Tax Secrets: Do not even think of creating an ESOP (until you read this)

Irv Blackman

Why don't I write about employee stock option plans (ESOPs) very often? Because in almost every case where an ESOP is being considered by a business owner, we have found better strategies to do what an ESOP claims to do. Faster. Less costly to implement. No cost or low cost to maintain compared to very high cost of maintaining an ESOP. Other strategies also avoid the huge fiduciary liability you risk with an ESOP.

Best of all, other strategies allow you to avoid income taxes and capital gains tax. Also, you can dodge all those estate tax (the ultimate tax enemy of successful closely held business owners) bullets.

An ESOP cannot avoid one penny of estate taxes.

Thinking of transferring your business to the kids? An intentionally defective trust (IDT), does the job better every time (instead of an ESOP). For example, an IDT allows you to transfer your business to your kids tax free – no income tax, no capital gains tax. Think about it, you can transfer your family business to your business kids (or employees) without paying one cent in taxes.

The crowning blow – and real reason for this article – came years ago. A new client (Joe), hired me to do wealth transfer and estate planning, had just finished a $24 million sale of his company to an ESOP. Joe was 63 years old. A large firm – specializing in ESOP transactions – guided Joe through the entire process. The lawyers who drew the ESOP documents and the bank (both specializing in ESOPs) that is now the ESOP trustee did their jobs well, and according to Joe, acted as cheerleaders from beginning to the end.

Okay, Joe’s company has an ESOP. Here’s how Joe summarizes the entire experience. “They never told me any bad things about an ESOP. Only the good parts. Little by little, after the endless meetings of how to structure the ESOP transaction, I found out things I would like to have known before we signed all the papers. Not happy now. I could have done better.”

To me it’s a professional sin. Doing a transaction with a client’s major asset (their closely held business) and not exploring how the transaction fits into his/her overall financial picture, lifetime goals and estate planning consequences.

The ESOP sales team – here the three professionals (the ESOP specialist firm, the lawyer and the bank) – had an economic interest in having Joe’s company do the deal. For them it’s all or nothing: ESOP (victory and fees) or no ESOP (defeat, no fees). All were credible. None did anything wrong. Yet, Joe (his family, his company and its employees) was not – in the end –served well from an economic and tax standpoint.

Often an ESOP when compared to a do-nothing option makes the ESOP look good. But once other viable strategies are fully explained, the ESOP option fails to make the cut.

Always, but always follow the after-tax dollars (from the beginning of the transaction to the end). First, the current income tax or capital gains tax. Next, any possible deferred tax (like money in a profit-sharing plan or ESOP). And finally, how will the estate tax play on the dollars left after the transaction is done. Experience proves that an intentionally defective truth (IDT) will beat the pants off an ESOP (taxes and economically) every time. Simply put: Got a succession problem, look at an IDT.

Have a question or need to fill in some blanks in your personal situation, call me (Irv) at 847-767-5296 or email me (