A Tax Bonanza: S Corporations And Esops


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by Robert Nein

The 1997 Tax Relief Act has made possible the best of all worlds for insurance agencies. One could not hope for a better opportunity.

There has long been an argument that a sub-chapter S corporation is a better format for agencies. A different camp maintained that a C corporation had the advantage of avoiding double taxation on sale of the agency assets, but the individual income tax on agency owners was higher than the corporate tax. The C corporation has lower corporate income taxes, and if you sell to an ESOP, you can achieve no capital gains tax.

Now, the argument is moot. The S corporation can now have an ESOP, and if the ESOP owns 100% of the agency, there's no tax on corporate earnings since the ESOP is a tax-free entity.

How can agencies attain this status? Agency owners of an S corporation must sell all their stock to the ESOP to obtain a tax-exempt status. Selling to the ESOP does not mean that the owners give up control of the agency. They continue to manage the agency; the board of directors continues to elect officers and run the company as before. The agency owners pay 20% capital gains tax but are eligible to participate in the ESOP. The ESOP borrows the money to buy the stock, and pays off the loan through ESOP contributions and agency profits (distributions). Since the ESOP is a tax-free entity, no corporate income taxes are paid. ESOP contributions are allocated to all employees on the basis of total remuneration.

If you're now a C corporation, one additional step is required; set up an ESOP for your C corporation and sell 100% of the stock to the ESOP. The ESOP can borrow the money to purchase the stock-or even better, the stock can be sold to the ESOP on an installment basis, reducing the need for borrowing. The C corporation is then converted to an S corporation. Since the only stockholder is the ESOP, a tax-free entity, the loan is then repaid with pre-tax dollars.

Do you now have a profit-sharing plan? If so, you may now convert your current profit-sharing plan to an ESOP, sell all the stock to the ESOP, and then convert to an S corporation. Distributions to the ESOP go to the account of each participant on the basis of its value in relation to the overall plan. This rewards long-term employees. ESOP contributions are allocated on the basis of payroll.

And what's the icing on the cake? The same board of directors retains control of the agency. Of course, there's a fiduciary responsibility to the ESOP shareholders, but isn't a good agency always run that way? So you may have your cake and eat it too-with icing!

Robert K. Nein, CPCU, CLU is president of Central Virginia Insurance Consultants, Inc., 407 St. Andrews Circle, Lynchburg, VA 24503, (804) 384-0140, fax (804) 386-4842, E-mail: [email protected].

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