ESOPs as Estate Planning Tools

by Charles Epstein, CLU, ChFC

As a business owner, you realize your largest asset is your employees. Providing them with adequate compensation is just one way to show your appreciation. Establishing an employee stock ownership plan (ESOP) could be another. An ESOP not only benefits your employees but also enables you to take advantage of several estate planning strategies.

An ESOP is similar to a traditional defined contribution plan in which an employer makes contributions to accounts established for employees. But, rather than investing in a variety of assets, an ESOP invests primarily in the stock of the company involved.

Selling a portion of your stock to an ESOP can provide you with liquidity. You can defer gain on the sale through the purchase of qualified replacement property (QRP), such as some stocks and bonds in operating companies that meet prescribed rules (and that need not be publicly traded). In addition, your family members can retain control of the company by controlling the ESOP and exercising buy-back requirements when an employee leaves or dies.

Estate Planning Strategies

After establishing an ESOP, you may hold assets, a promissory note or QRP from the company in place of the stock sold to the ESOP. Here are estate planning strategies available to you after the sale of your stock to your company’s ESOP.

Hold on to the QRP. Estate planning options for QRP are similar to those for other low-basis assets. But disposition of QRP will trigger recognition when gain would ordinarily not be recognized, such as a transfer to a family limited partnership (FLP) or a limited liability company (LLC). As with other appreciated property, the simplest plan is to hold the QRP until death, at which time your estate will receive a stepped-up basis. While this strategy may eliminate capital gain, it may be less effective than other options at minimizing transfer taxes.

Buy other assets. An alternative to buying QRP with the proceeds from the initial sale of company stock is to pay the 20% capital gain tax and use the remaining cash to buy assets to fund an FLP. You then give shares in the partnership to the limited partners (usually your children) to take advantage of the valuation discount for minority interests and lack of marketability.

Make gifts of the assets. While disposing of QRP generally results in taxable gain, making gifts of QRP does not. You may make gifts either outright or in trust to charities, charitable trusts or noncharitable beneficiaries. You can receive an income tax deduction (limited in some situations) for the gift without incurring offsetting capital gain on the QRP’s disposition. Here are two ways to use your assets to make gifts:

  1. Charitable remainder unitrusts. Rather than make an outright gift to charity, you may wish to use the ESOP stock sale assets to establish a charitable remainder unitrust. You could receive cash flow and a current income tax deduction for the remainder interest that passes to charity after the term ends.
  2. Promissory notes. If you receive a promissory note from the ESOP as part of the stock sale price, the note may be an appropriate asset to give away. You may be able to discount the note because there is always the risk that the note will not be timely paid. The note also may be a good candidate for an outright gift to charity or for funding a charitable lead annuity trust. This type of trust pays an annuity to a charity for a period and then pays the remainder to a noncharitable beneficiary.

Establish a grantor trust. You may establish a grantor retained annuity trust (GRAT) for the benefit of your children with the QRP or other assets of the stock sale. At a low gift tax cost, you can retain all or most of the cash flow while removing the property from your estate and saving estate tax. GRATs are most effective when funded with income-producing property that you expect to appreciate significantly in a short period of time.

Complete installment sales. You can also follow the popular strategy of making an installment sale to a grantor trust. This arrangement involves a completed gift to the trust for gift-tax purposes, but under the trust arrangement you are taxed on the trust income. You may fund this type of trust with QRP without triggering gain.

Buy bonds. You can buy qualifying long-term bonds as QRP. Such bonds pay a “floating” interest rate and are well suited as security for loans. You can use the proceeds of loans made against such bonds to make other investments. You can also establish an FLP with the loan proceeds that would otherwise trigger recapture of the QRP gain to implement a gifting program.

Establish QPRTs. You may want to consider buying a vacation home and establishing a qualified personal residence trust (QPRT). The trust beneficiaries receive a gift of a remainder interest in the property, which is discounted for your right to live in the home.

Which Strategy is Right for You?

Your estate can benefit from substantial tax savings if you plan your ESOP correctly. Ideally, you should consider all options before you establish an ESOP because the type of assets you acquire from the ESOP stock sale determines your later estate planning strategies.

If you plan to establish an ESOP or have questions concerning an already established ESOP, please call us. Our professionals would welcome the opportunity to discuss ways to maximize the benefits to your estate from the assets you receive from the ESOP transaction.