A business founded during a marriage can be one of the largest marital property assets that spouses must divide upon divorce. Unfortunately, a community property business or business owned by a married couple can also be the most complicated asset to divide when other marital assets are not sufficiently liquid to allow for a “cash out.” There is at least one option available to help create liquidity in these businesses that can result in the spouse seeking to be cashed out to obtain their desired liquidity without the active spouse losing control of the business.
One innovative technique often overlooked by divorcing spouses is the use of an Employee Stock Ownership Plan (ESOP) to acquire the community or marital interest in a business. An ESOP is a unique type of qualified retirement plan that can own stock of the corporation that sponsors the ESOP. In other words, the ESOP itself becomes part owner of the corporation. To accomplish this ownership structure, the ESOP is permitted to buy stock from a related party (such as the shareholders of the corporation). Most other types of qualified retirement plan transactions that involve company stock are deemed “prohibited transactions” under the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA); therefore, an ESOP presents a distinct advantage.
Furthermore, an ESOP stock transaction can be accomplished by using a promissory note financed by the selling shareholder or by using a loan obtained from a bank. The benefit of a financed transaction is that the ESOP can pay for the stock with pre-tax dollars as opposed to the normal stock repurchase arrangement between spouses which would require one spouse to generally use after-tax dollars for the purpose of buying out the former spouse's interest in the stock. Essentially the U.S. government is subsidizing the initial cost of the buy-out through use of tax deductible payments.
Under certain circumstances, Section 1042 of the Internal Revenue Code permits the spouse receiving the stock sale proceeds to reinvest the sale proceeds and defer the payment of income tax which would normally be due on the sale. Thus, the use of an ESOP can provide significant tax-related benefits to both spouses:
- The spouse acquiring the former spouse's interest by use of an ESOP can redeem that interest with pre-tax dollars. While the beneficial ownership of the ESOP acquired shares belongs to the employees participating in the ESOP, the former spouse still active in the business can serve as ESOP Trustee and control the vote on these shares in most circumstances; and
- The spouse selling their interest may be able to defer the payment of the tax related to the sale of their stock.
Although ESOPs do not fit every circumstance, ESOPs are a flexible mechanism that may work well in a family law-related business division circumstance.
If you have any questions about ESOPs and division of family-owned businesses or retirement benefits upon a divorce, Butterfield Schechter LLP is here to help. We are San Diego County largest law firm focusing its law practice on employee benefits law. Our firm can help you and your business plan for the future. Contact our office today with any questions on how we can help you and your business succeed.