Beating Taxes When Selling Your Business: What Benjamin Franklin Didn't Know Can Help You

• Publication year: 2020
• Author: By Eric Bardwell, Esq. and Jeremy Huish JD, CPA

Beating Taxes When Selling Your Business: What Benjamin Franklin Didn't Know Can Help You

How Combining Qualified Small Business Stock with an Employee Stock Ownership Plan Transaction Can Reduce or Completely Eliminate Federal Income Tax on a Liquidity Event

By Eric Bardwell, Esq. and Jeremy Huish JD, CPA¹

When Benjamin Franklin famously proclaimed that "in this world nothing can be said to be certain, except death and taxes," he did not contemplate the availability of Employee Stock Ownership Plans and Qualified Small Business Stock.

While it is true that when a business owner sells a company over one-third of the proceeds from the sale may never make it to his bank account, for many business owners this tax can be avoided with proper planning. There are two often overlooked Internal Revenue Code provisions that could defer and potentially eliminate the owner's long-term capital gain tax on the sales proceeds. Structuring a business to take advantage of these provisions often takes some advanced planning, but the extra effort is typically well worth the taxpayer's time. Those two tax provisions are the Section² 1042 election for companies selling to an Employee Stock Ownership Plan ("ESOP"), and Qualified Small Business Stock under Section 1202.

I. EMPLOYEE STOCK OWNERSHIP PLANS AND SECTION 1042

A Section 1042 transaction is similar at a high level to the popular Section 1031 exchange available to defer income taxation on real estate gain. The Section 1042 election allows a business owner to sell the stock of the business and defer the federal and state capital gains tax if the proceeds are rolled over to other stocks and bonds of another U.S. company, and certain other requirements are satisfied.

At a high level, those requirements are:

1. At least 30 percent of the company's stock is sold to an ESOP;³
2. The seller has owned stock in the company for at least three years prior to the sale;⁴
3. The company is a C corporation, or can convert to a C corporation, at the time of the sale, and the stock is not publicly traded;⁵
4. The seller "rolls over" the proceeds of the sale by reinvesting them in qualified replacement property ("QRP") during a period that ends 12-months after the date of the sale.⁶ Mutual funds and government securities do not qualify as replacement property;⁷
5. The seller, the seller's children and certain other relatives, and shareholders who own 25 percent or more of the outstanding shares of the company are prohibited from receiving allocations of the stock acquired by the ESOP in the Section 1042 transaction;⁸ and
6. The rollover must be elected in writing on the seller's income tax return.⁹

If these and other requirements are met, then federal and state income taxes are deferred until the QRP is subsequently liquidated.¹⁰ If the seller is still holding QRP at his or her death, then the QRP will receive a step-up in basis and the taxation on the gain will be avoided entirely. Other ways the Section 1042 deferral can be continued is under a Section 368 transaction, a gift or another Section 1042 transaction.¹¹

QRP generally includes securities (debt or equity) issued by a domestic operating corporation that does not have passive investment income in excess of 25 percent of the gross receipts of the corporation, more than 50 percent of the assets are used in the active conduct of a trade or business, and is not in the same controlled group of companies as the business being sold.¹² For example, assume a taxpayer sold his or her business to an ESOP and then purchased stock in one or more publicly traded companies and satisfied all the requirements of Section 1042. The taxpayer would not pay tax on the gain from the sale unless the deferral is terminated by a subsequent disposition of the QRP.

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Most sellers today choose as their QRP certain financial investments that may provide more flexibility than investing in specific stocks and bonds. Such investments may allow the seller to borrow 80 to 90 percent of those proceeds on a non-recourse, no restriction basis for the remainder of the seller's life, and keep the deferral of Section 1042 in place. The details of QRP are beyond the scope of this article, but the reader should know that there are options.

II. DOES AN ESOP MAKE SENSE IF THE SECTION 1042 TAX ELECTION IS NOT MADE?

There are reasons for a business owner to sell to an ESOP, even if the Section 1042 tax deferral transaction is not available. Such reasons include:

1. The owner can sell the company at full fair market value to a ready and willing buyer (i.e., the ESOP trust);
2. The owner avoids selling the business to an outside 3rd party and becoming an employee;
3. The ESOP generally provides a greater benefit to long-term employees;
4. ESOP owned companies generally have fewer layoffs during a downturn in the economy;
5. The ESOP may assist in transferring ownership to key management or children;
6. The company can operate completely income-tax free if it is structured as an S corporation that is 100% owned by an ESOP.¹³

Reasons for not making the Section 1042 election include scenarios where the business is organized as an S corporation or a limited liability company and the owner does not want to make the C corporation election, the owner wants to be allocated shares of stock from the ESOP and such allocation is prohibited if the Section 1042 election is made, or the stock in the company qualifies as Qualified Small Business Stock under Section 1202 such that there is no need to make a Section 1042 election to defer income taxation.

III. QUALIFIED SMALL BUSINESS STOCK

Section 1202 allows taxpayers to exclude up to 100 percent of the federal capital gains they realize on the sale of "qualified small business stock" ("QSBS") held for at least five years.¹⁴ This provision of the tax code was added in 1993, but it originally allowed only 50 percent of eligible capital gains to be excluded. In 2009, the percentage of capital gains eligible for exclusion was increased to 75 percent, and in 2010, this percentage was increased to 100 percent and the QSBS incentive was made permanent.¹⁵ Many entrepreneurs and investors, as well as their tax advisors, are still not aware that they may be eligible for this benefit.

For stock to qualify as QSBS, the following requirements must...