Coupling ESOPs with Charitable Remainder Trusts, Part 1 of 2

Coupling ESOPs with Charitable Remainder Trusts, Part 1 of 2

Article posted in Privately Held Business Interests on 27 July 2016| comments
audience: National Publication | last updated: 28 July 2016


Attorney Lou Diamond explains Employee Stock Ownership Plans (ESOP)s and how they may integrate with several charitable solutions.

By: Louis H. Diamond, Esq.


It is rare that we come upon situations that enable us to take advantage of major tax saving opportunities that, when coupled together, get even better.  One such opportunity is when employee stock ownership plans (ESOPs) are coupled with charitable remainder trusts (CRTs).  Congress has made it clear, by providing tax incentives, that two things it desires to promote are employee ownership and charitable giving.  Our mission in this article is to acquaint you with the outstanding results that can be achieved by means of coupling ESOPs with CRTs. 

I.          INTRODUCTION.[1]

            In time, all astute owners of non-publicly held businesses become interested in estate and business succession planning and diversification.  More often than not, Employee Stock Ownership Plans (ESOPs) provide the best means to accomplish all of these goals.  However, only it is not common knowledge that coupling Charitable Remainder Trusts (CRTs) with ESOPs can provide a lucrative way to achieve these objectives under circumstances where all parties involved -- existing stockholders, heirs, up-and-coming management, and stockholders' favorite charities -- come out well ahead of where they would be under other planning alternatives, with the only loser being the Fisc.

            To lay the foundation for the planning that can be accomplished through this combination, we should first become familiar with the salient features of each of these components separately.  First, ESOPs.


            An ESOP is a type of a qualified deferred compensation plan.  It is a defined contribution (as opposed to defined benefit) plan that is similar to a profit sharing plan, but that is specifically designed to invest primarily (i.e. more than 50%) in employer stock.  The participants in this plan are employees of the sponsoring employer and will, in time, reap the rewards that can be expected to come from having a financial stake in the well being of their employer.  To induce employers to implement ESOPs, Congress has extended to business owners an aggregation of special tax and other benefits that exceed anything else within our tax system.  For instance, in all qualified deferred compensation arrangements, employers obtain a current deduction for funding these plans which then grow tax-free until benefits are paid out, and employee's taxable income is deferred until the time when it is paid out to them from the plan.  ESOPs have these advantages, but also many more.  In particular, actions that would constitute prohibited transactions in other plans are permitted in ESOPs.  Companies and their stockholders that sponsor ESOPs can sell stock to them[2], lend them money[3] and guarantee their loans[4] without triggering prohibited transactions.  This makes possible the "ESOP loan" which is, in turn, the touchstone that gives rise to so many more outstanding benefits.[5]

            More specifically, among other things, ESOPs can accomplish the following:

            A.        Enhance Liquidity / Preserve Working Capital.

                        ESOPs can enable their sponsor to enhance liquidity and preserve working capital through the simple expedient of contributing company stock, rather than cash, to its ESOP and thereby obtaining a tax deduction without the expenditure of an "asset", as such.  Instead, only a "below-the-line" capital adjustment results.  This tax savings without use of assets enhances liquidity and builds a stronger balance sheet.  It does, however, dilute to some degree the ownership percentage of existing stockholders.

            B.        Increase Tax Deductions.

                        ESOPs can provide larger tax deductions than normal qualified plans.  Corporate employers can enhance deductible ESOP contributions that are used to amortize an ESOP loan by excluding from the normal 25% of payroll both forfeitures and the portion of the contribution that is used to pay interest and thus, in some instances, double the permissible contribution from 25% up to 50% for all of the company's qualified plans.[6]

            C.        Avoid Tax Through S Corporation Status.

                        ESOPs are eligible tax-exempt stockholders of S corporations, but are relieved of the obligation to pay a federal unrelated business income tax (UBIT) on their share of company earnings.

            D.        Conversion of Ordinary Income Into Long-Term Capital Gain.

                        Employee participants can obtain long-term capital gain, rather than ordinary income, on the appreciation in company stock that is distributed from the plan to them as a part of their benefit entitlements, provided certain conditions are met.

            E.         Deduct Dividends.

                        C corporation employers can deduct (subject to the alternative minimum tax) dividends paid on ESOP stock when the ESOP either uses them to repay stock acquisition debt or passes them through to participants, or if plan permits, allow participants to direct the ESOP trustee to use their aliquot share of the dividend to purchase more company stock for their account.[7]

            F.         Tax-Free Diversification.

                        The best known and most utilized ESOP benefit is the entitlement of stockholders to diversify tax-free by selling stock to their company's ESOP and "rolling-over" (i.e., reinvesting) their proceeds into Qualified Replacement Property (QRP) that consists of securities (i.e., stocks, bonds or notes) of other U.S. operating corporations.  In contrast, normally sellers of stock must pay tax on their gain while buyers incur a non-deductible cost.  Since these replacement securities need not be sold by the taxpayer prior to death, this particular ESOP attribute of IRC §1042 enables sellers to permanently, not just temporarily, avoid the payment of an income tax on their gain, while their corporation, by means of both deductible contributions and dividends to its ESOP, gains a deduction for the monies that the ESOP pays tax deferred, or even tax-free with proper planning, to the selling stockholders.  The following example illustrates how dramatic this combined tax benefit can be.

Sale to ESOP at $7,000,000 vs. sale to Company at $7,000,000

After-Tax Benefits to Seller

After-Tax Cost to Company

ESOP Alternative



Non-ESOP Alternative






Total Tax Savings Using ESOP


Here, a $7,000,000 stock sale to an ESOP produces aggregate tax savings to the company and the shareholder of $4,200,000.

            Congress recognized that IRC §1042 bestows upon those who qualify for its use most enticing tax benefits and, accordingly, placed a number of readily satisfied requirements as prerequisites to its use, to wit:

            1.         Characteristics of Stock to Be Sold

      a.   The stock involved must constitute "best common," which means that it must have voting and dividend rights that are at least equal to those of any other class of common stock.

      b.   The stock must be of a nonpublic U.S. corporation.

      c.   The stock must have been held by the seller for at least three (3) years.

      d.   The stock cannot have been received in a distribution from another qualified plan or pursuant to an option or other tax advantaged arrangement available only to employees.

      e.   A sale of that stock to other than the ESOP would qualify for long-term capital gain treatment.

      f.    Immediately after the sale of stock, the ESOP holds at least 30% of the total value of all stock, or 30% of the total number of shares of each class of stock.

      g.   An S corporation stockholder is not eligible for IRC §1042 treatment (nor is a C corporation seller).

                        2.         Requirements to Effect an IRC §1042 Election

      a.  Seller must file a timely election with its federal income tax return for the year of the sale.  The requirements for this election are strict, but compliance with them should not present a major problem so long as the seller is properly represented by knowledgeable advisors.

      b.  Consent by the company to a 10% tax on the amount of a “premature distribution.” 

      c.   Consent by the company to a 50% prohibited allocation tax.  Stock sold to an ESOP in an IRC §1042 transaction cannot be allocated within the ESOP, to either the seller or 25% stockholders of Target.  Stock can also not be allocated to the family of the seller subject to a 5% de minimis limitation. 

      d.   "Qualified Securities" must be purchased by the seller as "Qualified Replacement Property" (QRP) within one year from the date of the sale.  In general, QRP consists of stock, bonds, or notes of active U.S. corporations. 

            A problem frequently arises when the corporation involved is an S corporation.  Unfortunately, stock in an S corporation is not "qualified employer securities"[8]and is thus ineligible for 1042 treatment.  While this is often viewed as a reason not to even consider a 1042 transaction, it shouldn't be.  In most instances, the owners of an S corporation can give up that status and become a C corporation eligible for a 1042 sale.  Then, during the five year hiatus until S status can be restored,[9] enhanced ESOP contributions and deductible dividends[10] usually can be made to reduce the now C corporation's net taxable income down to or near zero.  It is wise to confirm this by means of a feasibility study covering the time-frame involved.

III.       What Are Charitable Remainder Trusts?

The charitable remainder trust is a technique that allows a Donor to take an income, estate and/or gift tax charitable deduction for an amount transferred in trust, where the income of the trust (expressed as a percentage of the trust’s initial or yearly fair market value) is paid to the Donor (and/or others designated by him or her) for a specified term or for life, and the remainder is paid to one or more charities at the end of the term.  The amount of the deduction is limited to the actuarial value, determined under IRS tables, of the remainder interest at the time of the contribution.[11]  In general, these trusts must be in the form of a “charitable remainder annuity trust” or a “charitable remainder unitrust”. 

A charitable remainder annuity trust is a trust that pays a sum certain annually (expressed as either a dollar amount or as a fixed percentage of the initial fair market value of the trust’s assets) to one or more non-charitable beneficiaries during the term of the trust, which may be measured by the income beneficiary’s life (or lives) or by a fixed period of no longer than 20 years.  This sum must be at least five percent, and no more than 50 percent, of the value of the assets of the trust valued as of the date they were transferred to the trust.  Again , however, the charity’s remainder interest in the trust must be equal to at least 10 percent of the value of the assets placed in the trust.  No additions may be made to an annuity trust.

A charitable remainder unitrust must pay a fixed percentage of at least 5 percent, and no more than 50 percent, of the net fair market value of its assets valued annually to one or more non-charitable beneficiaries for their lives or for a period of no longer than 20 years.  The unitrust requires yearly valuations, and, for this reason, the amount of the payout will vary, and hopefully increase, with the value of the trust assets. The charity’s remainder interest in the trust must be equal to at least 10 percent of the value of each contribution to the trust.  Donors may make additional contributions to a charitable remainder unitrust.[12]

After the initial contribution, the annuity or unitrust beneficiary is taxed on the annuity or unitrust amount received to the extent of the trust’s income for the taxable year.  The trust itself is exempt from all income taxes except in a year in which it has "unrelated business taxable income" - generally income from active business, as opposed to investment, activities. 

Any Donor considering establishing a charitable remainder trust should be aware, in general, of the private foundation provisions (other than the §4940 tax on net investment income) as they apply to these trusts.  The primary private foundation provision with which charitable remainder trusts must be concerned is the prohibition on self-dealing found in §4941 of the Code.  Section 4941 imposes a series of taxes on “disqualified persons” and foundation managers who engage in certain types of prohibited business transactions with a private foundation.  “Disqualified persons” include substantial contributors to the private foundation, foundation managers (such as trustees), and persons related to them, such as family members and related business entities.

            A.        Advantages.

            The charitable remainder trust has several advantages.  These include:

  1. Retention of the right to the income from the contributed property for a term of years or for life;
  2. The ability to sell appreciated property contributed to the trust without incurring a tax;
  3. The ability to control the investment decisions of, and, to a certain extent, the timing of distributions from, the trust (assuming that the donor, or his designee, is the trustee); and
  4. Recognition of the contribution by the charitable remainderman which is in most cases equivalent to that accorded outright gifts.
  5. The charitable remainderman may be the donor's private foundation, thus enabling the Donor's family members (generally children) to continue to manage and distribute trust assets as part of the foundation's endowment after the trust's termination.

            B.        Disadvantages.

                        Among the disadvantages of charitable remainder trusts are:

  1. The income (and estate and gift) tax charitable deduction is smaller  because it is limited to the actuarial value of the remainder;
  2. The trust will be treated as a private foundation and will be subject to many of the restrictions imposed on those entities; and
  3. The remainder will eventually go to charity, rather than to the donor’s family. In some cases, depending on the age and insurability of the donor, the wealth lost by contribution to a remainder trust may be replaced by using the income and tax savings from the trust to establish an insurance trust for the benefit of the donor’s children.

            Charitable remainder trusts are irrevocable trusts designed to, ultimately, pay out their corpus to qualified charities.  But, during the interim between the time when they are created and pay out their corpus to their charitable beneficiaries, the grantor and persons designated by him or her (usually a spouse) receive payments from the CRT in the form of either a straight annuity (a Charitable Remainder Annuity Trust [CRAT]) or a fixed percentage of the annually determined fair market value of the trust's corpus (a Charitable Remainder Unitrust [CRUT]). CRTs are income, gift and estate tax exempt and donors are entitled to a current income tax charitable deduction equal to the actuarially calculated value of the charity’s remainder interest. 

For instance, a contribution of $1 million to a CRAT by a 60-year-old person in July 2004 with a retained 5% (i.e., $50,000) annuity, payable annually at the end of the year, would produce a current charitable contribution deduction in the amount of $406,245.  A contribution of $1 million in the same month to a CRUT with a reserved pay out equal to 5% of the annual fair market value of the trust would give rise to a current charitable deduction in the amount of $394,400.  The amount of the charitable deduction varies based upon the “applicable federal rate” (published each month by the IRS) in effect during the month of the contribution.  Interestingly, since interest rates were so much higher two years ago, the same contribution to a CRAT in July 2002 would have produced a charitable deduction in the amount of $458,605.

            Then there is an interesting phenomenon known as a "Net Income Makeup Charitable Remainder Unitrust" (NIMCRUT).  Under this arrangement, the grantor can retain the entitlement to a current payment equal to the lesser of actual income earned by the trust or the stated percentage of the trust's fair market value as of year-end.   Where, however, actual income is less than the stated percentage times the fair market value of the trust, the deficiency can be made up in future years if actual post-contribution appreciation exceeds the fixed percentage times the enhanced fair market value of trust assets as it would with just the passage of time.  With proper planning, a NIMCRUT can be designed so as to constitute a form of pension arrangement that should correlate well with the changing needs of the grantor.  This would be the case where the grantor, who controls the investments of the trust, chooses during his working years to cause the trust to invest primarily in high growth/low yield securities, and then, upon reaching retirement, changes the investment philosophy so as to sell the appreciated portfolio (tax-free, of course) and reinvest the proceeds into high yield/low risk securities that can be expected to produce a current yield higher than the reserved percentage.  Accordingly, a later reversal of the investment strategy should enable the distribution shortfall to be recovered through subsequent payouts that are higher than called for under the terms of the trust.  Since the NIMCRUT will have made small (or, perhaps, no) distributions during the years they were not needed, it will have been primed to make larger ones during the later post-retirement years when larger payments are desired to support the grantor’s lifestyle.

About the Author

Louis H. Diamond, Esq., is one of the leading ESOP (Employee Stock Ownership Plan) attorneys in the country. His work with ESOPs is all encompassing, ranging from representing owners selling stock to an ESOP, employees pooling ESOP funds to purchase their division/subsidiary from corporations large and small, banks and others making ESOP loans and ESOPs themselves and their trustees. Representing the employees of the Illinois Institute of Technology Research Institute (now Alion Science and Technology) in a $130 million employee buyout of its operating assets is among Mr. Diamond’s most notable ESOP achievements.

Visit Diamond ESOP Advisors LLC for more information.

[1] This article is an adaptation of Chapter 26 in a two-volume treatise compiled  under the direction of Robert W. Smiley, Jr. and other ESOP experts entitled "Employee Stock Ownership Plans," published by the Beyster Institute at the Rady School of Management, University of California, San Diego. 

[2]    IRC §4975(d)(13) and ERISA Section 408(e)

[3]    IRC §4975(d)(3), ERISA § 408(b)(3), and Treas. Regs. §54.4975-7(b)(3)(i)

[4]    Treas. Regs. §54.4975-7(b)(1)(ii)

[5]    See IRC §404(a)(9) which permits a plan sponsor to deduct 25% of covered compensation plus interest on an outstanding ESOP loan.  This expanded contribution and deduction limitation is only available to leveraged C corporations.

[6] A good argument can be made that, pursuant to IRC §404(a)(9), the ordinary 25% contribution limit can be combined with the 25% limit for leveraged C corporation ESOPs and authorize the allocation of up to a 50% contribution to the ESOP without violating the IRC §415 limits.  This deduction limit is independent of the limit in IRC §404(a)(3) (dealing with multiple defined contribution plans) and IRC §404(a)(7) (dealing with defined benefit and defined contribution plan combinations) which permits the deduction of annual contributions of up to 25% of participants' covered compensation.

[7]   IRC §404(k)

[8]   Qualified Employer Securities is defined as securities that are issued by a domestic C corporation with no stock outstanding that is readily tradable on an established securities market. See IRC §1042(c)(1).

[9]   An S corporation that gives up that status cannot reelect S status for a period of five years.  IRC §1362(g).

[10]   IRC §404(k) makes dividends to an ESOP on stock acquired through financing deductible under circumstances that would usually apply to the type of transaction here contemplated.

[11]   See IRC §664.

[12] On August 29, 2005, the IRS released approved forms for CRUTs.  See Rev. Proc. 2005-52, Rev. Proc. 2005-53, Rev. Proc. 2005-54, Rev. Proc. 2005-55, Rev. Proc. 2005-56, Rev. Proc. 2005-57, Rev. Proc. 2005-58, and Rev. Proc. 2005-59.

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