As a business owner, you care about your business, your employees, and your customers. Deeply. And as a parent, grandparent, spouse or sibling, you care about your family. But when it comes time to transition your business, planning for your business and your family can be overwhelming, and oftentimes personal planning takes the back seat to business planning. But it doesn’t have to. The rewards for planning well for personal financial and family transition are substantial, particularly in advance of an Employee Stock Ownership (ESOP) business transition.

ESOPs are a tax-advantaged means of monetizing a family business and allowing employees to become owners in the company. The owner sells her shares to a trust established for the benefit of employees (the ESOP). The ESOP finances the purchase with tax-favored borrowing. We have seen a surge in ESOP transactions in recent years and expect the trend to continue. This level of transaction activity and the current tax environment elevate the need to focus on the personal financial and family transition side of planning for business owners who may have an ESOP transaction in their future to optimize the personal financial and family benefits.

• The Goal. The long goal is simple – optimize the transfer of the hard-earned wealth from the business to family, and possibly to charity, in a way that positions family members for a successful experience with wealth and delays and minimizes taxes (income, gift, estate, and generation-skipping transfer) to the greatest extent possible. Surprisingly, we have an ally in the Internal Revenue Code (“Code”) in achieving this goal.
• The Time. The earlier the start, the greater the benefits, but it is never too late to begin. In 2021 an individual can transfer up to $11.7 million ($23.4 million for a married couple) free of gift, estate and generation-skipping transfer tax. This is an historic high level and is not expected to continue. In addition, the Code currently provides for the deferral of capital gain on the sale of stock to an ESOP if certain conditions are met. This deferral will become of increased significance if (some would say when) the tax rate on capital gain increases. On the other hand, recognizing capital gain when rates are lower (rather than deferring) will in some instances be preferred. The time to run the numbers for the business owner personally is well in advance of the flurry of the transaction.
• The Way. A combination of partnership, limited liability company, and trust planning, stock transfers, and tax elections provide for the optimization for family and minimization of tax.
  • Partnership, limited liability company, and trust planning. Stock may be contributed by the owner to a partnership or limited liability company. Gifts of partnership or limited liability company interests may then be made to family members, outright or in trust. Where minority interests are transferred, discounts are applied, leveraging the use of the $11.7 million lifetime gift and estate tax exclusion (and associated generation-skipping transfer tax exemption). Trusts may be designed to be insulated from gift, estate, and generation-skipping transfer tax for generations. And with the selection of the managers of a partnership or limited liability company and trustees of trusts, responsible management can be put in place for the long term.
  • Tax conditions and elections. A taxpayer (or the executor of a deceased taxpayer) can elect to defer the capital gain recognized on securities sold to an ESOP if certain conditions are met.
    • The securities must be issued by a C-corporation (not an S-corporation) and must not have been received from a distribution from a qualified plan or transfer pursuant to the exercise of an option.
    • Immediately after the sale, the ESOP must own at least 30% of each class of outstanding stock of the corporation or 30% of the total value of all outstanding stock of the corporation.
    • The taxpayer must have held the securities for at least 3 years prior to the sale. If there are prior gifts, the holding period of the donor and the recipient (such as a transfer to a trust) may be tacked, but the holding period in a sale to a grantor trust may not be tacked.
    • The taxpayer must reinvest in what is known as qualified replacements property (“QRP”) (securities issued by a domestic operating company) in the period 3 months to 12 months from the date of the sale. The taxpayer’s basis in the QRP is adjusted (downward) to account for the deferred gain. However, at least under current law, a basis adjustment to fair market value at death is available for QRP. Tax is triggered by certain dispositions of QRP, such as a sale or a transfer to a partnership, but not by a lifetime gift, charitable contribution, or transfer at death. Working with an investment advisor familiar with ESOPs and QRP, the taxpayer can invest in floating rate notes that she can borrow against and invest without the QRP restrictions.
    • The taxpayer must file a timely election to defer the tax under IRC Section 1042.

Of course, there are many important tax and investment details, but this is the general framework.

Whether a business transition is expected due to a change in family circumstances (a divorce or other falling out among family members), a desire to retire from the business and pursue other interests, or a change in the business environment, planning for the transition for the business and the personal wealth and family transitions is achievable. And well worth the focus and attention it takes.

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