You've probably heard of employee stock ownership plans, or ESOPs, but did you know they can be excellent tax and succession-planning tools for family-owned businesses?

And did you know that the Small Business Jobs Protection Act of 1996 and the Taxpayer Relief Act of 1997 have made them even better? If not, it's time you took another look.

An ESOP is an employee benefit plan that operates like a profit-sharing program. It's designed to enable employees to invest heavily in the stock of the sponsoring employer. Like other plans that are qualified under the Employee Retirement Income Security Act, contributions to the plan are currently tax deductible while earnings of the plan are tax-deferred and the pay out at retirement or separation from service can be very favorable for the participant.

What sets an ESOP apart from all the other qualified plans is the benefit to the company and to shareholders who sell their stock to an ESOP.

To create an incentive to spread ownership to rank-and-file employees, Congress has provided incentives in the form of tax benefits to motivate small-business owners to set up an ESOP and have it invest in company stock.

For example, an ESOP creates a ready market for closely held stock. If the ESOP owns at least 30 percent of the stock after a particular purchase, the seller may avoid all current income tax on the sale by reinvesting in the common stock of any U.S. corporation, including a new company the seller sets up to start or purchase another business. If the selling shareholder takes advantage of this technique to avoid current income tax and holds the stock in which he or she reinvested until death, the seller can avoid the income tax on the original sale to the ESOP forever.

The company can benefit from the sale to the ESOP in several ways:

-Rank-and-file employees will have a greater stake in the firm, which is likely to motivate them and give them greater incentive to make the company successful. (United Airlines and Avis are ESOP companies.)

-The corporation can use tax-deductible contributions to the plan to pay for stock, making purchases easier to handle.

-The company can contribute company stock to the ESOP and receive a tax deduction without an outlay of cash.

The ability to combine shareholder and company benefits has been a catalyst for the increased use of ESOPs in closely held businesses. For a retiring family business owner, the tax benefits are so attractive that many use ESOPs as their exit strategy.

If you have no family successor, your ESOP may be the perfect way to sell out all of your stock and retire with the maximum after-tax proceeds. If you have a family successor, your ESOP, combined with other succession tools, can leave your successor in control while you continue to receive the ESOP's benefits.

If the younger generation wants to take over your family business, one solution is to sell only part of the stock to an ESOP. For example, if you sell 50 percent of your stock to the ESOP and transfer the other 50 percent to your children, you can still take advantage of the income tax benefits on the 50 percent sold. With these benefits, you may be able to live on the proceeds of 50 percent of the stock, and make a gift of the rest to your family. Your remaining family members will still, in essence, control the corporation.

Usually, shareholders and participants request cash for their shares as they leave the company. These redemptions can increase your children's percentage ownership and put them in control.

However, you cannot indirectly sell your shares to your children via the ESOP, unless you are willing to forego the tax deferral on the sale.

While the benefits are numerous, be aware of the potential drawbacks before you set up an ESOP:

-Your children will have to deal with the ESOP trustee, who is required to scrutinize the transactions between the children and the company, including their perks and benefits.

-The plan carries annual administration fees.

-An independent appraiser must value the ESOP stock annually.

Despite all the benefits, ESOPs did not proliferate as Congress hoped, partially because, until the Small Business Jobs Protection Act was enacted, S corporations could not remain S corporations if an ESOP owned any of the company's shares. Thus, many business owners whose companies started as or converted to S corporations could not have an ESOP.

In 1996, the law was amended to allow ESOPs to be shareholders without destroying the S election.

Also, ESOPs now pay income tax on the income of S corporation stock allocated to the ESOP. This latter requirement made sponsoring an ESOP unappealing for most S corporations.

Even if this dampens your enthusiasm, you should still consider ESOPs for S corporation, family-owned businesses.

ESOPs have many combinations and permutations. They may be leveraged or unleveraged. They may or may not provide tax deferral. And depending on whether they provide tax deferral, they can include or exclude particular family members.

Michael D. Cohen is a partner at Singer Lewak Greenbaum & Goldstein, a firm of certified public accountants and management consultants in Westwood. He can be reached at mcohen@slgg.com.

Entrepreneur's Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.

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