Estate Planning as Part of an ESOP Transaction
The following piece is a guest blog written by one of our partners, Jason C. Ray of Morgan Lewis and Bockius, LLC.
An often overlooked tax-planning tool is using a family limited partnership (“FLP”) with the tax-deferred sale of stock to an ESOP under Section 1042 of the Internal Revenue Code (“Code”). Using an FLP as part of an ESOP transaction can greatly enhance and protect the value of the selling shareholder’s qualified replacement property (“QRP”). A properly structured FLP can build a protective barrier around the QRP to: (i) prevent seizure of those investments by future judgment creditors; and (ii) provide a significant valuation discount for purposes of estate and gift taxes.
The ESOP Transaction
Company shareholders have the ability to sell their shares of stock to an ESOP and defer, or possibly permanently avoid, taxation on any capital gain resulting from such sale. Code Section 1042 allows individuals, partnerships, trusts, and estates that sell shares of stock of a C corporation to an ESOP to elect to defer the capital gains tax resulting from such a sale.
How does it work?
The non-recognition treatment under Code Section 1042 is available only if all of the following requirements are satisfied:
- The employer’s stock must be sold to an ESOP;
- The ESOP must own, immediately after the sale, at least thirty percent (30%) of either: (i) each class of outstanding stock of the employer that issued the employer stock; or (ii) the total value of all outstanding stock of the employer (disregarding non-voting preferred stock).
- The selling shareholder must have held the employer stock for at least three (3) years before his or her sale of such stock to the ESOP.
- The employer stock (which is being sold to the ESOP) must not have been received by the selling shareholder in a distribution from a qualified plan or a transfer under an option or other right to acquire stock by, or on behalf of, the employer corporation.
- The selling shareholder must file with the Internal Revenue Service (“IRS”) a written election of deferral no later than the due date (including extensions) of his or her income tax return for the taxable year of the sale.
- The selling shareholder must purchase QRP with the proceeds from the sale of his or her employer stock to the ESOP within a period which begins three (3) months prior to the date of sale and ending twelve (12) months after the date of sale.
Qualified Replacement Property
For purposes of Code Section 1042, QRP is defined as any security issued by a domestic operating company which: (i) is not a member of the controlled group of the company in which the employer stock was issued; and (ii) did not have passive investment income in the preceding taxable year in excess of twenty-five percent (25%) of its gross receipts. For purposes of this requirement, the operating company means a corporation in which more than fifty percent (50%) of its assets are used in the active conduct of a trade or business.
Recognition of Previously Deferred Gain
If the selling shareholder sells or otherwise disposes of any item of his or her QRP, he or she must then recognize any previously non-recognized gain with respect to that item. However, this recapture rule does not apply to a transfer of QRP that occurs in one of the following manners:
- In certain corporate reorganizations under Code Section 368;
- By reason of the death of the selling shareholder who elected Code Section 1042 treatment;
- By gift;
- In any transaction to which another Code Section 1042 election is made;
- By way of allocations made to separate trusts partitioned from a trust which had sold the employer stock to an ESOP;
- Pursuant to a distribution from a grantor trust to its beneficiary; or
- Pursuant to a contribution made to a charitable remainder trust.
Family Limited Partnerships
FLPs are a popular estate planning tool and they provide a number of benefits for families, including, but not limited to: (i) income shifting; (ii) protecting assets from creditors; and (iii) reducing or eliminating estate gift taxes by obtaining major valuation discounts on the assets held in the FLP.
How do FLPs work?
An FLP is simply a limited partnership in which all or most of the partners are family members. An FLP arrangement is generally structured so that senior family members transfer assets to the FLP in return for a nominal general partnership interest (usually one percent (1%)) and a substantial limited partnership interest (usually ninety-nine percent (99%)). The general partner of the FLP controls partnership operations and also bears all liabilities of the FLP. Therefore, a good planning technique is to structure the FLP with a corporation or a limited liability company serving as a one percent (1%) general partner. The majority of the interest of such general partner is owned by senior family members. Since the general partner controls FLP operations, and management, senior family members are actually the ones who are in control of the FLP. Some portion of the senior family members’ interests can then be transferred to junior family members by gift or sale over the senior family members’ lifetimes.
Protection Against Creditors
A partnership interest in an FLP is a personal property interest. Each partner owns an undivided interest in the underlying assets of the FLP, but has no specific rights with regard to any individual FLP asset. As a result, a future creditor of a partner has no rights to the assets held in the FLP. Such creditor is limited to recovery only against the debtor partner’s FLP interest.
In most states, the primary remedy of a creditor of a debtor partner is generally to obtain a “charging order” against that partner’s interest in the FLP. Such an order gives the creditor only a right to: (i) the income portion of the debtor partner’s interest (when and to the extent declared by the general partner); and (ii) inspect partnership records. Once the creditor obtains the charging order, such creditor is only an “assignee,” rather than a substitute partner. As such, the creditor is limited to distributions from the FLP actually authorized by the general partner, in its discretion.
A major reason why an FLP is a popular tax planning tool is that transfers of FLP interests (either during life or at death) are often valued at a discount for estate and gift tax purposes. According to IRS rules, the value of transferred property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of all relevant facts. A practical effect of transferring assets to an FLP is that senior family members convert “desirable assets” into “undesirable assets” because of certain restrictions contained within the partnership agreement. A willing buyer would generally be more willing to buy assets outright than to buy an interest in an FLP holding the assets. Therefore, the value of an FLP interest will often be discounted. If properly structured, an FLP can be used by senior family members to transfer assets to junior family members at significantly discounted values (i.e., ten percent (10%) to fifty-five percent (55%) discount).
How do the ESOP & FLP work together?
What often happens following a Code Section 1042 transaction is that the selling shareholder purchases QRP and holds such investments until death. Because the selling shareholder’s heirs get a stepped up basis on the inherited QRP, the result is that no income tax is ever paid on the Code Section 1042 sale transaction. However, the QRP is subject to an estate tax on the value of the QRP at the time of the selling shareholder’s death. Further, the QRP is also subject to the claims of judgment creditors. If the QRP could be transferred into an FLP, however, the results would be: (i) a reduced amount (or eliminated amount) of estate tax upon the shareholder’s death; and (ii) protection against judgment creditors.
The question then becomes how can the QRP be transferred into the FLP without triggering a disposition of the QRP and thereby triggering tax on the previously deferred gain? The answer is contained in certain IRS private letter rulings.
In one IRS private letter ruling, the IRS ruled that a taxpayer’s transfer of QRP to a partnership in exchange for a partnership interest was a disposition of the QRP. The taxpayer, therefore, was required to recognize the previously deferred gain. The IRS reached this conclusion even though a general rule of partnership taxation under Code Section 721 provides that no gain or loss is recognized in the case of the contribution of property to a partnership in an exchange for an interest in the partnership.
The IRS in another ruling, however, held that the following chain of events was not a disposition of the QRP and, therefore, recognition of previously deferred gain was not required: (i) the taxpayer first transfers stock eligible for Code Section 1042 to a partnership, such as an FLP, in a tax free exchange for a partnership interest under Code Section 721; (ii) the partnership sells the stock to the ESOP; (iii) the partnership makes the proper election under Code Section 1042 to defer the capital gain; and (iv) the partnership purchases securities that qualify as QRP.
The effects of combining an ESOP transaction and an FLP arrangement can be substantial. However, it requires careful analysis and strict compliance with all IRS requirements.