ESOP and a Charitable Trust: Stronger & Better Together

For a business owner, selling their business may be the most significant financial decision in their life. But what if that sale not only brought the monetary windfall desired, but did it in a way that lessened any tax impact, and allowed a long-lasting charitable legacy to be built?

By utilizing both an ESOP and charitable trust together, the business owner can get the best of all outcomes.

Planning a business exit? An ESOP and a charitable trust are a powerful duo.

What is an ESOP?

An employee stock ownership plan (ESOP) is a qualified retirement plan, much like a 401(k), but with a critical difference: it's designed to buy and hold the company's stock. Although a business owner can create an ESOP at any time, this article will focus on the creation of an ESOP specifically for the purpose of a business owner looking to exit their company.

In this context, the owner has a ready-made customer for their business: the company employees.

Tax Advantages for the Owner

Depending on the company’s legal & tax structure, these include:

- Tax-Deferred Capital Gains:  For C-Corporation owners who sell at least 30% of their stock to an ESOP, capital gains tax on the sale can be deferred (or potentially eliminated) by reinvesting the proceeds in U.S. securities.

- Tax-Free S-Corporation Earnings: A 100% ESOP-owned S-Corporation effectively pays zero federal income tax on its share of the profits. This creates powerful cash flow for the company.

What is a Charitable Trust?

A charitable trust is an irrevocable trust that exists to provide financial benefits to nonprofits, but also provides tax & income benefits to the donor who created the trust.

There are two primary types:

• Charitable Remainder Trust (CRT): this trust provides an income stream first to the donor (or their heirs) and the remainder gets paid to charity. The income stream can be set for a specific number of years, or the life of the donor.

• Charitable Lead Trust (CLT): this trust provides an income stream first to the charity and then the remainder gets paid to the donor (or their heirs). This income stream can also be set for a specific number of years, or the life of the donor.

How Does an ESOP and Charitable Trust Work Together for a Business Exit?

In simplest terms, the process works as follows:

1. The business owner transfers all (or a portion) of the company stock to a charitable trust

2. The charitable trust becomes the seller of the company stock

3. The ESOP is the buyer of the company stock

4. The company owner and charity(s) receive income. The timeliness of that income is dependent upon if a CLT or CRT is being utilized.

Key Benefits

Several advantages of this integrated approach for the business owner include:

• Maximize After-Tax Wealth: Capital gains tax can be deferred/eliminated with the sales proceeds working for the owner inside the trust.

• Income Stream: If a CRT is used, it can provide a reliable ongoing income stream during retirement.

• Diversification: The business owner is able to convert the illiquid company stock into a diversified portfolio inside the charitable trust without incurring immediate tax liability.

• Charitable Impact: By its nature, the trust is designed to provide gifts to charity(s), allowing the owner to do societal good beyond their business success.

Conclusion

Creating an ESOP and a charitable trust is a string of complicated choices and processes that require time, expense and thoughtfulness. At Generosity Nexus, we have the professional insight, experience, and expertise to guide you through this complex process.

Don’t hesitate to schedule an appointment to learn more about how we can help you.