ESOPs and FLPs
Ron J. Lint, ASA, CEO
Business Valuation and ESOP Specialist
ATI Capital Group of Colorado, LLC
3578 Hartsel Dr., Unit E, PMB 321
Colorado Springs, CO 80920
Issue: All of us probably agree that Family Limited Partnerships (FLPs) are an excellent planning tool. Assets are protected, estate and gift taxes are reduced, family members can be brought into the business, control is maintained and asset planning and management are simplified and enhanced. All of these are worthy goals; however, nearly all of the monetary benefits of the FLP occur following death. Essentially, the heirs benefit in real dollars, while the donor benefits by knowing that he/she preserved the estate and planned wisely.
The issue raised by this article is: Could planning be enhanced such that donors benefit in real dollars today in addition to the more futuristic and altruistic benefits achieved through FLPs? Is it possible to sell assets today, avoid capital gains taxes and remain in control of the assets? Is this type of POWER PLANNING possible?
Discussion: The answer to the above questions is YES, assuming the client is the majority owner of a corporation. Employee Stock Ownership Plans (ESOPs) are powerful planning tools which provide the "today-type" benefits (the kind that benefit the client today); and when combined with an FLP, which provides basically the "tomorrow-type" benefits (the kind that benefit one's heirs), the results can be nothing short of astonishing. Consider the benefits of an ESOP:
Exit Strategy: The planning process for an ESOP serves as a catalyst for management succession and ownership transfer planning. The planning process is brought into clear focus and critical issues are addressed. The selling shareholder sees the planning process from his point of view, i.e.: How does this benefit me? At the conclusion of the planning process, the company has a type of combined operating plan and last will and testament, which is designed to carry it into the future. The selling shareholder is able to sell his shares to an ESOP and avoid (or defer) the payment of capital gains taxes. This provides a real "today-type" benefit. As an example, suppose a company was valued at $5 million, and the shareholder's basis in the investment is basically zero. An ESOP sale would save the seller $1.4 million in tax (see Section 1042 of the IRC). Furthermore, the seller could still remain in control of the company.
From the standpoint of the company, which borrowed the funds to buy out the seller, the loan will be repaid with pre-tax dollars because the principal on the loan, as well as the interest, is tax deductible to the company. This increases cash flow by reducing or eliminating taxes. Furthermore, under some circumstances, the company can obtain a below prime rate loan to repay the indebtedness (see Section 133 of the IRC). This gets the banker's attention.
From the standpoint of the lender, an ESOP loan can be the best collateralized and most profitable loan in the bank's entire portfolio. If structured properly, only 50% of the interest received on an ESOP loan is included in taxable income (see Section 133 of the IRC). This gets the banker's attention.
From the standpoint of the employees, they become shareholders in the company that employees them. They paid nothing for the shares (the company purchased the shares over time from profits) and they are not responsible for the repayment of the ESOP debt.
Conclusion: POWER PLANNING enters the picture when an ESOP is combined with an FLP. In this way, the client enjoys today's benefits (cash today) and the altruistic benefits of tomorrow. Current cash benefits are increased through avoided taxes and, accordingly, the size of the estate is ultimately increased. Control is never lost. This is POWER PLANNING!! This is the missing link of financial planning.