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III.
Selected ESOP Tax Incentives
A.
Deduction of Principal
Because of federal income tax
incentives designed to promote the leveraged use of ESOPs,
a company may effectively repay both the principal and interest
of an ESOP loan with pre-tax dollars. Contributions by the
employer to an ESOP are deductible as retirement plan contributions.
These amounts are then used to repay the principal of the
ESOP loan. By contrast, only the interest paid on a conventional,
non-ESOP loan is deductible. Assuming an effective income
tax rate of 40%, a company would have to earn approximately
$17 million pre-tax to amortize the principal of a $10 million
loan. Pre-tax income of only $10 million, however, would
be needed to amortize the principal of a $10 million loan
through an ESOP. Thus, cash flow available to repay the
debt is increased substantially with a properly structured
leveraged ESOP. This enhanced cash flow makes an ESOP transaction
easier to finance than a comparable non-ESOP transaction.
This ability to amortize the principal
of the ESOP loan with pre-tax dollars is what is frequently
referred to as the "magic" of ESOPs.
B.
Nonrecognition of Gain on Sale of Employer Securities to
an ESOP
Under Section 1042
of the IRC, an individual shareholder of a private company
who sells "qualified securities" to an ESOP can defer paying
federal income tax on his gain as long as he acquires "qualified
replacement property" within the period beginning three
months before the sale and ending twelve months after the
sale.
Nonrecognition of gain is available
for a sale to an ESOP only if, After the sale, the ESOP
holds at least 30% of the total value of the qualified securities
outstanding as of the time of the sale. " Qualified securities"
for this purpose are employer securities which (i) are issued
by a domestic operating corporation which has not had securities
tradeable on an established securities market for at least
twelve months prior to the sale, (ii) have been held by
the seller for more than three years, and (iii) were not
acquired by the seller in a distribution from a qualified
employee benefit plan or pursuant to the exercise of an
option or similar program.
"Qualified replacement property"
means securities issued by a public or private domestic
operating corporation. A corporation is not an operating
corporation if its passive income exceeds certain limits.
For nonrecognition treatment to
be available, the company must consent to the imposition
of a 10% excise tax on any amount realized by the ESOP if
it sells the qualified securities within three years of
having acquired them in a Section 1042 transaction. The
excise tax does not apply to any distributions made by the
ESOP by reason of a participant's death, retirement after
age 59-1/2, disability or other separation from service.
Also, the company must consent to the imposition of an excise
tax on certain prohibited allocations by the ESOP to selling
shareholders who have taken advantage of the regognition
treatment, their relatives, and 25% shareholders of the
company.
Furthermore, the ESOP plan document
must specify that during the "non-allocation period", employer
securities purchased from a selling shareholder electing
nonrecognition treatment under Section 1042 may not be allocated
to the account of (i) the selling shareholder or any person
related to the selling shareholder (except lineal descendants
who may be allocated up to 5% of such employer securities
in the aggregate), or (ii) persons owning directly or indirectly
more than 25% of the employer's stock. The "non-allocation
period" is a period beginning on the date of the sale and
ending on the later of (i) ten years after the date of sale,
or (ii) the date that employer securities are released from
the suspense account and allocated to participants' accounts
attributable to the final payment of any acquisition debt
incurred in connection with the sale.
The selling shareholder must file
certain notarized forms with the IRS to ensure nonrecognition
treatment. This is a trap for the unwary, and the selling
shareholder should proceed with great care to be sure that
all appropriate filings are made.
Nonrecognition of gain under Section
1042 should be very attractive to individual shareholders
of a private company who desire to sell their stock to the
company's employees. If the shareholder holds the qualified
replacement property until death, a step-up in basis will
occur, and income tax on the gain will be avoided completely.
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