Consider an ESOP for business succession planning

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As a farm business owner, your business is probably your most important asset and a substantial source of wealth. This raises two questions:  What is your transition plan?  How can you diversify a portion of your wealth?

Identifying potential successors and implementing strategies to ensure a smooth transition of ownership requires much thought and deliberation. And, in many cases, it requires a willingness to give up control of the farm.

Many strategies exist — from transferring ownership interests to family members to selling stock to outside buyers. But for agri-business owners who wish to diversify their ownership while maintaining continuity and deferring taxes, employee stock ownership plans (ESOPs) can be an attractive option.

ESOP defined

Employee stock ownership plans facilitate the transfer of some or all ownership from business owners to their employees. When you sell shares to the ESOP, the employee-participants receive proportional ownership of the company and you receive cash.

An ESOP can be tailored to your needs, but it is important to note that it is an employee benefit plan that must meet the applicable rules for employee eligibility, participation and vesting. As a result, you should carefully evaluate factors such as the farm’s financial condition, employees’ eligibility for plan participation, and stock allocation and vesting schedules before you set up the plan.

An ESOP requires a formal valuation of the farm business, which includes profits, cash flow, market conditions and outlook, assets and any other relevant factors. Next, you must choose how to fund the ESOP. Two options exist:

  • A leveraged ESOP borrows funds to buy company stock. The ESOP can borrow the funds directly, using the purchased stock as collateral. More frequently, funds are borrowed at the corporate level then re-lent to the ESOP. This helps make some of the debt repayment deductible.
  • Unleveraged ESOPs buy stock without debt financing. The funds can come from Treasury stock, the farm’s contributions, employee contributions or other profit-sharing plans the farm has established.

Once the plan is operational, a trustee assumes responsibility for overseeing it. You can serve as trustee, but an outside individual or corporate trustee can be hired for that role, also.

Selling stock to the ESOP

For agri-business owners, one of the most important benefits of an ESOP is the ability to diversify tax efficiently. The mechanics are straightforward. You sell stock to the ESOP, and the ESOP buys your shares for cash at the valuation price. Internal Revenue Code section 1042 permits a taxpayer who sells shares in a privately held company to an ESOP to defer paying taxes on any capital gain from the sale of those shares if the following requirements are met:

  • You (or any other seller) must have owned the shares for at least three years and cannot have received the shares as a form of compensation.
  • The ESOP must own at least 30 percent of the company after the sale.
  • You (and other sellers) must reinvest the sale proceeds in “qualified replacement securities” within 12 months of the sale to the ESOP.

Investing ESOP proceeds

By reinvesting the proceeds in qualified replacement securities within 12 months of selling your shares to an ESOP, you receive cash for your otherwise illiquid shares. Then, you can use these proceeds to diversify your overall investment portfolio. 

Qualified replacement securities are generally defined as stocks and bonds issued by a U.S. domestic operating company. Several widely held types of investments, including mutual funds, certificates of deposit, government securities and real estate, do not qualify as replacement securities.

There are multiple strategies for reinvesting ESOP-related proceeds. A thorough discussion of these approaches with your advisers, including related pros and cons, is very important.

When developing your business-succession and wealth-diversification plans, ask your advisers if an ESOP plan would be a good option for you and your business.

David Chlus is senior vice president of investments with Smith Barney, Inc., in Utica, N.Y., and a partner in a 90-cow dairy.

 



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