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Monday, April 29, 2024
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Case Studies |
A Real Life Story from ESOPs Fables
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Case:
Fred Johnson, age 58, is the sole shareholder in a closely held C corporation that remanufactures and distributes used computers. The company was established in 1985 and due to Fred's hard work, ingenuity and foresight, has grown from a garage-based operation into a very successful corporation that nets over $500,000 annually.
To reward his many faithful employees and provide benefits for them in the event of death, disability or retirement, Fred created an employee stock ownership plan (ESOP) in 1990. This is a qualified plan in which the company makes cash contributions that are deductible from its pretax earnings. The money is then reinvested in company securities that are held in trust for the benefit of the employees. The shares purchased by the ESOP may be newly issued shares purchased from the company, or existing shares held by individuals desiring to divest themselves of such shares.
One of the nice benefits to Fred is that he is able to divest himself of some of his shares by selling shares to the ESOP. Then, if he invests the sale proceeds in qualified replacement property (QRP) within 12 months from the date of the sale, the capital gains tax on the sale can be deferred until a disposition of the QRP (not including death, gift or in the event of a reorganization). If there is a disposition of the QRP, in whole or in part, gain must be recognized. Generally, QRPs are defined as securities of U.S. domestic operating corporations and can include stocks, bonds, other certificates of indebtedness and convertibles, as long as they qualify as securities of companies incorporated in the United States.
In fact, in 1995, Fred did sell $500,000 of his closely held stock to the ESOP and took advantage of this deferral of gain rule, i.e., he purchased $500,000 of QRP with his sale proceeds. He has now held these securities over two years and his QRP portfolio has increased in value to $650,000. Fred would like to sell the QRP and reinvest the proceeds in order to diversify his holdings, but he has not done so because of the substantial gain that would be incurred and subsequent capital gains tax that would be due on the sale. (Because Fred's basis in the QRP is equal to his original basis in his closely held stock rather than the purchase price of the QRP, and his basis in the company stock was next to nothing, his gain on the sale would be substantial.)
Fred is an active volunteer and supporter of the local rescue mission. He was recently approached by the planned giving director of the mission regarding making a gift to the mission's new $5.5 million endowment campaign. He has been challenged to make a gift to a life income vehicle in the amount of $500,000 to help support the mission's endowment needs in future years.
Question:
Can Fred use the QRP to fund a life income vehicle and avoid the capital gains tax? In other words, would the transfer of the QRP to, say, a charitable remainder trust be characterized as a disposition of the stock under the ESOP rules resulting in payment of capital gains tax?
Solution:
In consultation with his tax attorney, Fred is pleased to learn that according to Private Letter Ruling 9547022, a gift is not considered a disposition of QRP. Therefore, Fred can contribute part or all of the QRP to a charitable remainder trust. The charitable trust can then sell the QRP without payment of capital gains taxes, which can, in turn, diversify its investments. As a result, Fred decides to transfer $500,000 of the QRP to a 6% charitable trust payable to him over his life. At his demise, the assets in the trust will be transferred to the mission.
The benefits to Fred of using the QRP to fund the charitable trust are many: (i) He receives a current income tax deduction of $160,275, (ii) He bypasses capital gains on the sale of the QRP of almost $500,000, (iii) He receives lifetime income, and (iv) He is able to benefit the mission's endowment needs in the future.
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