There are a myriad of reasons why a corporation or its owners may, or should, be considering forming an employee stock ownership plan and trust (an “ESOP” and “ESOT”).  An ESOP allows owners of a C corporation to accomplish one or more of the following objectives:

  1. sell the stock of that corporation and defer, potentially indefinitely, the tax on the proceeds of the sale while remaining involved in the corporation’s ongoing operations;
  2. increase the corporation’s working capital and cash flow;
  3. transition ownership and management of the corporation in an orderly manner over a period of years;
  4. buy out majority or minority shareholders with pre-tax dollars;
  5. make acquisitions of other corporations (and entities) with pre-tax dollars that are potentially tax-deferred to the selling shareholder(s);
  6. minimize the cost of borrowing loan principal from an external lender or the selling shareholder(s) by deducting principal payments as well as interest on the repayment of such debt;
  7. establish and foster an ownership culture that could potentially improve productivity and profitability of the corporation; and
  8. provide employees with equity incentives without any cash outlay on the part of the employees.

Regardless of the reason for entering into an ESOP transaction, the last quarter of 2012 is a great time to implement an ESOP transaction.

With potential increases in the tax rates under federal, California and other state tax laws on the horizon, as well as the addition of a new “Medicare surtax” on investment income, there has never been a better time to explore how the use of an ESOP and an ESOT can help a corporation, its shareholders, and its employees achieve their financial and other goals and objectives.  Substantially greater tax rates on a federal and state basis generally are anticipated.  Thus, the competitive advantage of an ESOP should increase in 2013 and beyond, and the use of the deferral provisons of Section 1042 of the Internal Revenue Code of 1986, as amended (the “Code”), that are currently available only to ESOP sellers where the plan sponsor is taxed as a C corporation, may experience a renaissance.

What is a Code Section 1042 Tax-Deferred Transaction?

A shareholder of a “closely held” C corporation may sell company stock to an ESOP and defer the taxation of gain to the extent that he or she reinvests in securities of other corporations (the “replacement securities”).  The transaction must have the following characteristics:

  1. it must be one that would otherwise result in long-term capital gain (“LTCG”) to the shareholder,
  2. the shareholder's holding period for the stock must be at least three years,
  3. the shareholder must not have received the stock from a qualified employee plan (such as an ESOP), by exercising a stock option or through an employee stock purchase program,
  4. the replacement securities (defined below) must be purchased within the 15-month period that begins three months before and ends 12 months after the sale of company stock to the ESOP, and
  5. after the sale, the ESOP must own (in a fully diluted basis) at least 30% of the common equity of the employer that sponsors the ESOP.

Procedurally, the employer must consent to the election of tax deferred treatment, and a 10% excise tax is imposed on the employer for certain dispositions of stock by the ESOP within three years after the sale.  The stock that is purchased by the ESOP may not be allocated to the ESOP accounts of the seller, certain members of his or her family, or any shareholder who owns more than 25% of any class of company stock. A prohibited allocation causes a 50% excise tax to be imposed on the employer and adverse income tax consequences to the participant receiving the allocation.

Generally, “replacement securities” must be securities of unrelated U.S. operating companies whose passive investment income does not exceed 25% of gross receipts.  The replacement securities are defined to include equity (stocks) and debt (bonds) of U.S. corporations, either public or private, including common stock, preferred stock, corporate notes and bonds, convertible bonds and floating rate notes.  Unfortunately, the replacement securities do not include U.S. government municipal securities, foreign securities, mutual funds, interests in limited partnerships, REITs, passive investments, or the stock of the corporation (or its affliates) that is the subject of the ESOP transaction.

Some brokerage and investment firms offer products that essentially allow the sellers to borrow against the replacement securities, the proceeds of which the seller may choose to invest in securities that do not qualify as the replacemement securities or otherwise as they see fit.

In the hands of the original seller, the replacement securities have a carry-over basis from the stock sold to the ESOP.  However, as an estate planning matter, if sellers were to hold on to the replacement securities until the sellers’ death, it would pass to their heirs with a stepped-up basis for tax purposes.

Anticipated Increases in Federal and State Tax

The tax rates and the treatment of investment income are matters of political contention and economic uncertainty.  The federal government and many states have been turning to their tax laws in an attempt to raise revenue.  On the federal level, if Congress does not act soon, the current tax rates (the so-called Bush era tax cuts) will sunset at the end of this year.  If this occurs, the current rate on long-term capital gains (“LTCGs”) will in general increase from 15% to 20%.

This uncertainty also is exacerbated by the fact that, in an attempt to generate needed revenue, tax rates have been or may be rising in many states.  As of this writing, in the last few years, at least 37 states have raised taxes (e.g., Connecticut, Delaware, Illinois, Michigan, New York, Ohio, and Oregon) or are in the process of trying to do so.  For example, if California’s Proposition 30 (included on the ballot in November 2012) passes, the applicable marginal tax rate on taxable income in California will increase from 10.3% to 12.3% for single filers with over $500,000 of taxable income and for joint filers with over $1 million of taxable income.  “Marginal” tax rate refers to the last dollar of taxable income received.  Given that the size of many ESOP transactions exceed $500,000, it is easy to see how the marginal tax rate of 12.3% could apply to selling shareholders for stock sales in California after 2012.

Furthermore, under the current health care reform law, beginning in 2013, certain investment income will be subject to an additional 3.8% surtax (the so-called “Medicare surtax”) under new Section 1411 of the Code.  This additional tax would be on top of the income tax rates otherwise applicable to the investment income.

“Medicare Surtax” Summarized

For an individual (other than nonresident aliens), the 3.8% Medicare surtax is imposed by new Code Section 1411(a)(1) on the lesser of:

“(a) ‘net investment income’ (‘NII’), or (b) the excess of ‘modified adjusted grossIncome’ (‘MAGI,’ which includes some otherwise exempt foreign-sourced income) over a certain threshold amount.”

NII is defined under the Code to consist of three categories of gross income:

“(i) Gross income from interest (other than on tax-exempt municipal  bonds), dividends, annuities, royalties and rents.

a.  An individual’s income of this type which is generated in a trade or business is not subject to the tax, unless it would fall within MAGI.  i.  For example:  rents that are generated in the ordinary course of a non-passive trade or business would not be included in NII.

“(ii) Gross income from:  (1) a passive activity, or (2) a trade or business of trading in financial instruments or commodities.

a.  A ‘passive activity’ is defined to be a trade or business in which you do not ‘materially’ participate.  i.  For example:  Where a family member of an active ‘family-business’ operating under a pass-through structure (such as an LLC or S-corporation), is not actively involved in the operations of the business, their income from the business would be included in NII.

“(iii) Net gain ‘to the extent taken into account in computing taxable income,’ including, but not limited to capital gain income.”

In defining what income is subject to the 3.8% Medicare surtax, Section 1441(a)(1)(A) of the Code provides that NII “for the taxable year” is taxed.  Thus, it would seem clear that capital losses incurred “for the taxable” year would be included in arriving at the amount of taxable capital gains. Unfortunately, the statute is not clear whether capital losses carried forward from a prior year would be allowed in calculating “net gain” that is subject to the 3.8% Medicare surtax.

Moreover, Section 1411(a)(1) of the Code states that the 3.8% Medicare surtax is to apply “in addition to any other tax imposed by this subtitle.”  “This subtitle” refers to the part of the tax law that contains both the regular income tax and the alternative minimum tax.  Therefore, the 3.8% Medicare surtax is in addition to your regular income tax, and it is in addition to any alternative minimum tax.

The good news is that, under Section 1441 of the Code, gain that is excluded from income under the Code for regular tax purposes is not subject to the 3.8% Medicare surtax.  This would exclude gains such as the gain on the sale of stock to an ESOT that is excluded from income due to the purchase of “qualified replacement property” under Code Section 1042.

What are the Realistic Possibilities in Federal Capital Gains Tax Law Changes after 2012?

The 2001 and 2003 tax cuts are scheduled to expire at the end of 2012.  If that occurs, the regular marginal tax rate on capital gains will rise to 20%.

Furthermore, an obscure provision of the Code, the phase out of itemized deductions, will return in full force.  That provision, known as “Pease,” increases effective tax rates on high-income taxpayers by reducing the value of their itemized deductions.  This will add another 1.2% to the effective capital gains tax rate for high-income taxpayers.

Moreover, the so-called “Medicare surtax” will add another 3.8% to the marginal tax rate.

These changes will increase the marginal tax rate on capital gains from 15% to 25% on January 1, 2013.  A result of this increase might be a torrent of asset and stock selling in November and December of 2012 as wealthy taxpayers take final advantage of the lower tax rates.  This will apply to ESOP transactions as well.

It is possible that the tax cuts might get extended for all U.S. taxpayers, including high-income taxpayers. That occurred in 2010 during the middle of the Great Recession.  If the 2001 and 2003 tax rates are extended for all taxpayers, the increase in the capital gains rates will be smaller.  Because of the Medicare surtax, the marginal capital gains tax rate will increase from 15% to 18.8%. That is a large increase, however, it would likely not trigger as many tax-driven sales of stock and assets at the end of 2012.  The only way that the marginal capital gains tax rate remains at 15% will be if the tax cuts are extended for high-income taxpayers and the Medicare surtax is repealed.

What Does This Mean to Someone That Considering Selling His or Her Company in 2012?

Assume a sale of C corporation stock to a third-party, and a realized net gain for tax purposes of $1,000,000, and the proceeds are eligible for LTCG treatment under the Code.  A brief summary of the federal and California tax consequences are as follows:

Calendar Year 2012:

  1. Federal LTCG (15%): $1,000,000 x 0.15 = $150,000
  2. California (10.3%)1 : $1,000,000 x 0.103 = $103,000
  3. Federal tax deduction of state income taxes @ 33% rate = ($33,999)2

Total Federal and California Taxes - $219,000

Calendar Year 2013 (and after):

  1. Federal LTCG (20%): $1,000,000 x 0.20 = $200,000
  2. California (12.3%): $1,000,000 x 0.123 = $123,000
  3. Medicare surtax (3.8%) $1,000,000 x 0.038 = $38,000
  4. Federal Tax deduction of state income tax @ 37.6% rate= ($46,250)3

Total Federal and California Taxes - $326,750

While it is clear that the sellers are better off closing the sale in calendar year 2012 than 2013 from a tax perspective, at a minimum effective tax rate of 21.9% and a maximum effective tax rate of 32.7%, neither alternative seems particularly attractive.

The ESOP Alternative

Now assume the creation of an ESOP and a tax-deferred Section 1042 sale to an ESOT instead.  Assuming all of the tax and ERISA requirements are satisfied, the selling shareholders would be able to reap many of the same benefits of a sale to a third-party, and, with some careful planning and expert guidance, this same sale could be accomplished with all or a portion of the LTCGs and California income deferred indefinitely.

What this effectively means is that the net appreciation on the replacement securities should be considered as having increased by the value of the deferral and, if the amount deferred is, in fact, invested, by the additional value of any appreciation on that amount.  This gives the seller the opportunity to leverage off of the tax savings resulting in a substantially greater pool available at the point the investments are sold.  Of course, taxpayers should work with their tax advisers to determine the specific advantages of any such strategy, especially in light of the possibility that marginal rates at liquidation may exceed those at the time of investment.  The advantages of the Section 1042 tax-deferral are not available for sellers to an ESOP sponsored by an S corporation.  Therefore, these sellers may consider completing a sale in 2012 prior to the potential capital gains tax rate changes and the application of the Medicare surtax, or the prospects of the termination of the sponsor's S election prior to the sale.  The termination of an S election needs to involve careful tax planning to ensure that the action is completed properly and that the action is beneficial for the plan sponsor.

The ESOP Task Force of Jackson Lewis LLP’s Employee Benefits Counseling and Litigation Practice Group has extensive experience in advising the owners of businesses in structuring wealth preservation and investmnent strategies and in working with owners’ estate planning counselors in devising effective strategies for designing and implementing ESOPs and related ESOP transactions.