Pub. 11 2016-2017 Issue 4

www.nebankers.org 14 Extraordinary Service for Extraordinary Members. compensate for this risk. Unfortunately, seller financing might also limit a tax advantage available to certain owners of banks that are C corporations. An ESOP can provide estate planning opportunities for certain individual owners. If a bank is structured as a C cor- poration, § 1042(a) of the tax code allows some owners to defer the capital gains tax on resulting from the sale of their company stock to an ESOP. To take advantage of § 1042, the owner must use the money he or she receives from the sale and invest it in qualified replacement property within a year of the sale. “Qualified replacement property” is gener- ally defined as the stock of a domestic corporation that does not receive a substantial amount of passive income. Many individuals include this replacement property in their estate to avoid tax on capital gains altogether. This tax advantage to owners of banks sometimes allows an ESOP to pay less for the bank than a third-party because of the adverse tax consequences of a traditional sale. The window to take advantage of the § 1042 rollover is only open for one year after a buyout takes place. Thus, if the owner decides to exchange his or her ownership interest for a note, and the ESOP is not able to pay back the seller within one year, the seller might not be able to take full advantage of this tax strategy. The § 1042 rollover is not available with the sale of an S corporation. However, where an ESOP owns stock in an S corporation, the distributions of income attributable to the stock held in the ESOP are not subject to income tax. This means that some of the money the bank would have been paying in taxes can be redirected to pay for the buyout of the owner’s stock. As an ESOP’s ownership gradually increases to 100 percent of the bank, the avoidance of income taxes becomes a very powerful tool. The bank is able to redirect the money that would otherwise go towards paying taxes into funding growth, retiring debt, or improved employee compensation. Finally, employee ownership can help improve a bank’s performance. Studies have shown that companies with ESOPs experience higher profitability because the employ- ees act like owners. Unlike traditional succession plans, an ESOP allows the successors (current employees) to become owners over time. Giving employees the opportunity to become owners through an ESOP provides them invalu- able experience in owning and operating the bank. This will enhance the continuity of a bank’s culture and success long after a transition of ownership occurs. There are several considerations an owner should pon- der when deciding whether to incorporate an ESOP into his or her succession plan: • The use of an ESOP as a succession planning tool will require the bank to make payments to the ESOP for a long period of time. Owners should consider how likely it will be for the business to continue after they are gone. Bank owners should consider whether their successor employees would be able to handle a transition of ownership. • An ESOP cannot pay more than fair market value for the owner’s stock. Valuations of small, non-public corporations are done by appraisers who attempt to estimate what the stock would sell at if there was a market for the company stock. Because an ESOP cannot pay more than the appraised value,  Counselor’s Corner — continued from page 13 An ESOP can serve as an advantageous succession planning tool for banks. As hundreds of banks across the country have learned, a well-structured ESOP benefits the bank, selling shareholders, and the bank’s employees.