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Bail yourself out with an Employee Stock Ownership Plan

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in Small Business Tax

Are you facing a cash crunch because most of your wealth is tied up in your company? If the current economic slowdown continues, your personal assets could be depleted over time.

Of course, you could sell a portion of the company and reinvest the funds elsewhere. But this may cause you to lose control of the business. And the sale might generate a huge tax bill.

Create an Employee Stock Ownership Plan (ESOP). Sell some or all of your shares in the company to a separate entity that becomes the official “owner” of the business. This technique enables you to reinvest in a diversified portfolio, retain control of the business and avoid taxes indefinitely—all in one fell swoop.

Balance all the factors

Be aware that ESOPs aren’t right for everyone, and they come with a price tag. It’s important to conduct a feasibility study to see whether it makes sense to go ahead. To protect the deal from an IRS challenge, obtain a formal valuation from an independent expert in the field. You may find the pros outweigh the cons if the bulk of your net worth is locked up in highly appreciated shares of the company.

Moreover, after the ESOP is in place, you can continue to run the operation as before. Employees don’t vote to select board members, and you don’t need to provide employees with the company’s financial data. One requirement: Let each participant vote the shares allocated to his or her account for certain transactions, such as mergers and liquidation.

Big tax break:
If you own a C corporation and hold the shares for at least three years, 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% of the company after the purchase.

Leverage the deal

Where does the ESOP get the money to pay for the company shares? It can borrow the money from the company, the same money the company borrowed from a third-party lender.

To sweeten the deal, the tax code provides special treatment for leveraged ESOPs (see box).

When it repays the loan’s principal, the C corp can make deductible contributions up to 25% of the covered participants’ compensation. Plus, it can deduct contributions used to repay loan interest.

Note that an ESOP will work only if the company generates adequate cash flow and shows enough financial strength to obtain a loan from the third-party lender. In these circumstances, it’s a good source of diversification and liquidity.

Tip: This is not a do-it-yourself proposition. Have your tax pro explain the details.

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