How would you like to sell all or part of your business, remain in control, and pay no tax on the transaction? Well, you can do it! Would you like for your company to be able to deduct the principal on the loan taken out to buy your stock holdings in your company? Well, you can do it! How would you like for Uncle Sam to repay your loan for you? Well, you can do it!

Perhaps the most basic challenge to the owners of family businesses is the concept of an exit strategy. Family business owners normally don't care to discuss the topic. After all, they will never die, you know. Like it or not, however, the issue must eventually be dealt with. For purposes of this discussion, let's assume that a family business owner wishes to enjoy the fruits of his labor while still alive and healthy. Let's further assume that the family business is successful, well established and that it has been valued at about $5 million. The founder and current president wishes to sell about 50% of his holdings and to reinvest the funds in a more diversified portfolio. He will sell the remaining 50% at a later date, when he is ready to retire completely and turn the company over to hand picked second generation management. For now, he would like to begin the process of exiting from his business and he wants full value for any stock he sells. In addition, our founder would like to avoid taxes on the transaction. Who wouldn't?

So, how can all this be accomplished? Consider this challenge in two different scenarios. This first scenario is based upon the business as a 'C' corporation, while the second scenario is based upon the assumption of an 'S' corporation.

Scenario 1: After a great deal of investigation, the founder decides to establish an Employee Stock Ownership Plan (ESOP) in his company. In order to do so, he puts together an ESOP team of experienced advisors and establishes an ESOP for his employees. An ESOP is simply a qualified plan, much like a profit sharing or a 401(k) plan. The purpose of an ESOP is to allow company employees to own part or all of the stock of their employer through a trust arrangement. The trust actually owns the stock, and a trustee, appointed by the board of directors, is responsible for management of the trust.

Having now established the ESOP, the founder arranges for a loan of $2.5 million; 50% of the total value of the company. This loan will be on a long-term basis at a very competitive interest rate. It has been determined by the entire ESOP team that the company can easily handle the repayment of the note. Since the loan was made to the company, the company now makes an identical loan to its ESOP. The ESOP now has the funds necessary to make a purchase of stock for its participants.

The ESOP offers to purchase 50% of the founder's stock for $2.5 million. The sale is consummated: the founder now has $2.5 million and the ESOP has the stock. The founder now must, according to Section 1042 of the Internal Revenue Code of 1986, as revised (the Code), reinvest the proceeds into the stocks or bonds of other companies. The founder and his investment advisor choose a portfolio of blue chip securities, which will yield dividends of approximately 5% per annum. These dividends will be paid directly to the founder.

The transaction has now been completed, but what has been accomplished? Because an ESOP was used, the Code allows many preferences. For example, the entire principal on the loan, as well as the interest, is fully tax deductible to the company. Imagine that: writing off the principal on a loan. This means that the company will be repaying the loan on a pre-tax basis, as opposed to an after-tax basis. This alone will save the company $850,000, based on a marginal federal tax rate of 34%. The effective cost, therefore, of purchasing this stock is only $1,650,000. This move was clearly in the best interest of the company. Other than the use of an ESOP, there is no other way under the Code to deduct the principal on a loan.

The founder, however, will enjoy an even greater tax advantage. Since he followed the requirements of Section 1042 of the Code, he will pay zero tax on the transaction. That's right. He can avoid tax altogether on the sale of his stock to an ESOP. Assuming a zero basis for the founder's stock, he will save $500,000 in taxes, based on a 20% capital gains rate. The founder was, therefore, able to reinvest the entire $2.5 million in a diversified portfolio of public securities producing approximately $125,000 per year in dividends. He will, of course, be taxed at his ordinary rate on the dividends. Given this new found source of income, company founders often then reduce their compensation from the company, which in turn helps the company repay the ESOP note. The combination of the founder reducing his compensation, together with the tax savings produced by deducting the principal on the note, often provides the cash flow necessary to repay the entire note. If the company's cash flow is sufficient, the founder might not feel it necessary to reduce his compensation at all.

At the end of the day, an astonished founder tallied the savings: the company saved $850,000 in taxes, and he saved $500,000 in taxes, for total savings of $1,350,000, or stated another way, a 54% tax subsidy. Not bad!

Scenario 2: Assuming all the same numbers which were presented in Scenario 1, we will now work through an illustration using an 'S' corporation. Many of the rules change with an 'S' corporation, but some additional advantages are available.

Let's assume that our founder owns 100% of the company, and that taxable income is $500,000. At a 40% tax rate, the founder would be obligated to pay $200,000 in tax. However, with the ESOP owning half of the company, only $250,000 of earnings are allocated to the founder for tax purposes. In this case, he is now obligated to pay only $100,000 in tax. What happened to the other $100,000 in tax that would have been paid? It went to the ESOP as a cash deposit. It will never be paid to the IRS.

As a result of the 1997 Taxpayer's Relief Act [Pub. L. 105-34], that portion (from 1% to 100%) of an 'S' corporation, which is owned by an ESOP, is exempt from federal taxation. Therefore, in the extant case, 50% of the earnings were allocated to each owner for tax purposes: $250,000 to the founder and $250,000 to the ESOP. The founder, being a person, had to pay tax on his allocation. The ESOP, however, is exempt from federal taxes under the new law, which took effect January 1, 1998. The $100,000 that would have gone to Uncle Sam is now available to help repay the ESOP loan. In other words, Uncle Sam is paying $100,000 of the loan payment. Any additional amounts needed to pay the note are fully deductible (principal and interest) to the company as a contribution to a qualified plan. If taxable earnings from the company are high enough, it is very reasonable to expect that the entire ESOP loan could be repaid by Uncle Sam ‚ a 100% tax subsidy.

In addition to this powerful advantage, any monies left in the company by the founder serve to increase his basis in his remaining stock holdings, thus reducing significantly his eventual tax bill. Unfortunately, Section 1042 benefits are not available to the owners of 'S' corporations. As a result, he is not able to avoid taxes altogether on the sale of his stock to the ESOP. Careful planning, however, should serve to significantly reduce the ultimate bill to a fraction of what it otherwise would have been.

Conclusion: If your company is a 'C' or an 'S' corporation and is a profitable, well established and well-managed enterprise, you should at least consider an ESOP as a possible exit strategy. The tax advantages are astounding, and as an employee benefit, it is unmatched.

Ron J. Lint, ASA, President of Appraisal Technologies, Inc.,
is a Business Valuation & ESOP Specialist. www.bval.com