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Create an ESOP to diversify portfolio, earn sweet tax breaks

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in Small Business Tax

Small business owners like you often face diversification and liquidity problems because most of your wealth is tied up in the company. If your business experiences a serious reversal, your personal assets could be depleted.

You could sell a portion of your company, allowing you to reinvest elsewhere. But this may cause you to lose control of the business. What's more, the sale could generate a huge tax bill.

Solution: Address all of these concerns by creating an employee stock ownership plan (ESOP). You can sell some of your company's shares to an ESOP, reinvest in a diversified portfolio, retain control of the business if you desire and avoid taxes indefinitely.

The catch? Creating and maintaining an ESOP isn't cheap. You'll probably need to pay for a feasibility study to see if it makes sense to go ahead, then you'll have to pay for a formal valuation to protect the deal from an IRS challenge.

But the benefits may be worth the cost if too much of your net worth is locked up in highly appreciated shares of your company.

Moreover, after an ESOP is in place, you can continue to run your business as before. Employees don't vote to select board members, and you don't need to provide employees with the company's financial data. All you're required to do is let each participant vote the shares allocated to his or her account for certain transactions, such as mergers and liquidation.

The tax break? If you've held your shares for at least three years and your business is a C corporation, you can defer capital gains tax on the sale of stock to an ESOP. That tax deferral kicks in if the ESOP owns at least 30 percent of the company after the purchase.

Because an ESOP's impact and finer details are best illustrated by an example, see the box below.

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