As we have said, an ESOP is a very powerful tax and business succession planning tool available to shareholders of a closely held company. The owner has the ability to sell stock to a trust created pursuant to an employee stock ownership plan (ESOP) and defer or permanently avoid taxation on any gain resulting from the sale. This tax deferral (and, possibly, complete avoidance) is available, however, only if the following requirements are satisfied:

• The selling shareholder must be either an individual, a trust, an estate, a partnership, a limited liability company, or a subchapter S corporation (an “S corporation”), and must have owned the company stock sold to the ESOP trust for at least three years.
• The selling shareholder must not have received the stock from a qualified retirement plan (e.g., an ESOP or stock bonus plan), by exercising a stock option, or through an employee stock purchase program.
• The sale must, otherwise, qualify for capital gains treatment but for the sale to the ESOP trust.
• The stock sold to the ESOP trust must (in general) be voting common stock with the greatest voting and dividend rights of any class of common stock or preferred stock that is convertible into such voting common stock.
• For the 12 months preceding the sale to the ESOP trust, the company that establishes the ESOP must have had no class of stock that was readily tradable on an established securities market.
• After the sale, the ESOP trust must own at least 30% of the company that establishes the ESOP (on a fully diluted basis). Although not a requirement for the tax deferral, the company also must consent to the election of tax-deferred treatment. A 10% excise tax is imposed on the company for certain dispositions of stock by the ESOP within three years after the sale (and while the ESOP loan is outstanding, in certain circumstances); and, a 50% excise tax is applied if certain prohibited persons (i.e., the selling shareholder and/or certain family members and/or more-than-25% shareholders) receive allocations of the company stock that the selling shareholder sold to the ESOP trust.
• Within a 15-month period beginning three months before the sale to the ESOP trust and ending 12 months after the sale, the selling shareholder must reinvest the sale proceeds in qualified replacement securities (QRP) (common or preferred stock, bonds, and/or debt instruments) issued by publicly traded or closely held domestic corporations that use more than 50% of their assets in an active trade or business and whose passive investment income for the preceding year did not exceed 25% of their gross receipts. Municipal bonds are not eligible reinvestment vehicles, nor are certificates of deposit issued by banks or savings and loans, mutual funds, or securities issued by the U.S. Treasury.
• The ESOP must be established in a C corporation, not an S corporation. (S corporation ESOPs do, however, have their own substantial tax advantages, discussed below.)

Again, we strongly recommend that you confer with a knowledgeable ESOP advisor before proceeding.

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