One of the most compelling problems in a divorce concerns the division of marital property, which includes a closely held business.
In such instances, the business is frequently the major portion of the marital estate. Often this problem is somewhat resolved with a transfer of a portion of the company’s stock followed by a stock redemption. When property is transferred from one spouse to the other incidental in a divorce, it is a tax-free transaction under IRC Section 1041. Due to the complexities involved, the IRS has often challenged this type of program. Most divorces, therefore, result in the provider requiring either a bonus or distribution of profits to meet the obligation. The ensuing tax burden then reduces the amount of funds available to meet the payment for the portion of the business.
A unique alternative may be of value in certain circumstances. The use of an Employee Stock Ownership Plan (ESOP) affords the seller of at least 30% of the outstanding stock to the ESOP tax free treatment (under IRC Section 1042) when the sales proceeds are invested within the prescribed period in equalified replacement property (essentially US corporate stocks and bonds). The replacement stock can then be distributed tax-free to the spouse under IRC section 1041. The spouse will not need to be concerned about the provider’s ability to make payments and will receive a diversified portfolio. However, the receiving spouse will be liable for the capital gain taxes if, and when, the replacement stock is sold.
The ESOP will need to borrow funds from a lender (with a corporate guarantee) and the corporation will be able to make tax-deductible contributions to the ESOP to repay the lending institution. An example of the possible tax savings is presented on the attached page. Although simplified for presentation purposes, the illustration presents a large tax savings as well as enhanced cash flows.
An ESOP is, therefore, acting as a facilitator for the owner of a closely held business to meet the property obligations in a divorce situation, effectively minimizing taxes in the transaction. If desired, further programs relating to charitable and non-charitable gifting and estate tax planning become available with the formation of an ESOP.
The benefits to the parties in the illustration indicate that beyond the use of ESOPs for tax purposes, there is great merit in the attributes of an ESOP as a financial tool.
ESOPs And Divorce
Analysis of Property Settlement
Problem:
Property settlement is for $360,000 per year (Five years)
Tax rates:
Corporate 35%
Individual 40%
|
Company
|
Shareholder Provider
|
Total
|
|
| Income (currently) |
$700,000
|
$300,000
|
$1,000,000
|
| Needed to pay on settlement: | |||
| Bonus |
(600,000)
|
600,000
|
0
|
| Taxes |
(240,000)
|
(240,000)
|
|
| Payment to spouse |
(360,000)
|
(360,000)
|
|
| Normal tax |
(35,000)
|
(120,000)
|
(155,000)
|
| Remaining |
$65,000
|
$180,000
|
$245,000
|
| Total tax paid |
$395,000
|
UTILIZING ESOP:
|
Company
|
Shareholder Provider
|
Total
|
|
| Income (currently) |
$700,000
|
$300,000
|
$1,000,000
|
| ESOP Contribution |
(360,000)
|
(360,000)
|
|
| ESOP loan interest |
(120,000)
|
(120,000)
|
|
| Normal tax |
(77,000)
|
(120,000)
|
(197,000)
|
| Remaining |
$143,000
|
$180,000
|
$323,000
|
| Total tax paid |
$197,000
|
||
| Total Tax Savings (per year) |
$198,000
|
||
| Total cash flow savings (per year) |
$78,000
|
Robert J. Krawitz, CPA, CVA, has over 35 years of experience as a public accountant. He is a partner with BrookWeiner, L.L.C., a Chicago based CPA firm specializing in consulting and valuations of closely-held businesses.
Gregory K. Brown is a partner with Gardner, Carton & Douglas with 25 years’ experience in Employee Benefits and Executive Compensation, including extensive work with ESOPs and ERISA. He has represented clients as an expert witness on behalf of clients’ ESOP/Employee Benefits Plans both regionally and nationally.
Add A Comment