View From Morgan Lewis: The 2013 Capital Gains Tax Increase Highlights the Importance of Considering an ESOP Sale
By Brian D. Hector, Morgan Lewis
Beginning in 2013, long-term capital gains tax rates increased from 15 percent to 20 percent. Additionally, certain provisions of the new health care reform have imposed a new 3.8 percent tax on capital gains for certain high-income individuals in 2013, bringing the capital gains tax rate to 23.8 percent, which amounts to a 60 percent increase.
With the capital gains tax rate increase, a business owner stands to lose a greater portion of the wealth that he or she has worked hard over decades to accumulate when the owner sells his or her business. Moreover, if a selling business owner lives in a state with high state income tax rates, such as California or New York, the owner would be subject to an additional 8 percent to 13 percent tax above the federal capital gains rate. Thus, for the business owner who sells his or her business in 2013, the collective tax increases could wipe out as much as 30 percent to 35 percent of the wealth that the owner worked hard to accumulate for retirement, regardless of whether the owner’s stock is redeemed or sold to a third party. Further, beyond tax considerations, an outside sale may prevent the owner from (i) transferring control of the business to the owner’s children or the company’s current management, and (ii) ensuring job security for its loyal long-term workers.
ESOP Tax Advantage
There is a way to help a selling business owner eliminate the impending tax blow and at the same time unlock substantial liquid assets—an employee stock ownership plan (ESOP). An ESOP is a qualified retirement plan designed to invest primarily in company stock. As a tax-qualified plan, the stock owned by the ESOP is held in a tax-exempt trust, and the ESOP must comply with certain requirements under the Internal Revenue Code (Code). Because of its special tax features, an ESOP allows a business owner to sell his or her stock and diversify wealth on a tax-favorable basis, while retaining control of the business. An ESOP also provides a way for the owner’s children or current management to eventually take control of the business and provides retirement benefits to employees in the form of an ownership stake, which various studies have shown enhances business productivity and better retains employees.
The selling business owner can choose, with proper planning, to avoid the capital gains tax on the stock sold to an ESOP, as long as certain requirements under Section 1042 of the Code (1042 Transaction) are met. Some of the primary requirements include:
- the stock must be C corporation stock and the selling shareholder must have held the stock for at least three years,
- the ESOP must own at least 30 percent of the stock of the corporation after the stock is sold to the ESOP, and
- the sale proceeds must be invested in “qualified replacement property” within a certain time frame.
The chart below illustrates the tax savings of an ESOP sale versus the more conventional sale of stock to a third-party buyer, in both 2012 and in 2013. The 2013 federal long-term capital gains tax rate reflects the increase to 23.8 percent.
|Taxes on sale of stock generating $25 million gain/no ESOP||Taxes on sale of stock generating $25 million gain/with ESOP|
|2012 Federal Long Term Rate: 15 percent||$3,750,000||$0|
|2013 Federal Long-Term Rate: 23.8 percent||$5,950,000||$0|
As the illustration shows, the tax savings from an ESOP transaction were significant in 2012 at then-current capital gains tax rates. However, the tax savings in 2013 are even more substantial due to the fact that capital gains tax rates increased by 60 percent. Further, this ESOP savings comparison only shows the federal tax savings. There would also be a substantial savings at the state tax level as well. For example, California has a 13.3 percent income tax rate for transactions over $1 million. Accordingly, if the owner in the above example is a California resident, that owner would save $9,275,000 if the owner sold to an ESOP, at a combined rate of 37.1 percent (23.8 percent federal + 13.3 percent California).
Additional ESOP Tax Advantages
While the potential tax savings to the shareholder in a 1042 Transaction is one of the most significant current advantages due to the increase in tax rates, it is also important to consider the tax savings that an ongoing ESOP can provide for a corporation.
Contribution Deduction for ESOPs
Code Section 404(a)(3) provides that the deduction amount for company contributions to a stock bonus or profit-sharing plan is limited to 25 percent of the participants’ compensation. However, Section 404(a)(9) sets forth special deduction rules for C corporation contributions to an ESOP that are used to repay principal and interest on a loan that was used to acquire the shares (ESOP Loan). An employer’s deductions for contributions paid to an ESOP to repay only the principal on an ESOP Loan used to acquire stock can equal up to 25 percent of the ESOP participants’ compensation. In addition, there is no limit on the employer’s deduction for contributions to an ESOP that are used to pay interest on an ESOP Loan.
Also, it is important to note that, in certain rulings, the Internal Revenue Service has stated that because Code Section 404(a)(9) provides different authority from Code Section 404(a)(3) to allow for an ESOP Loan contribution deduction, a C corporation that sponsors both a leveraged ESOP and a separate qualified defined contribution plan (such as a 401(k) plan), may take (a) a deduction up to 25 percent of compensation for contributions used to make principal repayments on an ESOP Loan, (b) an unlimited deduction for the contribution to the ESOP used to pay down the interest on the ESOP Loan, and (c) an additional deduction of up to 25 percent of compensation for a contribution to another defined contribution plan, all in the same year.
Deduction of Employer Dividend Payments
C corporations may deduct dividends, pursuant to Code Section 404(k), paid on stock held by an ESOP maintained by the corporation, provided that the dividends paid are:
- paid in cash directly or through the ESOP to its participants or their beneficiaries;
- reinvested in stock, if participants have been given the election to receive the dividends in cash; or
- used to repay an ESOP Loan.
This deduction for dividends paid on stock held by an ESOP can be a useful mechanism for increasing the amount of stock that may be placed in an ESOP.
An ESOP offers unique tax advantages, not only to a selling business owner undergoing a business transition, but also as an ongoing tax-advantageous employee benefit plan that has been proven to motivate employees while conferring a great reward on long-term employees. The ESOP is becoming more and more recognized as a transition tool to be seriously considered by the many business owners who are approaching retirement age and find that much of their wealth is tied up in their businesses.
Brian D. Hector (firstname.lastname@example.org) is a partner in Morgan Lewis‘s Employee Benefits and Executive Compensation Practice and chair of the ESOP Task Force. He is resident in the firm’s Chicago office.
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