Business succession planning and wealth diversification

Having worked with a number of business owners, I see a lot of owners thinking about their customers, their employees and maybe even their suppliers. A business, after all, is a labor of love. But it's also likely to be their most important asset and a substantial source of wealth. Which raises two questions for business owners: What is my transition plan? How can I diversify a portion of my wealth?

This is not an easy subject to tackle. Identifying potential successors and implementing strategies to ensure a smooth transition of ownership require much thought and deliberation - and in many cases, a willingness to give up control of your company.

I don't have to tell you that there is no shortage of strategies to execute a transition plan, from transferring ownership interests to family members to selling stock to outside buyers. But for business owners who wish to diversify their ownership while maintaining continuity and deferring taxes, employee stock ownership plans (ESOPs) are an increasingly attractive option. Although ESOPs are not appropriate in every case, their growing popularity among business owners is evidence of their utility: the National Center for Employee Ownership, based in Oakland, California, estimates that the United States currently participates in about 11,500 ESOPs.

Employee Stock Ownership Plans facilitate the transfer of some or all ownership from business owners to their employees. When you sell your shares to the ESOP, the employee-participants receive proportional ownership of the company.

An ESOP can be tailored to your needs, but it is important to note that it is an employee benefit plan that must meet the applicable rules for employee eligibility, participation and vesting. As a result, you should carefully evaluate factors such as the company's financial condition, employees' eligibility for plan participation, and stock allocation and vesting schedules before you set up the plan.

You probably have a rough estimate of your company's value, but an ESOP requires a formal valuation that considers profits, cash flow, market conditions and outlook, assets and any other relevant factors. After determining the company's value, you must decide how to fund the ESOP.

A leveraged ESOP borrows funds to buy company stock. The ESOP can borrow the funds directly, using the purchased stock as collateral. More frequently, funds are borrowed at the corporate level then re-lent to the ESOP. This helps make some of the debt repayment a deductible expense item.

Unleveraged ESOPs buy stock without using debt financing. The funds can come from Treasury stock, the company's contributions, employee contributions or other profit sharing plans the business has established. Once the plan is operational, a trustee assumes responsibility for overseeing the plan. You are allowed to serve as trustee, but an outside individual or corporate trustee can be hired for that role.

For business owners, one of the most important benefits of an ESOP is the ability to diversify tax-efficiently. The mechanics are straightforward: You sell stock to the ESOP, and the ESOP buys your shares for cash at the valuation price. Internal Revenue Code Section 1042 permits a taxpayer who sells shares in a privately held company to an ESOP to defer paying taxes on any capital gain from the sale of those shares if the following requirements are met:

• You (or any other seller) must have owned the shares for at least three years and cannot have received the shares as a form of compensation.

• The ESOP must own at least 30 percent of the company after the sale.

• You (and other sellers) must reinvest the sales proceeds in "qualified replacement securities" within 12 months of the sale to the ESOP.

Importantly, the investor's private company tax cost basis is transferred to the qualified replacement portfolio. Appropriate management of this potential tax exposure should be discussed thoroughly as you develop this portfolio in concert with your advisors. Note: There is a step-up in basis to the estate if you subsequently sell a qualified replacement security; the deferred gain on the sold security becomes due.

By reinvesting the proceeds in qualified replacement securities within 12 months of selling your shares to an Employee Stock Ownership Plan, you receive cash for your otherwise illiquid shares. You can then use the proceeds to diversify your investment portfolio.

Qualified replacement securities are generally defined as stock and bonds issued by a U.S. domestic operating company. However, several widely held types of investments - including mutual funds, certificates of deposit, government securities and real estate - do not qualify.

There are multiple strategies for reinvesting ESOP-related proceeds. A thorough discussion of these approaches with your advisors, including related pros and cons, is very important. I can be reached at or 689-8704.

- William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.


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