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No ESOP Fable: Plan Is Used to Cash Out of Family Firm

If you run a family-owned business, federal tax law now allows you to set up an employee stock ownership plan, or ESOP, and turn your employees into motivated owners with a stake in the well-being of your company.

Under the correct circumstances, the law even makes it possible for you to use an ESOP to cash yourself out of a family-owned business.

Effective Jan. 1, 1998, Congress gave businesses organized as sub-chapter S corporations the same right to set up ESOPs as C corporations--so-called because of the sub-chapters in the federal tax code that define them. The change affects many family-owned businesses, which often choose S status for tax reasons.

In the 14 months since then, as many as 100 S corporations in the U.S. have set up ESOPs, according to the National Center for Employee Ownership, a nonprofit ESOP information group based in Oakland.

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Most just wanted to give their employees the spur of ownership, but a handful of family-owned S corporations set up ESOPs as vehicles for cashing the families out of the business, according to Corey Rosen, the group’s executive director.

As the numbers suggest, it takes some doing to use an ESOP to cash out of an S corporation lock, stock and barrel. For one thing, not all S corporations can--or should--take advantage of the opportunity. For another, tax law gives you some high hurdles to jump.

In general, Rosen says, an ESOP might cash you out of a family-owned S corporation if you show a high basis for your stock. If you show a low basis, the idea may not make sense, because a low basis means a high tax on your capital gains, and vice versa.

Most shareholders in S corporations show low bases for their stock because of the differences in the tax treatment of S and C corporations.

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S corporations do not pay taxes on earnings at the corporate level; they pass the burden to their shareholders. Put another way, the law considers profit made by S corporations to be income to their owners, taxable once--not twice--at individual rates.

On the other hand, C corporations do pay taxes on earnings at the corporate level, often at lower rates than individual taxpayers. Their shareholders also pay taxes on earnings received as dividends--double taxation--and a good reason many family-owned businesses elect S status.

To ease the burden on the individual shareholder, Rosen says, many S corporations distribute dividends equal to the tax liability of each shareholder every year.

The owners of S corporations consider this good news, but they face bad news too: They must increase the basis of their stock if they take interim dividends, and they must decrease the basis for any allocations on which they pay taxes, Rosen says.

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And when they sell their stock--for example, to an ESOP--they must pay taxes on the capital gains.

“If you don’t take year-end distributions,” Rosen says, “your basis in S corporation stock goes up. If you do, your basis stays the same or even goes down.

“And when you sell, if you have a high basis, you can avoid some taxation. If you have a low basis in the stock, you can’t.”

The bottom line, Rosen adds, is that it makes sense to use an ESOP as a vehicle to cash yourself out of an S corporation only if you have a high basis in your stock.

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As a consequence, the owners of S corporations usually switch to C status before setting up ESOPs designed to cash them out, Rosen says. In doing so, they gain two big advantages:

* C corporations can deduct as much as 25% of their employees’ pay to repay the principal on any bank loan taken out to finance the ESOP. As a rule, S corporations may deduct only 15%.

* The owners of a C corporation may defer capital gains taxes if they sell 30% or more of the company to an ESOP and invest the proceeds in stocks and securities of other publicly held or private companies.

Even so, it can still make sense to make the switch the other way--from C to S status--because of the tax shelter inherent in S status, Rosen says. Indeed, as many as 500 companies have done so since the law changed, he says.

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As nonprofit trusts, ESOPs escape taxes on dividends received on the stock they own, making it possible for owners of S corporations to use ESOPs to shelter part of their earnings. Some use this advantage to pool tax-sheltered cash to buy additional shares of the company or even to finance acquisitions.

The Clinton administration, however, may ask Congress to limit the advantage of the tax shelter, and companies now pursuing this strategy may or may not grandfather themselves into any change in the law, Rosen says.

In any case, he adds, no matter what your strategy, tax law is so complex that business owners need expert advice in setting up ESOPs for either S or C corporations--or switching from one status to the other.

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Columnist Juan Hovey can be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.


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