Incorporating a partnership and selling to an ESOP in a tax-free transaction.

• Author: Gruidl, Nick
• Position: Employee stock ownership plan

In addition to providing employees with ownership interests in the business, an employee stock ownership plan (ESOP) can provide significant tax benefits to the corporation and pre-ESOP shareholders. Specifically, for a shareholder selling qualifying shares of a C corporation to an ESOP, Sec. 1042 provides a tax-deferral opportunity. Operation as an S corporation, if qualified and elected after the sale to the ESOP, has the added benefit of preserving passthrough treatment for tax purposes, thereby eliminating corporate-and shareholder-level taxes on the business's earnings (ignoring entity-level S corporation taxes such as built-in gains tax), because an ESOP is generally tax-exempt. These tax advantages make ESOPs an attractive ownership transition tool for all parties involved.

As its name indicates, an ESOP must hold stock, which precludes a partnership from implementing an ESOP without restructuring. Taxpayers may argue that an LLC that has elected to be taxed as a corporation for federal tax purposes can implement an ESOP without formally restructuring; however, this position is unclear, and this item does not address whether it is acceptable. In the event an election to be taxed as a corporation qualifies the entity to implement an ESOP, the election is treated the same for tax purposes as a conversion to corporate status. Specifically, the check-the-box election deems steps to occur that are consistent with a Sec. 351 transaction in which property is contributed to a corporation in return for stock. Sec. 351 is discussed in this item, because if the requirements of Sec. 351 are met, the transaction is tax-free.

Where the existing owners and employees of a partnership or LLC taxed as a partnership wish to implement an ESOP ownership structure, careful planning is necessary to avoid traps for the unwary that could lead to unintended tax consequences. This item explores the main issues a partnership should consider from a restructuring perspective when considering such a transaction.

ESOP Background

An ESOP is a qualified retirement plan that simultaneously offers employee benefits and an ownership transfer mechanism. Specifically, some or all of the company's stock is transferred from existing shareholders or the company to the ESOP, which holds the stock in a retirement plan for the employees. Through the financing mechanisms generally used to fund the ESOP's purchase of company stock, the operating company in effect ends up with tax-deductible principal payments on a loan because the amounts paid on the loan represent contributions to a qualified retirement plan.

Implementation of an ESOP results in a new employee benefit plan, which may replace or supplement other employee benefits. In addition, it often increases cash flow to the...