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


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; out of academic necessity, I became a foreign film buff and never looked back. 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. Some of these limited series in German - Weissensee Saga, Line of Separation, 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.

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 to purchase the Company from its owners. As of 2014, there were approximately 7,000 ESOPs in existence covering 13 million employees with one trillion dollars of ESOP plan assets. The ESOP is similar to 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. Perhaps, 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 blog discussed 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. In order 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 thing under any scenario. However, qualification under IRC Sec 1042 the requirements for qualified replacement property generally 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!

Planning Discussion

Prior to the establishment of the ESOP in the independent valuation of the Company, the Seller can create an "Out of the Money" call option to purchase a 49 percent in the Company. 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 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 may be 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 is consummated. The 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 ultimately 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 in excess of 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.


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.


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