The capital gains tax is scheduled to soar next year—but an Employee Stock Ownership Plan can soften the blow.
Unless Congress acts, beginning in 2013 most high-income taxpayers will get hit with an almost 59 percent increase in taxes on capital gains income; capital gains, now taxed at a maximum rate of 15 percent, will instead be taxed at a maximum 23.8 percent. That increase actually comes in two parts. First, the capital gains tax rate will rise by one-third, to 20 percent. Second, single taxpayers whose gross income exceeds $200,000 ($250,000 for couples) will have to pay a new 3.8 percent tax on investment income.
These tax changes are particularly bad news for people who own shares in family or closely held businesses. The stocks of many private businesses have low tax bases, meaning higher capital gains upon sale. So if you’re selling your business in 2013, these tax hikes will slash your proceeds—which means less money for you during retirement and to pass along to your heirs.
One option can ease your pain: An Employee Stock Ownership Plan (ESOP) is an employee benefit plan that creates a tax-beneficial way for owners to sell shares and for employees to buy them. Though there are some restrictions, ESOPs offer an immediate tax deduction for contributions into the plan. Participants defer income until they actually receive distributions, and the returns or profits on such contributions are tax-free.
An ESOP may even borrow money to buy the shares of a retiring owner, with the company then contributing cash to a trust to repay the principal and interest on the bank loan. (Remarkably, both the interest and the principal are tax-deductible by the company.) And when an ESOP purchases S-corporation stock, there’s another advantage: An ESOP pays no federal tax (and, often, no state or local taxes either) on its income from the corporation, so nobody pays federal taxes on corporate income allocated to the ESOP.
When it comes to tax deferral for the departing owner, C corporations do have an advantage over S corporations. If the owner sells C-corporation shares to an ESOP, he or she can roll over the gain into subsequently purchased securities. Some restrictions apply: For the selling owner to achieve a tax deferral, the ESOP must own at least 30 percent of the total value of the company’s outstanding stock or at least 30 percent of each class of the company’s outstanding stock. Also, stock sold to an ESOP must have been owned for at least three years prior to the sale and there must generally be a qualified appraisal supporting the sales price.
Most important, to obtain a tax deferral, the prior owner must invest the proceeds from the sale of the shares to the ESOP in so-called “qualified replacement property.” Qualified replacement property generally includes stocks and bonds issued by domestic corporations engaged in “active” businesses, meaning that they must not have more than 25 percent of their gross receipts consisting of passive income.
Once these requirements are satisfied, the seller of stock to an ESOP can defer capital gains tax on his profit until he sells the qualified replacement property. If the seller dies owning the qualified replacement property, then his profit (both original and post-sale of the business) is never taxed, and the seller’s heirs will receive a step-up in basis to the value of the inherited qualified replacement property at the time of the owner’s death. If the qualified replacement property is gifted or transferred in a divorce, the recipient also doesn’t pay tax on the deferred profit until he sells the qualified replacement property.
Employees participating in an ESOP are also entitled to tax deferral of a different type. They hold shares in the trust, but don’t pay taxes on these shares until they leave the company, at which point the firm typically buys the stock back at fair market value and the employees pay capital gains taxes.
It sounds complicated, and it is. But the bottom line is that, if tax increases on capital gains occur as scheduled, an ESOP can help you hang on to more of your hard-earned profits.
This article originally appeared in the August/September 2012 issue of Worth.