Filed Under:Life Insurance, Life Planning Strategies

ESOPs: a plan to help business owners avoid "taxmageddon"

Photo credit: KROMKRATHOG
Photo credit: KROMKRATHOG

The potential massive tax increases looming in 2013 will be felt by many taxpayers, but they could take an especially hard toll on business owner clients who have plans to sell.  With nearly 80 percent of their net worth tied up in the value of the enterprise1, such business owners could lose a significant amount of assets which they have spent a lifetime amassing. 

On the horizon

If Congress allows the Bush-era tax cuts to expire in 2013, long-term capital gains rates will increase to 20 from 15 percent.  On top of that, the health care reform act will impose a new 3.8 percent tax on capital gains for certain individuals in 2013, bringing the capital gains tax to 23.8 percent.  The jump to 23.8 from 15 percent is a 60 percent increase. 

Higher income taxpayers will also experience a reduced benefit from itemized deductions if these tax cuts expire. The net effect could boost their capital gains tax rate to 25 percent from 23.8 percent.  Further, Congress and President Obama are discussing reducing deductions in other ways.

Then there are state taxes. Some, like California or New York, already have high capital gains tax rates, some as much as 8-10 percent, which high income taxpayers would pay in addition to the increased Federal rates.   Consequently, for the business owner who sells his or her business in 2013 as part of a succession plan, the collective tax increases could wipe out as much as 30 to 35 percent of the wealth the owner worked for decades to build up in the business and accumulate for retirement regardless of whether the owner’s stock is redeemed or sold to a third party.

Enter the ESOP Advantage

There is a way to help business owner clients soften (and in some instances completely eliminate) the impending tax blow and unlock substantial assets by using an employee stock ownership plan. Because of their special tax features, ESOPs allow owners to sell their stock and diversify their wealth on a tax-favorable basis, while effectively retaining control of their business. 

An ESOP also provides a way for the owner’s children or current management to take control of the business. The plan also provides retirement benefits to employees in the form of an ownership stake, which has proven to enhance business productivity.

An ESOP is a qualified retirement plan designed to invest primarily in company stock.  As a tax-qualified plan, the stock owned by the ESOP is held in a tax-exempt trust, and the ESOP must comply with the requirements under the tax code. 

The selling owner can choose to avoid the capital gains tax on the stock sold to an ESOP, as long as certain requirements under the tax code are met (known as Section 1042 rollovers). Among them: that the ESOP own at least 30 percent of the common stock of the corporation.   

The tax savings would be huge under the new rates that appear likely to kick in on January 1, 2013. But even if the capital gains rate remains the same, the savings is substantial.

The Opportunity for Financial Professionals

When the owner sells to the ESOP, the transaction can generate significant assets—assets that were once tied up in the business but now are available to be invested.  The financial professional who brings the ESOP idea to the owner is in the ideal position to assist the owner in managing the assets.  ESOP formation can also create new estate planning, life and disability insurance needs and other employee benefit opportunities—all of which can help financial professionals grow their businesses. 

Financial professionals don’t need to be an expert in ESOPs. They can team up with an ESOP consultant who can handle the technical details.

Are Tax Increases Coming?

Even if Congress maintains the Bush-era tax cuts, it is very likely that taxes are headed in one direction—up.  Financial professionals who understand that ESOPs can be used as part of a tax efficient liquidation strategy are in a unique position to help their business owner clients.  

1 2007 Survey of Consumer Finances; excludes value of primary residence. 

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