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(A)ESOP's Fables - The Income and Estate Tax-Free ESOP


If the pandemic was good for anything, it was TV watching. The pandemic may become known as the golden age of television. Since I was a foreign language major (Portuguese and Spanish) at West Point (mind you out of academic necessity) I became a foreign film buff and never looked back. I do not like anything dubbed. If a movie is Swahili, I want to hear the dialogue in Swahili.

My East German father (of blessed memory), Willy Wolfgang Nowotny, passed away in November 2019. He was from a small village right on the border of Poland and the Czech Republic, the Hooterville of East Germany most likely. During the pandemic, I had the opportunity to watch numerous German limited series and movies. Some of these limited series in German - Wiessensee Saga, Line of Separation, Deutschland 83 and The Lives of Others, have helped remain connected to his memory and the impetus to come to America with eighteen dollars in his pocket. These shows are well worth watching. Now for the rest of the story!

An Employee Stock Ownership Plan (ESOP) is a type of employee plan governed by ERISA that came into the statutory framework of federal tax law and ERISA in 1974. The ESOP allows the employees of a company to purchase the Company from its owners. As of 2014, there were approximately 7,000 ESOPs in existence covering thirteen million employees with one trillion dollars of ESOP plan assets. The ESOP is like a profit-sharing plan in many respects except the Company (sponsor of the ESOP) either contributes shares of its own stock or provides cash to buy existing shares of the Company. In many cases, the ESOP can borrow money to buy new or existing shares from the owner of the Company. The most significant tax benefit for the owner as the Seller is the ability to defer capital gains taxes on the sale of the shares to the ESOP under IRC 1042. This benefit is available for ESOPs of regular corporations but not S corporations.

This article discusses the use of Employee Stock Ownership Plans (ESOP) from the perspective of the Seller, the business owner. In my view, unless the business owner sees the personal benefits for himself from an economic standpoint before and after taxation, the business owner's altruism to do something beneficial for the Company's management and employees will evaporate quickly.

To qualify for the tax deferral benefits of IRC Sec 1042 which allows the business owner to defer capital gains taxation on the sale of the owner’s shares to the ESOP, the Seller must have held the stock for three years before the sale. Following the sale, the ESOP must own at least 30 percent or more of the Company's shares and must hold the shares for at least three years following the sale. Shares qualifying for deferral cannot be allocated to the accounts of the Seller's children, brothers or sisters, spouses, or parents of the Seller or to other 25 percent shareholders. The ESOP requires an independent valuation of the Company's shares.

Tax deferral is a good planning result under any scenario. However, qualification under IRC Sec 1042 the requirements for qualified replacement property limits the purchase to domestic stocks and bonds. Another limitation is the fact that the qualified replacement property is in the Seller's taxable estate unless additional estate planning to remove the qualified replacement property from the taxable estate. Of course, you would think having read my other articles that there must be a PPLI or Pooled Income Fund solution to the Seller's tax problems. You're correct!

Reengineering the ESOP for the Seller’s Perspective

As previously stated, the Company must be taxed as a regular corporation for the business owner to benefit from the IRC Sec 1042 rollover. An S corporation or LLC sold to an ESOP will not provide the business owner with the tax deferral benefit under IRC. However, the Company taxed as a pass-through entity can elect to be taxed as a corporation prior to a sale to the ESOP. The planning contemplated below would provide the business owner with tax-free treatment regardless of the choice of entity consideration. The planning benefit for the business owner as the Seller to the ESOP, regardless of the choice of entity - S corporation or regular corporation, is income and estate tax treatment of the rollover proceeds.

The planning for the business owner focuses on three different elements. One building blocks of the planning is private placement life insurance (PPLI). The second building block of the planning solutions is a Pooled Income Fund (PIF). The third building block is a Freeze Partnership as an investment vehicle with preferred and common membership units.

Private placement life insurance (PPLI) is an institutionally priced variable universal life insurance policy with customized investment options. PPLI provides for tax-free accumulation within the policy; tax-free policy loans and tax-free death benefits. A Pooled Income Fund (PIF) is a charitable trust that is similar but distinct to a Charitable Remainder Trust. The PIF provides for a charitable tax deduction for the contribution of the asset to the PIF. The PIF provides the donor with an income for a single or joint lifetime. Following the death of the last income beneficiary, the PIF assets (remainder interest) pass to a charity or a Donor Advised Fund administered by the Charity.

The Freeze Partnership is a limited liability company taxed as a partnership. The Freeze Partnership has two classes of membership interest – Class A Common and Class B Preferred. The Class B units provide a preferred investment return which may be cumulative or non-cumulative. The Class A units provide an investment return more than the preferred return. The Freeze Partnership is funded with a PPLI policy funded on a non-modified contract basis.

Prior to the establishment of the ESOP in the independent valuation of the Company, the Seller creates an "Out of the Money" call option to purchase a 49 percent in the Company. The Seller creates two call options to reflect 98 percent of the Company’s shares. The Strike Price of the call option is 110 percent of the appraised value of a 49 percent share of the Company. The valuation reflects valuation discounts for lack of marketability and lack of voting control for the 49 percent interest. Concurrent with the issuance of a PPLI policy, the call option is transferred as an in kind or non-cash premium to the life insurer for the issuance of the Policy. The Policy's investment fund becomes the option holder of the call option.

As the ESOP process progresses and the sale of the Company is consummated. The call option is exercised in a cashless exercise. The option is deemed to have been exercised and sold to the ESOP. The difference between the sales price of a 49 percent interest in the Company and strike price, is payable to the PPLI investment fund as investment income to the Policy. This income is non-taxable to the Seller. If the policyholder is a family trust, the proceeds will also be estate tax-free and outside of the reach of personal and business creditors. Trust planning can provide a planning design so that the Seller and his wife can become discretionary income beneficiaries of the policy and receive tax-free distributions from the Trust as beneficiaries.

The Seller receives payment directly from the ESOP and could use those funds to purchase qualified securities in accordance with IRC Sec 1042. The Seller could stop there and would have achieved tax deferral on an amount of the sales price up to the Strike Price of the call option. However, the rollover securities would be in his taxable estate. A better option is a contribution of the qualified securities to a new customized pooled income fund (PIF). the Seller will receive a tax deduction based on the value of the remainder interest passing to charity. The value of the contribution is the fair market value of the qualified rollover securities. The Seller may use the deduction up to 30 percent of adjusted gross income (AGI) in the current year with a five year carry forward of unused deduction. The PIF may sell the property without gain.

The proceeds may be reinvested into a Freeze Partnership with the PIF retaining the Preferred Interests (Class B) with a preferred cumulative investment return. The Seller's family trust may own the Class A Common units of the Freeze Partnership which may have access to investment gains more than the Class B Preferred return. The investment engine of the Freeze Partnership is a guaranteed issue PPLI policy funded on a non-MEC basis allowing tax-free withdrawals which may be used to provide tax-free income to the Seller and his spouse as income beneficiaries of the PIF. The Seller receives a significant tax deduction, tax-free income for multiple lifetimes with no estate tax inclusion. These benefits could not be replicated in a Charitable Remainder Trust because of the four tier distribution rules.



Roger Ramjet, age 60, is the sole shareholder of Acme, Inc, manufacturer of sporting goods. He is married with three children. Acme has fifty employees. Acme is taxed as a S corporation. Ramjet is contemplating retirement and would like to sell the Company to his management team and employees in an ESOP transaction. The company recently had an appraisal of the Company of $40 million. The valuation firm valued a 49 percent non-controlling interest at 12.75 million reflecting valuation discounts for lack of marketability and control. Ramjet would like to maximize the tax befits associated with the sale of the Company to the ESOP.

Planning Strategy

Ramjet creates two “Out of the Money” call option priced at $14 million each. Each option contract has a value of $2.8 million. The combined economic value of the two options is $5.6 million. The combined strike price of the two options is $28 million. The two-options cover 98 percent of the Company’s outstanding shares.

Ramjet is the settlor of a Spousal Lifetime Access Trust (SLAT). His wife and children are discretionary beneficiaries of the SLAT. The SLAT is the applicant, owner and beneficiary of a PPLI policy featuring a customized investment fund. Ramjet enters into a private restricted collateral assignment split dollar arrangement with the SLAT. He transfers $500,000 in cash and the two options contracts as in-kind premiums to the SLAT. The trustee transfers the cash premium and option contracts to Estandard Life, an offshore life insurer. The policy has a customized investment fund managed by an RIA in New York.

At the closing of the sale of the Company’s shares to the ESOP, the options are exercised in a cashless exercised, the difference between the sales price and the strike price for the two options ($28 million), $12 million is paid to investment fund within the PPLI policy. This income is treated as life insurance separate account income which payable to Estandard for the benefit of the Ramjet policy which takes a reserves deduction against the income. The money is reinvested within the Policy on a tax-free basis available for tax-free policy loans. The SLAT-owned policy is outside of the reach of Ramjet’s personal and business creditors.

Prior to the sale to the ESOP, Ramjet created a Pooled Income Fund (PIF) administered by a 501(c)(3) charity known as Alianza Charity. Alianza serves as the trustee of the PIF. Ramjet contributes his property interest in the option proceeds up to the Strike Price prior to the Sale and before the arrangement is binding. Ramjet does not receive a deduction on the contribution because the donation is a gift of short-term capital gain property and Ramjet’s basis in the property interest is zero. Nevertheless, the PIF receives the gain without capital gains taxation as the proceeds are allocated to principal.

The PIF reinvests the entire amount of the proceeds ($28 million) into a new Freeze partnership in exchange for Class B preferred units which will pay a yield/dividend of six percent per year to Ramjet and Mrs. Ramjet for their joint lifetime. Upon the death of the surviving income beneficiary, the Class B units will pass to the Ramjet Foundation, a donor advised fund administered by Alianza. The SLAT will contribute $2.8 to the Freeze Partnership in exchange for the Class A common units which will entitle the SLAT to the excess income above the preferred return in the Freeze Partnership. The underlying investment of the Freeze Partnership is a PPLI policy funded as a non-MEC. The Manager of the Freeze Partnership will take tax-freeze loans and withdrawals to make the Class B preferred return payments to Ramjet and his wife.

The assets in the PIF and the SLAT are not included in the taxable estate of Ramjet and Mrs. Ramjet. The income distributions from the PIF and the SLAT are non-taxable to Ramjet for income tax purposes. The planning has allowed Ramjet to the sell the shares to his management team and his employees as intended. The S corporation will not be taxable within the ESOP, and it uses its income to paydown the bank loan used to execute the purchase. While Ramjet was unable to benefit from an IRC Sec 1042 on the sale, he achieved better planning results from an income and estate tax standpoint.


ESOPs are a great tool for the business owner and employees. The planning technique complimenting the ESOP dramatically enhance the benefits for the Seller making the Seller more willing to enter into the ESOP arrangement. Tax-deferral for the Seller on the sale is a good benefit. However, planning the sale to make the proceeds income and estate tax-free produce a planning result which is stronger than the benefits available to Sellers in current ESOP transactions.

I look forward to your call.

(A)ESOP's Fables Article
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