On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012 (“ATRA”). ATRA, among other provisions, combined with the expiration of the Bush tax cuts result in a top marginal tax rate on capital gains of 20.0% for individuals with taxable income over $400,000 per year ($450,000 for a married couple filing jointly) in 2013 (up from 15.0% in 2012). In addition, the Health Care and Education Reconciliation Act of 2010 will impose a new 3.8% Medicare surtax on certain investment income, including capital gains on the sale of a business. As a result, business owners who sell their business this year, and likely in future years, will be subject to significantly higher taxes on their gains relative to recent years.
To highlight the potential magnitude of this difference, the chart to the right presents the potential combined federal and state capital gains tax liabilities that will be incurred in 2013 relative to 2012 assuming the sale of a $50.0 million company for which the business owner has no tax basis in the stock of the company. For simplicity, the state capital gains tax rate is assumed to be 5%. However, states such as California and New York tax capital gains at rates as high as 13.3% and 8.8% respectively. The higher capital gains tax rate and Medicare surtax result in a $4.4 million increase in the business owner’s tax liability in 2013 as compared to 2012, or a 44% increase.
Benjamin Franklin once said that “the only things certain in life are death and taxes.” While we can’t speak to the former, a properly structured sale of company stock to an employee stock ownership plan (“ESOP”) can defer or eliminate capital gains tax liabilities, including the Medicare surtax. Any business owner considering the sale of his or her company in this era of higher capital gains taxes should explore a sale to an ESOP.
ESOPs are a type of defined contribution benefit plan (i.e., similar to a 401(k) plan) that are designed to purchase and own company stock of the employer. ESOPs are unique in that ESOPs are the only employee retirement savings plan that the law permits to use leverage to acquire the employer stock. Although ESOPs have been around for decades, recent favorable legislation and greater realization of their benefits by legal and financial advisors have increased their popularity as a succession planning tool.
As a buyer of company stock, an ESOP is allowed to pay up to Fair Market Value for the company stock. Fair Market Value is generally interpreted to be what a financial buyer (e.g., a private equity fund) would pay for the stock. As a result, the transaction price paid by an ESOP for the company stock can be as competitive as other financial buyers (and often more competitive on an after-tax basis).
In certain situations, a strategic buyer (e.g., a competitor) may be willing to pay more than Fair Market Value for the stock. In these situations, the strategic buyer’s offer will be higher on a pre-tax basis than what an ESOP could pay. However, given the tax advantages of an ESOP transaction, a strategic offer may not always be higher than an ESOP offer on an after-tax basis.
According to the ESOP Association, there are approximately 11,500 companies in the U.S. that are owned in part or completely by an ESOP. These companies collectively employ over 10.0 million people. In over 60% of these companies, the ESOP owns more than 50% of the common stock outstanding.
While a sale of company stock to an ESOP can have numerous advantages for the selling business owner, the management team, the employees, and the company, the deferral of capital gains taxes under Section 1042 of the Internal Revenue Code is an attractive advantage that is even more important in a higher capital gains tax rate environment.
Deferring Capital Gains Taxes
The sale of company stock to an ESOP can be structured to defer capital gains taxes and, if structured properly, capital gains taxes can be deferred indefinitely. This tax advantage has become more advantageous with the increase in long-term capital gains tax rates and the Medicare surtax. As presented in the chart below, if a business owner sells his stock for $50.0 million to an ESOP instead of in a non-ESOP transaction, the business owner would net an additional 40.5% or $14.4 million in after-tax proceeds, assuming his stock had zero basis. Based on this example, the business owner would have to sell his stock at almost a 40.5% premium (or $70.2 million) in a non-ESOP transaction before his after-tax proceeds would be equivalent to the sale to an ESOP.
The primary requirements to qualify for the tax deferral are:
- The company must be treated as a C corporation for tax purposes at the time of the transaction.
- The seller must have held his stock for at least three years prior to the sale.
- The ESOP must own at least 30% of the value of the company’s stock following the transaction.
- The proceeds from the sale of stock to the ESOP must be invested in qualified replacement property (“QRP”) within 12 months from the date of sale.
QRPs are securities of domestic operating corporations. This includes the corporate stocks and bonds of public or private companies. The seller defers capital gains taxes until the sale of the QRPs. Only the QRPs that are sold are taxed, allowing the seller to spread the tax over his lifetime or potentially eliminate the tax completely if the QRPs are retained until death since the property would transfer to his heirs with a stepped-up basis. One additional option available in connection with the QRP requirement is to purchase floating rate notes with long maturities (30 to 60 years) and high credit quality. The seller can then receive the interest from these notes until his death or find a financial institution to offer him a margin loan against the QRPs. This would allow the selling shareholder to use the proceeds of the margin loan as he desires. Not only has the owner deferred or potentially eliminated capital gains taxes, but he has also diversified his investments.
Tax rates are increasing, including taxes on capital gains, which will dramatically lower after-tax proceeds for anyone who sells their company in 2013 and likely for years to come. ESOPs are an often overlooked and under-utilized liquidity tool. In the right circumstances, ESOPs are an advantageous succession planning tool that provides a number of benefits over more traditional succession planning techniques. During this period of rising taxes, especially increasing taxes on capital gains, the sale of stock to an ESOP can both create a liquidity event for the business owner(s) and dramatically minimize the tax consequences of a transaction of stock relative to other typical liquidity events.
ESOPs are gaining in popularity as a succession planning option as attorneys, accountants, and other company advisors become more aware of their benefits over traditional succession planning techniques.
Unfortunately, too few business owners and their advisors explore this option as part of the succession planning process. While ESOPs are not the ideal option in every situation, they are worthy of consideration as a succession planning technique given the numerous benefits available to all company stakeholders.