The Fabled ESOP

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Discussing Issues that Give Physicians Chest Pains…

Chapter 3: The Fabled ESOP

For many physicians, the value of their practice is the single largest retirement asset in their portfolio. When it is monetized—most often at retirement—a myriad of tax, diversification and control issues accompany the liquidity event. As a result, careful planning is crucial to maximizing the value of this asset and achieving a smooth transition.

The below hypothetical conversation with Bruce, a 61 year-old dermatologist, illustrates how an Employee Stock Ownership Plan (“ESOP”) could help a physician sell his practice and pay no immediate (and perhaps never pay) capital gains taxes on the sale proceeds. It also demonstrates how continuity and control of the business can be effectuated through the unique leverage afforded by an ESOP structure.

Background:

Dr. Bruce owns 100% of the stock of Picture Perfect Dermatology, Inc., a C Corporation that he founded 30 years ago. The estimated value of the business is $10 million. Bruce is interested in having two key employee dermatologists—one of whom is his 38 year-old son—take over the management of business. Bruce has been a client of ours for almost 11 years.

Conversation:

Me: Good morning Bruce! When we last met, one of your top priorities was formulating a game plan for transitioning ownership of your business as you move to retirement. In an ideal world, how does that look to you?

Bruce: Well, I’d like to retire by my 65th birthday. And, of course, I’d like to collect close to the full value of my business so I can use the money for retirement and estate planning. I don’t want to get fleeced by Uncle Sam and the state department of revenue so anything that will enable me to legally preserve that entire target value would be great.

Me: OK, sounds reasonable. What about the future of Picture Perfect—who’s running it?

Bruce: I would love it if my son and the other staff dermatologist could assume ownership equally after I’m gone. They’re both talented and fully capable of running that operation. Plus, the patients are comfortable and familiar with them and they would keep the staff—including my office manager who is the REAL brains behind the operation (laughs)—in tact and treated fairly. That’s important to me. They are like family.

Me: Great wish list. Well, if I had to boil it all down, I’d say you have 4 options to consider. Option one is that you could sell the business to a competitor or an outside party. This would certainly provide you with the liquidity you’re seeking. However, if the business is sold to outsiders, there can be no assurance that everyone gets to keep their jobs. Additionally, you could pay 25% or more of the sales proceeds in taxes to the federal and state government.

Bruce: Sounds like a clean and simple option. However, the tax and lack of control would leave too much of a bad aftertaste in my mouth. What are the other 3 options?

Me: Well, option number 2 is that you could exchange the shares of Unique Dermatology for the shares of a larger corporation. The benefit to this ‘swap’ is that you wouldn’t have to pay capital gains tax unless and until you actually sell the shares of the larger company.

Bruce: The additional deferral on the tax bite is nice but what if the acquiring company stock plummets? That’s a huge risk I don’t think I’m willing to take. Haven’t you always warned me against having my eggs in “one basket”? It’s different when the “basket” is my own company! You know me—I’m a control freak. I wouldn’t be able to sleep at night.

Me: I thought you might feel that way…

Bruce: Plus—there’s no assurance that the acquiring company would keep my current team in place.

Me: Excellent point. The third option is to have the Company buy back your stock. We would have a bank loan money to the corporation to supplement whatever cash the new owners could raise. Then the corporation—presumably owned by your son and the other staff dermatologist—would repurchase all of your stock. The downside to this approach is twofold: first, it is expensive for the new owners given that the corporation will be purchasing the stock with “after-tax” dollars. Second, you will also be subject to capital gains tax on your stock upon the sale.

Bruce: Please tell me this is leading to a better option. At this point, I’m ready to self-prescribe medication.

Me: Yikes! Well, hopefully option 4 is a little more palatable. Option 4 is that you could sell your stock to an Employee Stock Ownership Plan or ‘ESOP’. In order to pay the purchase price, the ESOP could borrow funds from a third party—typically a bank—to supplement any cash that the new owners would commit.

Bruce: Wait a minute; how is that any different from option number 3?

Me: Great question! Let’s suppose the new owners—through the ESOP—finance the full purchase price. The financing cost for the $10 million loan will be significantly diminished given that the corporation will be entitled to deduct not only the interest payments on the loan—like they would if they purchased it outside of the ESOP—but also all of the principal payments.

Bruce: Wow, that’s a huge number given the new 39.6% income tax bracket, state taxes and the fact that taxes will probably increase during the term of the loan. That deduction could cut the cost of the total loan repayment by half!

Me: Yep. That’s certainly a huge benefit. Additionally, you can also defer capital gain taxes on your shares under Internal Revenue Code Section 1042. To comply with s.1042, within the next year or so, we would have to reinvest the sales proceeds in a portfolio of individual stocks and bonds—what the IRS calls “Qualifying Replacement Securities (QRS)”.

Bruce: That would provide me with a lot of diversification. Is the capital gains tax avoided forever?

Me: That depends—the capital gains taxes are actually deferred until you sell the stocks or bonds. However, if you pass away before they are sold, your heirs would receive a step up in basis and there would be no capital gains tax paid according to current tax law. There are also some charitable strategies that would enable you to minimize the tax bite greatly—even upon eventual sale of the QRS—while creating retirement income for you. That’s something we can address in further detail as we walk through this transaction in the context of your overall retirement income picture.

The above conversation is for illustrative purposes only and is not intended to provide specific tax and/or investment advice. Please consult with your own legal, financial and tax advisors regarding whether any of the above strategies are appropriate for your individual tax situation.

Many states require physicians to incorporate as Professional Corporations (“P.C.”s). Although ERISA and the IRC do not preclude a P.C. from owning an ESOP, there could be an issue under state law as to whether legal title to the stock is held by someone other than a member of the profession (such as an office manager). If the trustee of the ESOP is deemed by the state to hold legal title to the stock of the ESOP, there should not be a problem with the applicable state’s corporate law if the trustee is a member of the class of professionals covered under the professional corporation. The ESOP would be required to contain a provision prohibiting the distribution of stock to former employee/participants of the professional corporation. A further discussion of P.C’s as owners of ESOPs is beyond the scope of this article.

IRC 1361 (c)(7) permits an ESOP to be an S Corporation shareholder. However, the non-recognition of gain provisions under section 1042 are not available with respect to the sale of S Corp stock to the ESOP. S Corps cannot deduct dividends paid to ESOPs. There are many benefits to having an ESOP as a shareholder in an S Corporation. Following a legislative change in 1996, it is now estimated that approximately 75% of ESOP implementations have been in S Corps.

by Christopher A. Hynes, JD, CFP®