A capitalist economy only can flourish if the rewards of capitalism are equitably shared with the workforce. Championed by the son of Huey Long, employee stock ownership plans (ESOPs) have made that possible since their adoption in 1974. The approximately 7,000 plans covering 10 percent of the workforce have assets nearing $1.1 trillion.1 Their average benefit is nearly two and one-half times greater than that for other types of qualified plans.2 Even better, a worker is more likely to benefit from a second qualified plan.3 Nearly half of ESOPs have been established in the last 15 years, a testament to their continuing viability despite the emergence of “the Gig” economy.4
ESOPs not only facilitate sharing the rewards of capitalism with labor, but also solve the business owner’s concerns about succession planning, tax minimization and liquidity. Converting ordinary income into capital gains and deferring payment of income tax are two workhorse tax minimization strategies that the ESOP affords. These extraordinary tax incentives make them especially useful for the philanthropically minded to achieve charitable and financial planning goals. Let’s examine some of the key elements of the ESOP and how it operates.
An ESOP is an individual account, profit-sharing plan designed to invest primarily in the securities of the employer.5 The stock may either be publicly traded or privately held as a C or S corporation.6 Unlike other qualified plans, the employer may receive a tax-deductible contribution for stock contributed to the ESOP. Of course, the employer can (and often does) also make tax-deductible contributions of cash to enable the ESOP to purchase stock of the shareholders or repay the debt incurred in the acquisition of the employer’s stock. To the extent the corporation can conserve cash during its life cycle, it’s available for other pressing business priorities.
The ESOP can serve as the buyer of the employee-shareholder’s stock, thereby eliminating the closely held business owner’s most pressing worry about how to monetize his most valuable asset. Now that the owner has cash, how is the tax bite managed?
IRC Section 1042 Election
Let’s examine the case of Carol Capitalist (age 65), the majority shareholder of a professional services C corporation. Over the last decade, Carol has developed a very reliable senior management team of owner-employees. She’s ready to receive from the ESOP her interest worth $15 million with a basis of $1.5 million, representing the fair market value (FMV) of her stock at the time of allocation to her ESOP account. If she makes an IRC Section 1042 election available for C corporations, she can use the $15 million in sales proceeds received from the ESOP to purchase “qualified replacement securities,” essentially publicly traded securities. Such securities are those of operating companies incorporated in the United States that don’t have passive income exceeding 25 percent of their gross receipts for the preceding taxable year. Investments in government bonds, municipal bonds, real estate investment trusts and mutual funds don’t qualify as qualified replacement securities.7 Carol defers capital gains and net investment income taxes of $3.213 million on the profit of $13.5 million. The effect of the Section 1042 election is as if like-kind exchange treatment were available for the exchange of privately held stock for publicly held stock. To the extent the dividends from the replacement securities are insufficient, Carol can sell the stock. The amount of the gain will be the excess of cash received over her original basis in the employer stock.
Qualified Replacement Securities
A useful strategy to maximize cash flow for Carol, who’s charitably inclined to support her family foundation, would be to transfer the replacement shares to a qualified split-interest arrangement, such as a charitable remainder trust (CRT) or charitable gift annuity (CGA). The transfer of the appreciated replacement securities to a CRT or CGA doesn’t trigger the recognition of the appreciation.8 The qualified replacement securities can be just as useful for charitable planning as any other type of publicly traded security.
Options for S Corporation Stock
The tax consequences to Carol would be different had she organized an S corporation. While the tax bite can be managed, the charitable planning possibilities are more restrictive.
The Section 1042 election is unavailable, though remember none of the income from the distributive share of the S corporation was ever taxed to the extent the shares were held by the ESOP. Carol has two options:
Option 1. On receipt of her shares, she would be taxed only to the extent of her basis of $1.5 million. The net unrealized appreciation (NUA) would be taxed only as the shares were sold. This is an extraordinary result, as Carol has received compensation for her services, which will be taxed as a capital asset. Most of the time, the distributions from a qualified plan are taxed as ordinary income. Any post-transfer appreciation would be preferentially taxed as long-term capital gains, so long as she held the stock for more than 12 months after distribution.
Option 2. Carol could forsake NUA treatment and elect rollover treatment.9 She wouldn’t be taxed on either the appreciation or her basis (the stock’s FMV at the time of allocation to her ESOP account) at the time of her rollover. However, she forsakes the chance to have her distributions taxed as capital gains.10 Electing rollover treatment would make the most sense if the NUA was relatively small compared to the FMV. For example, if Carol’s basis had been $11.5 million, there would have been NUA of $1.5 million. Electing rollover treatment forsakes favorable NUA treatment but defers taxation on $11.5 million. Here, the rollover merits loss of the NUA treatment.
Gifts of S Corporation Stock
While charities may receive S corporation stock, the charity will consider the negative consequences before deciding to accept. Any share of the corporation’s income is unrelated business income (UBI).11 Any gains from the sale of the stock will also be taxed as UBI.12 And of course, the charity and Carol have the risk of any subsequent redemptions being cast as a prearranged sale. So, while gifts of S corporation stock are possible for Carol, she may decide to use other assets.
Consider Gifts of Employer Securities
As Baby Boomer business owners continue to retire, gifts of employer securities will merit consideration. Although complicated, gifts of C corporation stock can be made so as to satisfy the donor’s business and financial planning goals and coordinate with charitable planning. Gifts of S corporation stock probably won’t be made unless the donor has no other viable assets.
1. National Center for Employee Ownership, Employee Ownership Report, “The Current State of ESOPs,” March-April (2015), at p. 5.
2. Ibid., “Three ESOP Myths, Debunked,” Table 2, September-October (2013), at p. 15.
3. Ibid., “ESOP Companies More Likely to Offer Both Other Defined Contribution Plans and Defined Benefit Plans,” May-June (2015), at p. 6, referencing the results of PLANSPONSOR’s annual defined contribution survey.
4. See supra note 1, Table 3.
5. Treasury Regulations Section 54.4975-11(a) and (b).
6. See Internal Revenue Code Section 409(L).
7. See Treas. Regs. Section 1042-1 T, A-1 (d).
8. See IRC Section 1042(e)(3)(C) and Private Letter Rulings 9438012 (Sept. 23, 1994) and 9715040 (April 11, 1997).
9. See IRC Section 402(e)(4)(B).
11. See IRC Section 512(e).