The confluence of three rules creates wonderful opportunities for business tax planning.

The first rule is that an S corporation is not subject to income taxation because its income must be reported by its stockholders.  (There is an exception in the case of a C corporation which converts to S status.)  

The second rule is that a qualified retirement plan which is designed to invest primarily in the employer’s stock and which meets certain other requirements can achieve status as an Employee Stock Option Plan (“ESOP”). ESOP’s are permitted to engage is certain transactions which are prohibited for other qualified retirement plans, such as borrowing from the employer or purchasing stock of the employer.

The third rule requires a bit of introduction. Normally, an exempt organization, such as a qualified retirement plan, must pay income tax at the highest rates on its UBTI. UBTI is that part of its business income which is not related to its exempt function. (The classic example is a church operating a spaghetti factory.) The reason for taxing UBTI is to avoid giving exempt organizations an unfair advantage over their taxable competitors. However, the Internal Revenue Code was amended in 1998 to provide an exemption from the tax on UBTI in the case of an ESOP which owns stock in an S corporation. Thus the portion of an S corporation’s income which is attributable to an ESOP is exempt from income taxation. Tax lawyers refer to such an ESOP as a SESOP, for S ESOP. If the SESOP owns all of the outstanding stock, then the corporation would be effectively exempt from income tax on all of its future profits.

Corporate employers can take deductions for contributions of stock to an ESOP. Such a noncash deduction can improve cash-flow.

Another major benefit of ESOP’s is that stockholders can qualify for a tax free rollover of the gain on the sale of stock to an ESOP if certain requirements are met, among which are that (i) the ESOP must own at least 30% of the outstanding stock after the sale, and (ii) the sale proceeds must be reinvested in stock of an operating US corporation (e.g., IBM).  Further, there are a couple of rules prohibiting the ESOP from allocating any of the purchased stock to the account of the seller, related parties and large stockholders.

ESOP’s are reputed to provide incentives to employees to behave more like owners, even to the point of not tolerating slackers.

Putting all of the above together means that the stockholders of a corporation can exit tax-free by selling to the ESOP with the corporation effectively paying the price via deductible employer contributions. The classic example is the ESOP borrowing the stock purchase price from a bank with the bank loan guaranteed by the corporate employer and the selling stockholder. The ESOP buys the stock with the loan proceeds and the corporation pays the debt via deductible cash contributions to the ESOP.

ESOP’s also provide a tax efficient way to buy or sell a business to a third party. It is even possible for suitor to use his or her own retirement money to make the purchase. For example, the corporation could establish an ESOP, the suitor could rollover his or her IRA or 401(k) money to the ESOP and the ESOP could buy the stock, with the great majority of the stock allocated to the suitor’s account within the ESOP.

Tax planning with ESOP’s can be particularly beneficial to small businesses with asset protection concerns, such as a group medical practice. (The P.A. would first be converted to an Inc. or LLC.) The corporate guaranty of the bank loan to the ESOP would be secured by a lien on the corporation’s receivables and other assets. The loan proceeds are ultimately received by the physician-stockholders at capital gain rates and the loan is paid back with deductible dollars. The result is tax planning which provides some asset protection as a sweetener.  It is also an excellent way for physicians to capture the stock value, rather than selling their stock for artificially low values on termination of employment.

©2007 Steven M. Chamberlain, Esq. All rights reserved. Republication with attribution is permitted.