April–May 2010
Tax Valuation
By Lance S. Hall
Estate Planning with Employee Stock Ownership Plan
Company Stock
Lance Hall, ASA, is a Managing Direc-
tor of FMV Opinions, Inc., a national
valuation and investment banking firm
with offices in New York, San Francisco,
Los Angeles, Orange County, Chicago
and Dallas. Mr. Hall heads up FMV’s
estate and gift tax valuation practice.
Mr. Hall can be reached at lhall@fmv.
com. Additional information regarding
FMV Opinions, Inc. can be accessed at
www.fmv.com.
JOURNAL OF PRACTICAL ESTATE PLANNING
E
mployee Stock Ownership Plans (ESOPs)
have been around for decades and most
practitioners are vaguely familiar with the
tax benefits associated with them. Currently, events
are on the horizon which will greatly expand the
use of ESOPs. As a result of the growth of ESOP
formations, estate planning professionals can
enhance their service offerings to take advantage
of some of the unique opportunities available for
non-ESOP owners of ESOP companies to reduce
the estate tax bite and to transfer stock to junior
generations through tax-advantaged means. This
article will provide a brief background of ESOPs,
explain why ESOP formations will grow signifi-
cantly, examine the financial benefits associated
with ESOPs, and explore the distinctive opportuni-
ties in estate planning for the non-ESOP owners of
ESOP companies.
Background
Ba
ackg
grou
und
d
The father of Employee Stock Ownership Plans,
famed attorney and investment banker, Louis O.
Kelso, established the first ESOP in 1956.1 Over the
next two decades, he worked tirelessly to promote
the benefits of employee ownership and, in the early
1970s, convinced Senator Russell Long that ESOPs
were good for the workers of America because it
allowed them to enjoy the benefits of their labor,
which previously had gone only to the company
owners. Senator Long spearheaded the Employee
Retirement Income Security Act of 1974, which pro-
tected employee pensions and laid the legislative
framework for ESOPs. Over the next two decades,
ESOP formations gained popularity and grew rap-
idly. One of the key benefits driving ESOP formation
was the Code Sec. 1042 deferral which allowed
13
Tax Valuation

those who sold more than 30 percent of a private assume that only 10 percent of these businesses
company’s stock to an ESOP the ability to defer are indeed suitable, that leaves 214,000 companies
capital gain taxes and, in some instances, eliminate that can potentially be sold to an ESOP. However,
them permanently. However, with the reduction of intending to sell to employees and actually selling
the capital gain tax rate from 28 percent in 1996, to to employees are two different things. If we further
20 percent in 1997 and 15 percent in 2003, ESOP assume that only 10 percent of those who intended
formation slowed dramatically. Between 2000 and to sell their company to their employees actually do
2008, ESOP (and equivalent) formations grew an so, then we can expect approximately 21,400 new
anemic 1.7 percent, com- ESOP formations over
pounded annually.2 the coming decade—
The future growth of ESOPs or 2,140 annually. At
Future Growth the end of 2008, there
is dependent on two factors: were a reported 11,400
of ESOPs changes in the capital gain tax rate ESOPs (or equivalents).6
The future growth of and Baby Boomers selling their Based on the above,
ESOPs is dependent on we can conservatively
two factors: changes in businesses to their employees. estimate a compound an-
the capital gain tax rate nual growth rate for new
and Baby Boomers selling ESOP formations of over
their businesses to their employees. While the capi- 11 percent for the next decade. If the capital gain
tal gain tax rate is currently at a historically low 15 tax rate also increases, so will the increase in the
percent, under existing law, in 2011, it will increase growth rate of ESOP formations.
to 20 percent. And, given the unprecedented federal
deficits continuing far into the future, returning to a ESOP Benefits
28-percent rate (in place as recently as 1996) is very
possible. Moreover, states are increasingly looking To encourage ESOP formations, over the years,
to raise
o rais revenue
se re evennu through increases in tax rates. As Congress has enacted legislation that allows ESOPs
most
mo sstates
ost state couple
es co
ou their federal tax
eir tax code to the fed to invest primarily in employer securities, sellers to
code,
co
ode, the Cod Codede Sec.. 11042 rol
rollover may als
also defer defer capital gain taxes, and debt used by the ESOP
thee state
staate capital
ccapittal gain
g tax.
ta In a recent
r survey of Baby to purchase employer securities to be repaid with
Boomers
Booome ers llooking
lookking to sell
ell their
the businesses,
businesses, the invest- tax deductible dollars. Also, significant literature
ment bank,
nt bank
b k WWhite Horse Advisors, found the number exists that points to increased productivity and
one concern was to “minimize z taxes”
t xe frfrom
m the sale nancial
fina n success of ESO
ESOP companies
p compared
p
of their business. With 3
h the
th increase
ncrea e in ccapital
apital ggain
in to non-ESOP com companies.
mp es.
tax rates, the value of the h Code Sec. 1042 deferral
d
increases and this, in turn, will lead to even more Code Sec. 1042 Rollover
ESOP formations.
In the same survey, White Horse Advisors found Provided a non-ESOP owner, or owners, sell 30
that business owners over 50 years of age wanted to percent or more of the company’s outstanding
sell their businesses in 7.7 years, on average.4 The stock to an ESOP, the owner or owners can reinvest
survey also found that 20 percent of all respondents the proceeds in certain “qualified replacement
wanted to sell their businesses to their employees. property” and defer the capital gain tax until the
Fifty percent of the respondents reported revenues owner sells the qualified replacement property. As
exceeding $11M (a rough minimum size for an there is an automatic step-up in basis upon death
ESOP). Currently, there are 10.7 million businesses (when there is an estate tax), the capital gain tax
owned by Baby Boomers. If we extrapolate the
5
may be avoided permanently.
results of the White Horse Advisors’ survey, 20
percent of these businesses, or 2,140,000, would Qualifying Employer Securities
be interested in selling their businesses to their In order to qualify for the Code Sec. 1042 rollover,
employees. Of course, not all businesses are suit- the ESOP must invest in a “qualifying employer
able for ESOPs. Therefore, if we conservatively security. ”7 A qualifying employer security must

14 ©2010 CCH. All Rights Reserved

 April–May 2010

be the stock of a C corporation.8 Moreover, the The company’s employee benefit contribution
qualifying employer security must be common deduction is limited to 25 percent of qualifying
stock “having a combination of voting power and payroll. However, there is no cap on the deductibil-
dividend rights equal to or in excess of (i) that ity of interest or dividends, provided the dividends
class of common stock of the employer having the are reasonable and are used to repay ESOP debt or
greatest voting power and (ii) that class of common distributed to participants. 12 Accordingly, instead of
stock of the employer having the greatest dividend selling common stock to the ESOP, a convertible
rights.”9 Convertible preferred stock qualifies if it is preferred stock may be specifically designed for the
convertible into common stock that is a qualifying ESOP. In doing so, the dividends received may also
employer security.10 be used to pay down debt principal even though
The seller cannot be a C corporation. However, the such payments may exceed the 25-percent limita-
seller of shares can be an S corporation, partnership, tion. It is also a legitimate way to sell stock to the
trust, estate, or individual. ESOP at a higher price than the price of common
stock—a price that takes into consideration the
Qualified Replacement Property extra dividend received.
To secure a Code Sec. 1042 rollover, the seller
must reinvest the proceeds in qualified replacement Figure 1. Step 1. Leveraged ESOP
property.11 Qualified replacement property must be
Transaction—Buying out ABC Shareholder
purchased within a period starting three months
prior to sale and ending one year after sale. Quali-
fied replacement property is any security issued by
a domestic operating company—this would include
stock, preferred stock, warrants, corporate bonds, etc.
However, passive investment income cannot exceed
25 percent of revenue for the preceding taxable year
and, it is important to note, U.S. Government bonds,
municipal
mu unic bonds,
cipall bonn partnerships, foreign investments,
mutual
mu funds
utuaal fun and Reall Estate Investment
nds aan Trusts gener-
nvestment Trust
ally
all y do not
o no qualify
ual ass rreplacement
ot qu em property.
roperty.

Th
The
he Le
Leveraged
eve
eraged EESOP—Debt
SOP——Debt
Repaid with Pretax
ax Do
Dollars
a
One of the unique features
ures of an ESOP is the ESOP’s
ability to borrow for the purpose of purchasing em-
ployer securities (the leveraged ESOP). As shown in Figure 2. Step 2. Leveraged ESOP
Figure 1 of a typical leveraged ESOP transaction (Step Transaction—Repaying Loan
1), the bank loans ABC company the amount neces-
sary to repurchase 30 percent of the ABC’s common
stock from one of the existing shareholders. In turn,
the company, in a mirror loan, loans the funds to the
ESOP. The ESOP then uses the funds to purchase the
qualifying employer securities from the shareholder.
An ESOP is noncash generating, however, and it
requires cash to repay the borrowed money. That
cash comes from the employer in the form of a
tax-deductible employee benefit contribution. The
ESOP then takes the employee benefit contribution
cash and repays the company. The company, in turn,
uses the funds to repay the bank. This is shown in
Figure 2 (Step 2).

JOURNAL OF PRACTICAL ESTATE PLANNING 15

Tax Valuation

ESOP Companies Perform Better trustee, and financial advisor. The ESOP valuator
will be engaged directly by the committee, and not
Than Non-ESOP Companies the company.13 Utilizing either the ESOP valuation
Over the years, there have been a number of studies for estate or gift tax purposes, or the ESOP valuation
which have concluded that, generally, ESOP com- firm to provide as separate valuation, may violate
panies perform better than non-ESOP companies. In the strict requirement of independence for ESOP
2006, the ESOP Association conducted a survey of valuators. Before doing either, obtaining approval
their members and found the following: from the committee, ESOP counsel and the trustee
Ninety-one percent of members thought that their should be sought.
ESOP was a “good business decision that helped
the company.” Adequate Consideration
Seventy-two percent reported that their com- Two regulatory bodies scrutinize ESOPs. First, the
pany “outperformed [the] three major stock Department of Labor oversees ESOPs to ensure the
exchanges.” safety of employee pensions. Second, the IRS ex-
“Only nine percent stated the company fared amines ESOP contributions to ensure that taxes are
worse than all three major indexes.” appropriately paid.
“Sixty-eight percent said the ESOP improved The Department of Labor has proposed regula-
overall employee productivity.” tions governing ESOPs, but has never finalized the
Even without the tax benefits, it appears that sell- “Proposed Regulations.”14 Nonetheless, the ESOP
ing company stock to an ESOP is good for company community looks to the Proposed Regulations as the
performance. Department of Labor’s key governing foundation for
Whether you consider increases in the capital gain ESOP valuation and fiduciary responsibilities. The
tax rate, Baby Boomers selling their businesses, or the Proposed Regulations focus on the term “adequate
fact that ESOP companies generally outperform non- consideration.” The definition of Adequate Con-
ESOP companies, new ESOP formations are poised sideration, for all practical purposes, is essentially
for rapid
p ggrowth over the next decade. equivalent to the definition of fair market value used
for estate and gift tax purposes. Logically, an ESOP
Estate
Es
sta
ate Pl
Planning
lan ng wwith
ith cannot pay more than adequate consideration. How-
ever, nothing prohibits an ESOP from paying less than
ESOP
E SO
OP Co
Company
om a St Stock adequate consideration. To avoid running afoul of the
Should
houldd yo
you
ou use
usse the ESOP
SOP Value
Va ue for estate or gift tax Department of Labor, it is not unusual for an ESOP
purposes? The short answer is “probably not.” The
posses? Th to have paid less than fair market value for the stock
difference between a value that is fair to t the ESOP in an
an initial transaction..
and one that reflects “fair
fair market
arket value”
value foror estate
est te
planning purposes can be b substantial.l For most situ- Disccount for L
Discount Lack
ck of M
Marketability—
arketab
bility
ations, an ESOP stock value should not be used for Repurchase Obligation
estate or gift tax valuations. Despite the fact that stock owned by an ESOP and
a non-ESOP shareholder may be identical, the fair
Valuation Date market value of the shares are, likely, very different.
An ESOP is required to have an independent valu- An ESOP (or the sponsoring company) is required to
ation performed, at least annually. If the ESOP is repurchase the shares of departing ESOP participants.
engaged in a significant transaction, then the valu- In other words, because of the repurchase obliga-
ation date must be the date of the transaction. It is tion, there is a market for the ESOP shares that is not
unlikely that an estate or gift tax valuation date will required for the non-ESOP shareholder. Typically,
be the same as the ESOP valuation date. because of the lack of marketability of non-ESOP
shares, these shares will have a much lower fair
Independence market value than the ESOP shares.
An ESOP valuator must be independent. Strict prac-
tices have arisen to ensure that independence. A A Control Premium
company considering an ESOP will likely establish The Proposed Regulations allow for an ESOP to pay
an ESOP committee and retain separate counsel, a control price even if the initial ESOP purchase is

16 ©2010 CCH. All Rights Reserved

 April–May 2010

only 30 percent of the voting stock. In such situations, the principal payment is an addition to value. An
the Proposed Regulations require: example of this concept in action is the purchase
Actual control (both in form and in substance) is of a home. If you purchase a home for $1M and
passed to the purchaser with the sale, or will be borrow 80 percent of it, the equity in your home
passed to the purchaser within a reasonable time is $200,000. If the value of your home remains
pursuant to a binding agreement in effect at the the same, but you pay $100,000 in principal pay-
time of the sale, and ment, your equity will increase to $300,000—a
It is reasonable to assume that the purchaser’s 50 percent growth rate. As the typical leveraged
control will not be dissipated within a short pe- ESOP loan is five to seven years, the opportunity
riod of time subsequent to acquisition. for rapid equity increases is strong. This makes
If the company gives the ESOP the option to purchase non-ESOP stock in an initial leveraged ESOP par-
over 50 percent of the company’s voting stock within ticularly attractive for Grantor Retained Annuity
a “reasonable time,” typically considered to be within Trusts (GRATs) that are slightly longer than the
three to five years, an ESOP may pay a control pre- typical two-year GRAT.
mium. On the other hand, the best gifts of non-ESOP If you engage in this type of planning, make sure
shares lack full control and lack marketability. you set up the GRAT immediately post ESOP pur-
chase. Because of the debt burden on the company,
Different Stock the per-share value will be the lowest immediately
Because the Department of Labor considers reason- after the ESOP acquisition.
able dividends on ESOP stock as an enhancement to
value, and such dividends do not count against the The Repurchase of
25 percent of qualifying payroll limitation,15 many Non-ESOP Stock by the ESOP
ESOPs own convertible preferred stock. Non-ESOP Successful estate planning often includes trans-
shareholders will not own convertible preferred stock ferring shares to a junior generation at a fully
because the dividend payments would be a drain on discounted price. When, at some point in the future,
the company’s
p cash flow and, therefore, the cash the company is sold at a much higher nondis-
being
e
eing used
used too pay down ESOP debt through ESOP counted price, that increase in value is transferred,
employee
emmplooyee benefi
bennefit contributions
tributio s and EESOP
SOP convertible
con gift tax free, to the junior generation. Likewise, it
preferred
pre sstock
eferrred stoc dividends.
ck d en is possible to gift stock to the junior generation at
Because
B
Beca a se
ause the
e th e valuation
at a fully discounted price
date
da between
ate betw
b wee n an ESOP SOP One
O n off the unique features of and then, later, have the
and d iintra-family
ntraa f stock junior generation sell
transfers is likely to be an ESOP
S is the ESOP’s O ability their shares
ha to the ESOP
different, the requirement ent to
t o borrow
bo
bo rrow
w for
f or the
he purpose
puu rp
p ose of at a hhigher price.. T
g her price The
of independence, differ- purchasing employer securities (the higher price is a direct
d re-
ences in lack of control sult of the typically lower
and lack of marketability,
leveraged ESOP). discount for lack of mar-
and the likelihood the ketability afforded ESOP
shares have different rights, preferences and privi- shares, as a result of the enhanced marketability
leges, the estate planning professional should not available through the repurchase obligation that is
use the ESOP value. not available to the non-ESOP shareholder.
Again, a GRAT may be favorable technique to use
Estate Planning Opportunities in this situation. If the initial ESOP transaction was a
step-transaction whereby the ESOP would eventually
Leveraged ESOP Company’s Equity (over a reasonable period of time) gain control and,
Growth Is Faster for that right, paid a control premium up front, the
ESOP is likely to want to purchase the gifted shares
In general, a highly leveraged company’s stock at a control price, regardless of what the value of
grows faster than a nonleveraged company’s stock. the shares are to the non-ESOP shareholder. And,
Simply put, debt is a subtraction from company because of the high debt burden, the ESOP may want
value. As that debt is repaid, all things being equal, to buy a small amount of shares annually to eventu-

JOURNAL OF PRACTICAL ESTATE PLANNING 17

Tax Valuation

ally achieve control, instead of a large amount of clusion. The ESOP is an independent entity, typically
shares at one time. This allows for the GRAT to sell represented by outside counsel, trustees and finan-
a smaller amount of shares annually to the ESOP to cial advisors. A sale that involves solely the gifted
fund the annual GRAT payments. However, since a shares may concern the outside counsel and trustee
post-leveraged ESOP com- enough to decline the offer
pany is likely to grow in to purchase such shares.
value rapidly, funding the Despite the fact that stock owned However, this decision
GRAT with some cash to by the ESOP and a non-ESOP must be balanced with the
make the annual payments trustee’s duty to acquire
will likely result in a more shareholder may be identical, the shares sufficient to give the
effective GRAT. fair market value of the shares are, ESOP the actual control
Selling gifted shares to likely, very different. the ESOP originally paid
an ESOP may be contro- for in its initial minority
versial and it comes with interest transaction.
many caveats. As is typically the case in a situation
where planning is done before a company sale, the Summary and Conclusion
IRS is likely to look at such a transaction as pre-
planned with the sale to the ESOP a foreordained ESOPs are poised for rapid growth. For the estate plan-
conclusion (step transaction). Moreover, the Depart- ning professional, ESOP companies provide unique
ment of Labor may be concerned that the ESOP was and favorable opportunities to minimize estate taxes
not acting with complete independence. The ESOP (as well as capital gain taxes) and transfer significant
cannot be forced to make the purchase. One solution wealth to junior generations through tax-advantaged
is to sell the junior generation or GRAT shares to the means. However, independence requires that the
ESOP at a price which is slightly below adequate valuation firm performing a valuation on behalf of an
consideration (making the price more favorable to ESOP be different than the valuation firm providing a
the ESOP). ) Another solution is to put time between valuation for estate tax and estate planning purposes.
the transfer
hee tra
ansfeer to tthe junior generation or GRAT and the And, the value arrived at for ESOP shares is likely to
ultimate
ulttimaate ssale
ale to
t the ESOP.
SOP. It may also
al o be preferable
pre be very different than the value of non-ESOP shares in
to sell more
moore stock
stoc to the
th ESOP
OP than only the shares the same company. As ESOP companies attract scru-
transferred
tra
ansfeerredd to ththe junior
nio generation.
era tiny from both the Department of Labor and the IRS,
I th
In the case
he caase ofo a leveraged
le eraged ESOP,
SOP, keep
k ep in mind
m that extreme care must be exercised. When done correctly,
the ESOP
ESOOP may
ma not have borrowing capacity when the
m typical estate planning techniques will likely produce
ideal time comes to sell the gifted
ift d shares
sh to
to the
th ESOP. ggreater
reat results with ESOPOP companies
p ie than non-ESOP
Also, the sale to the ESOP OP is not a foreordained
foreordained con- companies.
com
mpanies.
ENDNOTES
1 4 10
An ESOP is a defined contribution employee In response to the question: “How many Code Sec. 409(l)(3).
11
benefit plan that is allowed to invest primar- years from now is your ideal time frame to Code Sec. 1042(c)(4).
12
ily in employer securities. exiting the business?” Code Sec. 404(k).
2 5 13
National Center for Employee Ownership. “Statistics: Number of Baby Boomers, Baby The sponsoring company may pay the inde-
3
“2008 Survey of Closely-Held Business Boomer Business Owners and Potential pendent valuator’s fee.
14
Owners, America’s Enterpreneurialist Gen- ESOP Universe,” The One-Stop ESOP Blog, Original 1988 Department of Labor proposal
eration: Exit Planning and the Baby Boomer March 2, 2008. to amend Part 2510 of XXV of Title 29 of the
6
Age Wave,” White Horse Advisors—in National Center for Employee Ownership. Code of Federal Regulations; updated most
7
response to the question: “Please indicate Code Sec. 1042(c)(1). recently January 2008.
8 15
how important each objective is to you as a S corporation stock does not qualify for the Provided the dividends are reasonable and
motivation for considering an exit plan from Code Sec. 1042 rollover. used to repay ESOP debt or distributed to
9
your business.” Code Sec. 4975(e)(8) and Code Sec. 409(i). ESOP participants.

18 ©2010 CCH. All Rights Reserved

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