Only one in 20 family corporations survive as family-owned companies past the first generation.
There are several primary reasons for this, not the least of which are the onerous transfer taxes. Another stumbling block is the fact that heirs may not have been groomed to sit in the founder’s chair. Moreover, even if a child has been trained as a logical successor, it is unlikely that he or she will have sufficient funds to cash out the parent.
Typically, the assets of founders of private corporations are comprised principally of the non-liquid stock of their companies. They can seldom afford to give the major portion of their stock to their children since they will need its cash equivalent for their comfortable retirement. Even if the founder were willing to give stock of his or her company to an heir apparent, the government restricts the amount that can be given to their children without incurring gift taxes.
In essence, then, here is the typical problem Mr. Big, the founder, would like to keep the business in the family but his presumed successor cannot afford to buy him out and Mr. Big cannot afford to give the stock to his child. Moreover, he cannot find a buyer for a minority share of his company. A sale to an outsider would most likely result in severe dislocations among the loyal employees that the founder would like to protect. Fortunately, there is a solution to Mr. Big’s dilemma an Employee Stock Ownership Plan (ESOP).
An ESOP is a tax-qualified plan, which unlike pensions or profit-sharing plans, is mandated to invest primarily in the stock of the sponsoring company. The ESOP is the only qualified plan that can borrow to purchase employer stock from the stockholder or from the company itself. The stock must be valued by an independent appraisal firm to determine its fair market value. The lender, typically a bank, is repaid by having the corporation make annual contributions to the ESOP in an amount that is equal to principal and interest. The ESOP passes this on to the lender.
Tax deductions
Because these corporate contributions are tax deductible, the corporation is able to deduct principal as well as interest.
By contrast, if a corporation in the 41 percent combined tax bracket were to redeem $1 million of stock from the stockholder, the company would have to earn $1.7 million to repay principal, ignoring interest. This is because principal repayment is not tax deductible. The ESOP will save this company $700,000 of future pretax earnings.
Let’s assume that Mr. Big founded Big Inc. a number of years ago and grew the firm to its current appraised value of $10 million. Almost all of his net worth is in the form of Big Inc. stock.
Mr. Big’s son, Tim, has worked in various departments of the company and has proven to have the potential of sitting in the founder’s chair as CEO. Mr. Big learned that he could start selling some of his stock to the ESOP and could defer or possibly avoid paying any capital gains tax if the sale results in the ESOP owning at least 30 percent of the outstanding stock and he reinvests the proceeds in other securities of domestic operating companies. This would allow Mr. Big to start diversifying his estate and putting his assets into a liquid form instead of in their present non-liquid status.
Mr. Big had been concerned about relinquishing control but was pleased to find that the stock in the ESOP is voted by the trustee, which is directed by the administrative committee that is appointed by the corporate board of directors. He could maintain effective control even if the ESOP held most of the stock. The employee participants are not stockholders and have no right to access corporate financials.
The stock is allocated to the employees’ accounts according to their compensation as the principal payments of the loan are paid. The ESOP participants are subject to a vesting schedule so that they will forfeit some or all of the accounts if they leave before becoming fully vested. Eventually, they will be paid out in cash when they terminate, retire or die. Studies show that productivity and profitability gains occur because of employee ownership through ESOPs.
Mr. Big, the 100 percent shareholder, decided to sell 51 percent of his shares to the ESOP and reinvest the $5 million-plus in qualified replacement property. Because he did not have to pay taxes on the sale proceeds, $5 million was the after-tax equivalent to what he would have been left with had he sold $7 million of stock to a buyer other than the ESOP. Mr. Big was left with 49 percent of the outstanding stock. The appraisal gave the value of this minority interest a 25 percent discount, bringing the value down to $3.7 million.
Transferring stock
He wanted to transfer the balance of his stock to Tim. The appraiser pointed out that since Tim would have no guaranteed market for the stock, a 45 percent marketability discount would also apply, bringing the value of the 49 percent interest down to approximately $2 million. Mr. and Mrs. Big made a gift of $1.35 million to Tim free of gift taxes since this is within their lifetime gift exclusion. They sold him the remaining $650,000 on an installment basis. Tim then assumed effective control of the company and its ESOP since he owned 100 percent of the stock outside of the ESOP trust.
Robert A. Frisch is chairman of The ESOT Group Inc. in Los Angeles. The firm, incorporated in 1975, is a one-stop implementer of ESOPs. Frisch can be reached at [email protected].
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.
