Coupling ESOPs with Charitable Remainder Trusts, Part 2 of 2

Coupling ESOPs with Charitable Remainder Trusts, Part 2 of 2

Article posted in Privately Held Business Interests on 1 August 2016| comments
audience: National Publication | last updated: 3 August 2016


Lou Diamond concludes his analysis of the use of charitable planning combined with  ESOPs.

By: Louis H. Diamond, Esq.

Click here if you missed part one.


            That said, how can the combination of these two distinctively different types of tax advantaged alternatives be combined to provide benefits that, in the aggregate, exceed those available by utilizing each of them separately? 

            A.        Creation of a CRT using QRP.

                        Remember that QRP is the product obtained when proceeds of a 1042 sale are reinvested into qualifying securities.  It is important to note, however, that the gain deferred in the form of lowered basis in the QRP is triggered upon its disposition.  In effect, you get only "one bite at the apple".  Accordingly, one must be quite careful when choosing the QRP into which he or she invests the 1042 proceeds so as to minimize the adverse effect of the resulting investment "lock-in".  It is at this point that the CRT enters the picture.  Under applicable law, a contribution of QRP to a CRT is not treated as a "disposition"[1] and, accordingly, can be accomplished tax-free.  Under such circumstances, the selling stockholder’s investment philosophy can be unhampered by the otherwise stifling "lock-in" effect.[2]  Instead of investing ultra conservatively, a more aggressive reinvestment philosophy can be utilized with the intention that the QRP will, either shortly after the 1042 sale to the ESOP or incrementally when the holder of the QRP desires to dispose of it, be made the object of a contribution to a CRT.  This CRT can then sell the QRP tax-free and reinvest the proceeds in more aggressive investment alternatives.

            B.        Stock contribution to CRT followed by CRT sale to ESOP as an alternative to 1042.

                        While the benefits obtainable through 1042 are truly dramatic, this alternative does carry with it "baggage."[3]  However, a different ordering of the same basic scenario may produce significantly better results, depending upon the circumstances.   The alternative, which is advanced here for consideration, is the contribution of stock in the closely held corporation by its stockholder to a CRT which, although not legally bound to, then sells that stock to the company's ESOP which makes the purchase using tax deducted contributions by its corporate sponsor.  Under these circumstances, no tax will have been generated and the full proceeds would be available for investment inside the CRT so as to enable it to honor its annuity payout obligation to its grantor.  Such a scenario has received IRS approval in Revenue Ruling 81-76 (1981-1 CB 516) and its progeny (e.g. PLR 9542040).  In these rulings, the IRS held that the ESOP involved was not a "disqualified person that would otherwise have been prohibited from purchasing the stock of the selling shareholder".  So long as that selling shareholder does, or other disqualified persons do, not have a 35%[4] or more beneficial interest in the purchasing ESOP (which they rarely would), and even though the selling shareholder exercises effective control over the ESOP in his or her capacity as a corporate director, plan committee member or ESOP trustee, that does not negate the advantageous tax consequences of such a transaction.  The question then arises as to which course of action is best?  The answer, as usual, is "it depends".

            C.        Which Is The Best Alternative?

                        1.         1042 Sale Followed By Contribution Of QRP To The CRT.  This is the better alternative --

                                    a.         When the limitations and requirements inherit in 1042 are not particularly burdensome in context.  While the alternative route of stock contribution to a CRT followed by CRT sale to the ESOP is, if properly implemented, entitled to validity,[5] the 1042 sale followed by contribution of QRP to the CRT is not even subject to question.[6]  Accordingly, everything else being equal, we usually recommend utilizing the 1042 sale followed by QRP contribution to the CRT alternative.

                                    b.         Where the sale to the ESOP is to be, in whole or part, self-financed.  The CRT sale to the ESOP with payment in whole or in part being indebtedness (e.g., a note) route is not permissible in this instance since the CRT cannot, in effect, lend money[7] to the ESOP (which it would be doing if it took a note in part payment for the sale). 

                        2.         Contribution to a CRT followed by CRT sale to ESOP.  This is the better choice --

                                    a.         When the shareholder involved would not qualify under 1042, such as:

                                                (1)       When the shareholder is a C corporation or a non-resident alien; or

                                                (2)       Where the shareholder has not held the stock involved for three years or more (but has held it for at least one year, so that that stock is considered a capital asset for purposes of the income tax charitable deduction);

                                    b.         When the stock involved was received as a distribution from another qualified deferred compensation plan, a stock option, a stock purchase plan, or as a form of compensation under IRC § 83;

                                    c.         When the sale of the stock would not qualify as long-term capital gain to the selling stockholder (despite the fact that the amount of the charitable deduction will be limited to the stock's basis to the grantor);

                                    d.         Where, immediately after the sale the ESOP will not own at least 30% of either (1) each class of common stock, or (2) the aggregate value of all common stock of the sponsor corporation;

                                    e.         When the ESOP sponsor has, or has had within one year, stock that is actively traded on an established securities market;

                                    f.          When the ESOP sponsor corporation is not willing to agree to become liable for either (1) a 50% prohibited allocation tax or (2) a 10% premature disposition tax.;

                                    g.         When the shareholder:

                                                (1)       Wants his or her own participant account in the ESOP and/or the accounts of family members or other 25% shareholders, to participate in the allocation of the stock involved in the ESOP purchase;

            Example:        Shareholder and family work in business now an LLC.  Shareholder wants to diversity and plan for retirement.  Shareholder and family want to participate in ESOP on the same basis as other employees.  Action taken -- Shareholder incorporates the LLC as a C corporation.  Shareholder contributes C corporation stock to CRT.  Shareholder and spouse set up a Wealth Replacement Trust.  CRT sells 100% of stock to ESOP for financed cash.  C corporation elects S status and uses its pre-tax income to repay debt.  Shareholder and family get limited stock options without activating 409(p).

                                                (2)       Wants to invest the sale proceeds into non-QRP qualifying investments, such as real estate, mutual funds and government or foreign securities; or

                                                (3)       Wants freedom to actively trade with the stock sale proceeds without triggering a tax on the deferred gain.


            At some point in the business maturation process owners of non-public corporations should plan to diversity so as not to "have all of their eggs in one basket."  It is, of course, best if this can be accomplished on a tax-free (or at least a tax-reduced) basis.  Due to legal ramifications involved in all choices available, the ultimate route to take will be fact driven with no one alternative being always best.  In our opinion, however, utilizing an ESOP as part of the program will usually facilitate this process far better than its alternatives.  Frequently it may be best to combine these alternatives to get the best possible result.

            A.        Hold the QRP Until Death.

                        Diversification will have been achieved by using 1042 as a way to sell stock to an ESOP and use the proceeds of that sale to purchase a diverse portfolio of QRP.  This is true, but it results in the seller being "locked-into" holding that QRP until death.  Under current law,[8]heirs get the QRP at a tax basis equal to its fair market value as of the date when the seller dies.[9]  In effect, this "lock-in" prevents the seller from disposing of that QRP without triggering a tax upon the gain, which would otherwise remain locked into the now disposed of QRP.  Under such circumstances the seller's investment strategy should reflect choices that he or she would not otherwise make.  This "lock-in" can be avoided by the diversification alternatives discussed below.

            B.        "Monetize."

                        Monetizing is a form of recourse margin loan.  It is, however, one where the risk of a loss, and even a margin call, is minimal.   This is because the QRP utilized consists of specially designed notes which mature in not less than 40 years, are not subject to a call for 30 years, putable to the lender after 10 years, and pay interest at a rate that floats with market, being keyed to measuring devices such as short-term commercial paper, the Constant Maturity Treasury Index, or LIBOR.  The issuers of these notes are active U.S. corporations rated AAA/AA (or the equivalent).  Accordingly, the market value of these floating rate notes (FRNs) stays within a fraction of their face value.  They thereby qualify as security for floating rate margin loans of up to 90%, the proceeds of which can be reinvested without risk of triggering the 1042 deferred gain.  Moreover, the interest differential between the FRNs and the margin loan is small, varying between .4% to 1.5% depending upon factors such as the size of the transaction and the extent to which the lender wants the loan, with any excess of the amount paid over that received being deductible against passive income.  It is contemplated that this ensemble will remain in place until the seller dies, after which time the estate would sell or cash-in the FRNs and pay off the margin loan, thereby freeing up the margin equity amount.

                        Accordingly, through monetizing, at a relatively small after-tax interest cost (e.g. .4 - 1.0%), and a loss of the use of 10% of the sale price, 90% of those sales proceeds can be freed up to the seller who could then do with that money as he or she sees fit -- presumably invest it in other unrestricted investment alternatives (e.g., real estate, mutual funds), but also use these freed-up funds to pay for whatever else he or she may desire (e.g., purchase of a boat).

            C.        Go the CRT Route.

                        It should now be evident that the utilization of CRTs has significant potential, aside from their charitable aspects.  More specifically,

                        1.         Retain income from a diversified and tradable investment portfolio.

                                    By coupling 1042 with CRTs, the donor / seller becomes able to control the investment of the 1042 proceeds and reserve the entitlement to an annuity for his or her life and the life of a spouse.

                        2.         Control investments on an ongoing basis.

                                    Through use of a NIMCRUT, the donor / seller can attune the composition of the income stream to best suit his or her personal financial position, making it resemble a form of retirement plan.

                        3.         Obtain a charitable deduction.

                                    Since a CRT is a tax-exempt charitable entity pursuant to IRC §664(c), the donation of QRP or stock to it gives rise to an actuarially calculated deduction,[10] saving income tax in the year of the donation.

                        4.         Preserve the estate by coupling in a "Wealth Replacement Life Insurance Trust."

                                    In line with our specific objective of exploring ways to save tax through ESOP (as opposed to employee benefits and achieving charitable objectives, although they are, in and of themselves, more than worthwhile), we advance the thought of coupling in insurance where preserving an estate for heirs is also important.  Consider using the tax saving generated by the charitable deduction, supplemented by other funds as necessary, to purchase insurance through a "Wealth Replacement Trust" (i.e., an irrevocable life insurance trust).  If this is done correctly, that trust will bypass the donor's estate and create capital for heirs in lieu of leaving them stock in the corporation itself.  Where a couple are joint income beneficiaries of the CRT, it is probable that the cost of last-to-die insurance would be relatively cheap.  In effect, the use of insurance to preserve the estate completes the full planning circle and may be well worth looking into.

            For example, a husband, age 58, and wife, age 52, contribute $1,000,000 to a CRT and receive a charitable deduction worth $136,482.  Husband and wife (both in good health) then purchase a last-to-die life insurance policy with a death benefit of $1,000,000 for a cost of approximately $_____.  Husband and wife then create an ILIT for the benefit of their children and transfer the life insurance policy to the ILIT.  Husband and wife will receive annual payments from the CRT in the amount of $56,610 for as long as they both shall live and upon their death, the corpus of the CRT will go to the designated charity while the $1,000,000 death benefit will fund the ILIT for the benefit of their children.


            The following planning opportunities come to mind and are advanced for your consideration:

            A.        Non-ESOP Diversification Alternative.

                        1.         Diversify Using After-Tax Corporate Distributions.

                                    Diversification using what is left after receiving and paying income tax on corporate emoluments such as (a) compensation, (b) double-taxed C corporation dividends, or (c) S corporation profits, is a slower and less efficient process due to 35% - 40% tax bites.  There are better alternatives.

                        2.         Initial Public Offering (IPO).

                                    An IPO can work miracles (e.g., Google), but it is rarely a viable alternative.

                        3.         Be Acquired By a Publicly-Held Corporation.

                                    While exchanging stock in a closely-held company for stock in a publicly-held company is a step towards diversifying, it falls short of true diversification.  To get to this promised land, former stockholders of the acquired company would have to sell, or otherwise dispose of their stock in the acquiring company.  Keep in mind the fact that a company is publicly traded doesn't keep it from failing (e.g., Enron, Worldcom and many others).  In fact, you could end up locked into the acquiring corporation for any number of reasons (e.g., SEC and Blue Sky restrictions, a thin market, contractual limitation on sale, and more).  And, if the former stockholders of the acquired company want to remedy this successor lock-in, they will trigger the taxes that were otherwise avoided.[11]

            B.        Consider a Blend of Available Alternatives.

                        The alternatives here under consideration are not mutually exclusive.  It might be advantageous to implement an overall plan in stages.  Where the initial 30% ESOP stock holding percentage presents a problem, then the stock contribution to a CRT followed by sale to the ESOP alternative can be utilized initially, then followed later by a 1042 sale with the resulting QRP being contributed to a CRT.  Or, 1042 proceeds can be invested in QRP which is then pledged as security for a loan.  And, where personal access to at least some of the ESOP sale proceeds is desired, the straight sale to an ESOP followed by monetizing can fill that need.

            C.        Couple the CRT with a "Wealth Replacement Trust."

One problem inherent in planning using CRTs is that, following the last to die of the annuitants, the Trust corpus goes to its charitable beneficiary rather than to the grantor’s children.  What then happens to their inheritance?  Here, again, we are not without an answer, and the answer can be to weave a “Wealth Replacement Trust” into the overall plan.  A Wealth Replacement Trust is an irrevocable life insurance trust (ILIT) for the benefit of heirs that is funded with life insurance on the life of its grantor and, where applicable, his or her spouse.  Where two lives are involved, last-to-die insurance best fits this need.  Usually this type of insurance is significantly less costly since it does not trigger until the second death.  Moreover, the tax saved through the charitable deduction engendered by creation of the CRT can probably go a long way toward paying the insurance premiums.  All considered, the ensemble of ESOP, CRT and Wealth Replacement Trust can sometimes outperform a 1042 transaction. 

            D.        Engage In Broad-Based Estate And Business Succession Planning.

                        Usually this type of planning is done without considering the benefits derivable through use of an ESOP as an integral part of the plan agreed upon, let alone the ESOP/CRT combination.  Why this is the case, we don't know, but, as we see it, too many successful business men and women are simply "missing the boat."


            The combinations of ESOPs and CRTs are not for everybody.  But they are worthy of being considered as a planning alternative.  Not only can various ESOP/CRT combinations avoid the income tax, but, when they are coupled with a wealth replacement trust, the estate tax as well.  Hopefully, we have succeeded in our objective of adding another arrow to the planner's quiver.  As we see it, this ESOP/CRT combination is a viable planning alternative pursuant to which tax benefits pay for the cost of making generous gifts to charity (and basking in the recognition that this produces) at little to no cost to stockholders of closely-held companies or to their heirs.


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]   See IRC 1042(e).  A disposition of the QRP would trigger the deferred gain from the sale of stock to the ESOP.

[2]   See "Unlocking the Lock-In Effect of Selling to an ESOP" by Louis H. Diamond and Michael R. Holzman, Tax Management Compensation Planning Journal (February, 2004).

[3]   See infra at discussion of §1042 requirements.

[4]   Section 4946(a)(1)(A through E) defines a “disqualified person” as, among other things, a substantial contributor to the foundation; a foundation manager; an owner of more than 20 percent of the total voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation; members of the family of any of the above; or a trust or estate in which any of the foregoing hold more than 35 percent of the beneficial interest.

[5]   See Rev. Rul. 78-197, 1978-1 C.B. 83.  The same concept should apply to validate a sale of donated stock by a CRT to an ESOP. 

[6]   See TAM 9515002; discussion in Kaplan, Morrison, Curtis and Brown, 354 6th T.M. ESOPs at A-18-19; and Shanney-Suborsky, Transfers of Closely Held Businesses:  ESOPs and Succession Planning, Journal of The American Society of CLU & ChFC, September 1998, 78, 83.

[7]   IRC 4941(a).


[9]   Under the Economic Growth Tax Relief and Reconciliation Act of 2001, the estate tax is scheduled to phase out completely by 2010 and at that time, there will no longer be a step-up in basis at death.  This law, however, is supposed to sunset and in 2011, the estate tax and the step-up in basis at death will return.  Grassley, Chairman of the Senate Finance Committee, reported that there is zero chance that the estate tax will be fully repealed after 2010.  See Daily Tax Report, August 29, 2005.

3   We are, however, aware of a modest margin call when a corporation whose FRNs were QRP had its credit rating downgraded.  As discussed below, however, there is at least one entity that is making non-recourse loans secured by FRNs or other high grade QRP.

[10]   See III.

[11]   In large holdings of highly-rated public companies, there may be tax-free diversification alternatives.  A "forward sale" comes to mind.  But these "derivative" alternatives are both quite limited and expensive in that the fees of the brokerage house involved are relatively high.

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