With the steady increase of founders of companies exiting through family and management succession transactions, sales, and other dispositions, an often-overlooked alternative, has had considerable traction. Employee Stock Ownership Plans (“ESOPs”), popular 30-40 years ago with large corporations, have gained favor in recent years with many technology and GovCon companies.
Section 1042 of the Internal Revenue Code (the “Code”) offers favorable tax treatment to corporation shareholders similar to ‘like-kind” exchanges of real property under Section 1031, and annuity exchanges under Section 1035, of the Code.
Owners of closely-held C corporations can defer, or potentially eliminate, taxation on the capital gain from “qualified securities” sold to an ESOP if the proceeds are reinvested in “qualified replacement property” (“QRP”). Gain on the sale of the corporation stock is deferred until the QRP securities are later sold or could be eliminated entirely by step-up in basis of the QRP securities upon death. In addition, an ESOP can borrow money to buy existing shares, new shares, or treasury shares, and contributions to repay the loans can be tax deductible, so that financing is done in pretax dollars.
At the same time, the ESOP is an employee benefit plan regulated under the Employee Retirement Income Security Act of 1974 (“ERISA”) by the Department of Labor and the Internal Revenue Service, like other qualified employee benefit plans, which imposes a layer of complex requirements on such plans.
The basic requirements for the company’s “qualified securities” under Section 1042 of the Code are:
- Can only be common stock issued by the company – the ESOP sponsor
- Cannot be publicly traded stock
- Stock must have been held for at least 3 years
- Must not have been acquired from a retirement plan distribution, employee-granted option or restricted stock
- ESOP must own at least 30% of the company after the sale, acquired from one or more company shareholders
- Seller must reinvest proceeds of sale in the QRP no earlier than 3 months nor more than 12 months after the sale
QRP is securities of a domestic operating corporation, including common or preferred stock, bonds, notes, and other securities, which uses more than 50% of its assets in an active trade or business and cannot have passive income in excess of 25% of its gross receipts for the year preceding the purchase. It cannot be stock of the company that is the ESOP sponsor.
Qualification of the transaction for tax purposes requires that the selling shareholder(s) file a “Statement of Purchase” with their tax return(s). In addition, the selling shareholder(s) must sign a “Statement of Election” confirming intention to elect non-recognition of gain under Section 1042. Finally, a “Statement of Consent” must be signed by an officer of the company confirming agreement to being subject to excise taxes should the company be sold earlier than three years after the ESOP transaction, and agreeing to prohibitions of allocation of ESOP stock to the selling shareholder(s) and related parties. These two Statements must be filed with the IRS with the tax returns for the year of the ESOP transaction.
These are the essentials to a successful ESOP transaction, which gives the selling shareholders an unparalleled opportunity to sell as little as 30% and, at their option, much more of the company and to hold on to the balance, whether remaining in control or simply riding the future success of the company.
There are further complex requirements under Section 1042 and related Code sections, and like many other areas of the Code compliance is essential. This includes requirements for maintaining the ESOP, which involves a trustee and requires regular valuation appraisals to assure one of the other ESOP benefits – a market for the ESOP shareholders of the company to sell their stock at true fair market value.
Establishing an ESOP for a partial or full exit from a company is a worthy alternative to other means of liquidating an owner’s ownership interest. There is a lot of information on ESOPs online, but it requires diligence and guidance from legal and accounting experts to navigate the steps to success. For the right company, it could be the best choice for owners to exit.
ABOUT THOMAS HICKS
C. Thomas (“Tom”) Hicks III has more than 35 years of business law practice experience in Northern Virginia. Mr. Hicks represents business clients in all their legal needs, working with the management team as outside general counsel, and otherwise coordinating the company’s general legal needs. Mr. Hicks assists the organizers with choice of business entity and organization, initial and private equity financing and debt financing. He advises the management team regarding corporate governance, executive employment and compensation matters, contract matters, business acquisitions, equity and asset sales and merger, and business breakups and dissolutions of business entities, among other legal areas. He also advises business executives and companies regarding stock and other equity benefit plans, and wealth planning and asset protection. Mr. Hicks has advised commercial real estate developers in all legal aspects of their business.
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