August 20, 2018
When family business owners sell C corporation stock for a big profit, they usually qualify for the current 20% maximum federal rate on long-term capital gains (assuming they’ve owned the shares for over a year). While a 20% rate is good, a tax-free sale to an ESOP could be even better.
Current rules: The maximum federal income tax rate on C corporation dividends is now 20% for single people with taxable income above $425,800 ($479,000 for married joint-filing couples). Upper-income individuals may also owe the new 3.8% Medicare surtax on dividend income. For other taxpayers with lower incomes, the tax rate on dividends is 15%.
Under these rules, ESOPs remain an attractive option.
An ESOP is a type of qualified employee retirement plan that companies can establish for their staff members. Unlike other kinds of qualified plans, an ESOP is intended to invest primarily in stock of the sponsoring employer (the corporation that established the plan). A newly formed ESOP can borrow money from the corporation or from a commercial lender (or both) and use the resulting cash to buy some or all of the owner’s shares. Under the tax rules, however, a newly-formed plan must own at least 30% of the company stock.
After the ESOP acquires its shares, the corporation makes annual deductible contributions to the plan. Eventually, those contributions retire the ESOP’s loan, at which point the plan owns the purchased shares free and clear. As the corporation’s employees become vested in their accounts, shares are allocated to those accounts. Eventually, the employees become indirect stockholders through the ESOP.
As mentioned earlier, the corporation’s contributions to the ESOP are used to pay both the principal and interest on the plan loan that was used to buy the business owner’s stock. Since the contributions are deductible, the company effectively deducts both the principal and interest, which is a unique tax advantage. Even better, the business owner can elect to defer the federal income tax bill on the profit from selling shares to the ESOP. To do this, however, the owner must reinvest the stock sale proceeds in “qualified replacement securities” which can include publicly traded stocks and bonds.
The deferred gain reduces the tax basis of the replacement securities. The deferred gain isn’t triggered until the owner finally sells the replacement securities. If the owner dies while still owning the replacement securities, the tax basis is stepped up to fair market value on the date of death (assuming the current basis step-up rule in the tax code remains in force). So the deferred gain simply disappears. The business owner’s heirs can then sell the replacement securities and owe little or nothing in capital gains taxes.
Conclusion: In essence, the ESOP stock sale strategy allows qualified family business owners to trade their relatively illiquid company stock for ultra-liquid publicly traded investment securities while postponing or maybe even eliminating the federal income tax bill. Of course, there are a bunch of tax-law hurdles to clear in order to get such great results. Professional tax and valuation advice is needed to pull it off. Contact your attorney and tax adviser if you want to learn more about an ESOP stock sale.