If you own a business, establishing an employee stock ownership plan (ESOP) may provide you with a number of estate planning opportunities. An ESOP is similar to a traditional defined contribution plan in which an employer makes contributions to accounts established for employees. But, rather than investing in a variety of assets, an ESOP invests primarily in the stock of the company involved.

Selling a portion of your stock to an ESOP can provide you with liquidity. You can defer gain on the sale through the purchase of qualified replacement property (QRP), such as certain stocks and bonds in operating companies that meet prescribed rules (and which do not need to be publicly traded). In addition, your family members can retain control of the company by controlling the ESOP and fulfilling buy-back requirements when an employee leaves or dies.

Planning Options

After establishing an ESOP, you may hold cash, QRP or a promissory note from the company in place of the stock sold to the ESOP. Let’s look at some of the estate planning strategies available for the proceeds of the sale to the ESOP.

Holding the assets. The estate planning possibilities for QRP are similar to those for other low-basis assets. However, disposition of QRP will trigger the recognition of gain in some instances, such as a transfer to a family limited partnership (FLP) or a limited liability company, where gain would ordinarily not be recognized. As with other appreciated property, the simplest plan is to hold the QRP until death, at which time your estate will receive a stepped-up basis. While this strategy may eliminate capital gain, it may be less effective than other options at minimizing transfer taxes.

Gifting the assets. While disposing of QRP generally results in taxable gain, gifting QRP does not. You may make gifts of QRP to charities, charitable trusts or noncharitable beneficiaries, either outright or in trust. You can receive an income tax deduction (which is limited in some situations) for the gift without incurring offsetting capital gain on the disposition of the QRP.

Rather than making an outright gift to charity, you may wish to use the ESOP stock sale assets to establish a charitable remainder unitrust. You could receive cash flow and a current income tax deduction for the remainder interest value that passes to charity after the end of term. 

If you receive a promissory note from the ESOP as part of the stock sale price, the note may be an appropriate asset for gifting. You may be able to discount the value of the note due to the risk that the note will not be timely paid. The note also may be a good candidate for an outright gift to charity or for funding a charitable lead annuity trust. This type of trust pays an annuity to a charity for a period of time and then pays the remainder to a noncharitable beneficiary.

Establishing a grantor trust. You may use QRP or other assets of the stock sale to establish a grantor retained annuity trust (GRAT) for the benefit of your children. At a low gift tax cost, you can retain all or most of the cash flow while removing the property from your estate and saving estate tax. GRATs are most effective when funded with income-producing property that you expect to appreciate significantly in a short period of time.

Another popular estate planning technique is an installment sale by you to a grantor trust. This arrangement involves a completed gift to the trust for gift tax purposes, but under the trust arrangement you are taxed on the trust income. You may fund this type of trust with QRP without triggering gain.

Purchasing bonds. In some instances you may have decided to purchase qualifying long-term bonds as QRP. Such bonds pay a “floating” interest rate and are well suited as security for loans. You can use the proceeds of loans made against such bonds to make other investments. You can also establish an FLP with the loan proceeds (which would otherwise trigger recapture of the QRP gain) to implement a gifting program.

Buying other assets. An alternative to buying QRP with the proceeds from the initial sale of company stock is to pay the 20% capital gain tax and use the remaining cash to purchase assets to fund an FLP. You then give shares in the partnership to the limited partners (usually your children) to take advantage of the valuation discount for minority interests and for lack of marketability.

If you purchase real estate, you may want to consider buying a vacation home and establishing a qualified personal residence trust. The trust beneficiaries receive a gift of a remainder interest in the property, which is discounted for your right to live in the home.

Choosing a Strategy

Establishing an ESOP gives you estate planning options that can result insubstantial tax savings. Ideally, you should consider your options before you establish an ESOP, so the type of asset you acquire with the sale proceeds lets you use the most beneficial strategies.

If you have recently established an ESOP, or are considering one, we can advise you about various strategies for maximizing the benefits to your estate from the assets you receive from the ESOP transaction.

Adjustments for 1999

Many of the exemption and exclusion amounts used for estate and gift planning change over time, whether because of changes in the cost of living or changes in tax laws. The following will help you keep current for 1999.

Lifetime gift and estate tax exclusion amount      $650,000

Family owned business deduction          $650,000

Generation skipping transfer tax exemption        $1.1 million

Annual gift tax exclusion            $10,000