TAX PLANNING
To set up one of these plans, you’ ll require the expertise of a professional who is well versed in them and understands the exit-planning space.
How ESOPs Are Structured
A privately held company creating an employee stock ownership plan first sets up a trust with an appointed trustee. The company stock is purchased either with company funds or with a loan from the owner or institution. The stock is then transferred directly into the trust to be allocated to employees according to established rules outlined in the plan, usually compensating them more for salary or tenure.
It’ s the trustee’ s responsibility to ensure that there’ s a fair stock valuation and to represent the employees by collectively voting for them on company matters. Employees’ allocations in the stock plan increase each year through a vesting plan. Participants normally receive a distribution when they retire, when they’ re terminated or when they become disabled or die.
The boards of companies normally appoint officers who then hire managers to run company operations. This organizational blueprint would remain intact after the establishment of an ESOP, and things would pretty much remain business as usual. The trustees, meanwhile, carry on the fiduciary responsibilities of the plan, meet with officers to track financial performance, and vote the ESOP shares. They also communicate with employees to keep them aware of relevant particulars— reporting, for instance, the annual valuations of individual accounts to plan participants. However, in privately held companies, employees do not have access to financial data.
C Corp Tax Shields
Employee stock ownership plans are attractive to C corporations because of the tax deductions they allow: C corps are allowed to deduct contributions( stock or cash) of up to 25 % of the covered payroll amount. And the ESOP’ s loan interest is not subject to the limitation and is 100 % deductible. Dividends distributed to the ESOP enjoy the same tax advantage, though they are bound by some limits. In these respects, these plans operate as tax-free trusts.
Section 1042— A Possible Tax-Free Sale
Many people are familiar with Section 1031 of the Internal Revenue Code, which allows taxpayers to defer capital gains on the sale of business-use or investmentuse property by reinvesting it in like-kind property. But there’ s another part of the code, Section 1042, that aids employee stock ownership plans in the same way.
Under the code, employees who own shares of closely held C corps are in cer- tain cases allowed to defer their capital gains when they sell their shares by purchasing stocks or securities in qualified replacement property. The capital gains deferment remains in place until the business owner sells. The only caveat is that the company must be at least 30 % owned by the ESOP, and it applies only to C corps, not S corps.
This section of the IRS code has a striking advantage for those seeking an estate-planning strategy. While a sale of the replacement securities by the owner triggers a capital gains event, their heirs experience something very different. If the deferment is still in place when the owner dies, the value in the securities steps up in basis. Thus, the capital gains from the original sale of the securities are deferred or eliminated.
The Tortoise and the Hare
Anyone familiar with the famous Aesop fable knows that the tortoise uses smarts and diligence to beat the hare. Owners of privately held companies who build successful businesses the same way deserve to be richly rewarded. ESOPs offer many advantages not only to owners but to the employees contributing to a company’ s growth and achievements. The company itself also benefits since the plan better engages the workforce, helps retain more talent and offers a smoother power transition.
ESOPs are not all rainbows and unicorns. These trusts are complex entities that come with a cost to administer. They are certainly not for any do-it-yourselfer. To set up one of these plans, you’ ll require the expertise of a professional who is well versed in them and understands the exitplanning space.
If you’ re a company owner who sees the finish line, consulting with a qualified financial advisor to discuss implementing an exit strategy is evidence of a race well run.
GERRY SPITZER, CPA, CEPA, is the co-founder of Questar Capital Partners and advises owners of privately held businesses on succession planning, exit planning, liquidity needs and wealth management.
48 | FINANCIAL ADVISOR MAGAZINE | JULY / AUGUST 2025 WWW. FA-MAG. COM