust, which is a tax-exempt trust and serves as the legal owner of the

stock.

2. The corporate sponsor borrows funds from a senior lender.

The corporate sponsor lends these same funds, and perhaps additional

funds from its own cash reserves, to the tax-exempt trust in exchange

for a promissory note issued by the tax-exempt trust.

3. The tax-exempt trust uses these funds to purchase the capital

stock of the corporate sponsor from the selling shareholders.

4. The corporate sponsor makes tax-deductible contributions

and may pay tax-deductible dividends to the ESOP. The tax-exempt

trust uses these contributions and/or dividends to amortize the debt

owed to the corporate sponsor under the promissory note.

The preceding example illustrates some of the fundamental concepts

underlying a leveraged ESOP transaction. First, the ESOP creates

a market in which the business owner may sell any portion of the

stock of the corporate sponsor in exchange for full market value of

the equity sold. Second, the ESOP enables the corporate sponsor to

mitigate and even eliminate corporate income tax liabilities through

the use of tax-deductible contributions and tax-deductible dividends.

Third, the ESOP provides its corporate sponsor the opportunity to o#er

a meaningful retirement bene"t its employees.

Armed with a fundamental understanding of ESOPs and leveraged

ESOP transactions, business owners must understand that new

legislation enacted by Congress and the Obama administration creates

new taxes and increases existing tax rates. These legislative changes

have enhanced the value that a leveraged ESOP transaction may o#er

business owners who have spent their lives accumulating wealth

within their businesses. Business owners must carefully consider

how recent legislative changes will a#ect the wealth diversi"cation

and business succession strategies they formulated in recent years. A

thoughtful "nancial plan must consider the tax advantages o#ered to

business owners and their businesses by a leveraged ESOP transaction.

To fully understand the bene"ts these tax advantages o#er, business

owners must understand recent changes in the law.

Health Care and Education Reconciliation Act of 2010. On March

30, 2010, Congress and President Obama enacted the Health Care

and Education Reconciliation Act of 2010.2 Business owners seeking

to develop a thoughtful "nancial plan must understand that this

legislation imposes a new surtax on certain items of gross income,

including long-term capital gains.

This legislation adds a new provision to the Internal Revenue Code

that imposes a surtax on “net investment income” of certain taxpayers.3

Referred to as the “Medicare surtax,” the provision was intended to help

"nance health care reforms by imposing a levy on certain taxpayers.

This tax applies to individuals, estates, and certain trusts. The tax is

equal to 3.8% of the lesser of (1) “net investment income” and (2) the

amount by which the modi"ed adjusted gross income of the taxpayer

exceeds certain thresholds which are based on the "ling status of the

taxpayer.

Business owners evaluating their wealth diversi"cation and business

succession strategies should be mindful that the Medicare surtax

applies to “net investment income,” which may include the long-term

capital gain realized in connection with a disposition of the equity

of their business. However, a business owner may defer this same

Medicare surtax if the business owner sells the capital stock of the

business to an ESOP. In fact, under certain circumstances, the business

owner may be able to eliminate the Medicare surtax obligations that

would have been incurred in connection with alternative business

succession and wealth diversi"cation strategies such as management

buyouts and mergers and acquisitions.

A leveraged ESOP transaction o#ers substantial savings to the

business owner seeking to implement business succession and wealth

diversi"cation strategies under the new tax regime. Business owners

who inde"nitely defer the Medicare surtax through leveraged ESOP

transactions receive greater value for the investments they made in

their businesses: up to 3.8% of the total amount realized that would

have been payable to the federal government.

American Taxpayer Relief Act of 2012. On January 2, 2013, Congress

and President Obama enacted the American Taxpayer Relief Act of

2012.4 The ATRA was intended to avoid the "scal cli# by addressing

certain Bush-era tax changes. Existing law provided for an increase in

the marginal tax rates imposed on individuals in all tax brackets, for the

elimination of tax preferences for capital gains and quali"ed dividend

income, and for the reversion of the federal estate tax to a maximum

rate of 55%.

The ATRA makes permanent then-existing ordinary income tax rates

and added a new top marginal rate of 39.6% that applies to individuals

based on "ling status and income thresholds. In addition, the ATRA

imposes a new top rate of 20% on certain adjusted net capital gain.

Existing law provided that adjusted net capital gain of an individual

would be taxed at a maximum rate of 15%. The ATRA made the 15%

rate permanent, but added a new 20% capital gain rate for certain

taxpayers. Adjusted net capital gain that would have been taxed at

the newly established 39.6% tax rate if it were ordinary income is now

taxed at the new 20% rate.

Business owners evaluating their business succession and wealth

diversi"cation strategies should consider how increased ordinary

income and long-term capital gains tax rates a#ect the options

available to them. The most conscientious of these business owners

will evaluate how a leveraged ESOP transaction may help defer and

even eliminate long-term capital gain tax obligations incurred in

connection with the disposition of capital stock held by the business

owners.

Questions and Answers Regarding ESOPS as a Liquidity Tool and

Business Succession Plan.

How does an ESOP create a market for shares of a privately held business?

An ESOP is a tax-quali"ed retirement plan designed to invest primarily

in the capital stock of its corporate sponsor. Generally, in a leveraged

ESOP transaction, the trustee acts as the buyer of shares of the

corporate sponsor that are being sold by the business owner, who acts

as the seller.

Who buys the shares and how much can they pay for the shares? Generally,

the board of directors of the corporate sponsor appoints a trustee to

act on behalf of the tax-exempt trust. The trustee will negotiate the

details of a leveraged ESOP transaction with the corporate sponsor

and its selling shareholders. Existing law prohibits the trustee from

paying in excess of fair market value for any portion of stock sold by

the business owner. Unlike a synergistic buyer, the trustee cannot o#er

a premium above the fair market value of the stock.

How does a business owner defer the recognition of long-term capital gain

realized in connection with selling shares in a privately held business to

an ESOP? Under certain circumstances, the business owner may make

an election under section 1042 of the Internal Revenue Code to defer

the recognition of the long-term capital gain realized by the business

owner in connection with the sale.

How can a business owner who sells a majority of the voting stock of the

corporate sponsor to an ESOP retain control of the corporate sponsor after

the sale? A business owner may receive a promissory note from the

business as part of the consideration for the shares sold in a leveraged

ESOP transaction. Therefore, the business owner becomes a creditor of

the corporate sponsor and becomes entitled to certain creditor rights

protections. One of these rights is to nominate candidates for election

to the board of directors by the shareholders of the corporate sponsor.

In addition, the trustee of the ESOP will be interested in preserving a

successful management team to ensure the continued performance of

the corporate sponsor.

How can a business owner who sells all of his shares of stock of the business

receive equity-like returns following the sale? The business owner can

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continue to receive equity-like returns through non-quali"ed deferred

compensation plans. For example, stock appreciation rights may be

awarded to key employees, including the business owner, entitling

participants in such plan to receive the appreciation in the value of

the stock of the corporate sponsor. In, addition, a business owners

who receives a promissory note from the business as part of the

consideration in the leveraged ESOP transaction may receive warrants

(in lieu of cash pay interest) entitling the noteholder to purchase shares

of stock in the corporate sponsor.

How does a corporate sponsor of an ESOP claim tax deductions? The

corporate sponsor may claim a deduction from gross income in

the amount of contributions made to the ESOP and in the amount

of dividends paid on shares held by the ESOP, subject to certain

limitations.

How can a corporate sponsor of an ESOP operate free from state and federal

income taxes? A corporate sponsor that is taxable as an S corporation

operates free from most state and federal income taxes by virtue of

having a tax-exempt trust as its sole shareholder. S corporations do not

incur a corporate level of tax. Rather, taxable income is taxable to the

shareholders of the business at their individual marginal tax rates. An S

corporation that is wholly-owned by its ESOP has a tax-exempt trust as

its sole shareholder. As a result, the business operates free from most

state and federal income taxes.

How does an ESOP a"ord its corporate sponsor the opportunity to attract

and retain talented employees? The ESOP o#ers its corporate sponsor

the opportunity to provide potential hires with equity participation

in the business. In addition, unlike other quali"ed retirement plans, a

portion of the bene"t participants receive may be taxed at favorable

long-term capital gains rates as opposed to ordinary income rates,

making the ESOP an attractive retirement savings strategy relative to

other quali"ed retirement plans o#ered by competitors.

Conclusion.

Congress and the Obama administration recently enacted legislation

that creates new taxes and increases existing tax rates. Business

owners who have spent their lives accumulating wealth within their

businesses must carefully consider how recent legislative changes will

a#ect the wealth diversi"cation and business succession strategies

they formulated in recent years. A thoughtful "nancial plan must

consider the tax advantages o#ered to business owners and their

businesses by a leveraged ESOP transaction.

1 Michael R. Holzman is a member in the Washington, D.C. o&ce of

Dickinson Wright PLLC. Mr. Holzman concentrates his practice on

ESOPs and non-quali"ed deferred compensation plans. Mr. Holzman

can be reached at 202.659.6931 or mholzman@dickinsonwright.com.

Christopher T. Horner is an attorney in the Washington, D.C. o&ce

of Dickinson Wright PLLC. Mr. Horner focuses his practice on exist

strategies with a focus on leveraged ESOP transactions. Mr. Horner can

be reached at 202.659.6961 or chorner@dickinsonwright.com.

2 Pub.L. 111–152, 124 Stat. 1029.

3 See §1411.

4 Pub. L. 112-240, 126 Stat. 2313.

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