Transfers to Outsiders
The lifetime gifting and sale techniques available for intrafamily transfers may also work with non-family members. While lifetime gifts are usually directed toward family members, there are circumstances where a gift to an unrelated party makes sense.
Gifts to Key Employees
A sole proprietor may wish to cement an eventual buy-sell arrangement with a key employee. Beyond negotiating the ultimate sale upon death, the proprietor could give the employee a small minority interest in the business during their lifetime. By making the employee a part owner now, the proprietor is better assured of retaining the employee and securing their commitment to the succession plan. If the owner’s compensation is primarily salary and the business pays no dividends, there is little practical disadvantage to giving up a small minority interest — the employee shares in future appreciation but receives no current cash distribution.
Sales to Outsiders
Frequently, a lifetime transfer to outsiders will take the form of a sale. The installment sale, private annuity, and other techniques described on the previous page can all be used in sales to unrelated parties. In fact, a non-family sale will not be subject to the same level of IRS scrutiny as an intrafamily transaction, since the deal takes place between unrelated parties negotiating at arm’s length. The IRS is far less concerned that an unrelated buyer paid less than full and adequate consideration.
Employee Stock Ownership Plans (ESOPs)
One particularly interesting mechanism for transferring ownership to outsiders is the Employee Stock Ownership Plan (ESOP). For larger corporations, an ESOP may be a feasible method to transfer ownership, both during the owner’s lifetime and at death. To work successfully, the plan must be established during the owner’s lifetime.
How an ESOP Works
The owner names himself or herself as trustee of the ESOP, retaining effective control over the plan and the business during their lifetime. The owner must sell a minimum of 35% of the business to the plan. Typically a bank loan finances the ESOP’s purchase of the stock. The plan then uses annual contributions from the business to repay the loan. As a group, the employees become part owners of the company.
One significant tax benefit: the owner will not owe capital gains tax on the sale proceeds if the proceeds are reinvested in qualified domestic securities (most U.S. stocks and bonds qualify under IRC §1042). After the sale, the owner’s estate becomes more liquid, and the value of the transferred stock is frozen — any future growth in the business accrues to the ESOP, outside the owner’s estate.
After the initial sale, the owner retains the remaining controlling interest. Ultimately, the owner’s estate may sell the remaining business interest to the ESOP as well, or the family could choose to retain the controlling interest indefinitely.
- Owner retains control as trustee during lifetime
- Capital gains tax deferred or eliminated (IRC §1042 rollover into qualified domestic securities)
- Business contributions to repay the ESOP loan are tax-deductible
- Provides estate liquidity — converts an illiquid business interest into cash
- Freezes the value of transferred stock; future appreciation passes to employees outside the estate
- Increased employee morale and productivity from ownership stake
- Flexible — owner can sell remaining interest later or family retains control
- Available only for corporations (not sole proprietorships or partnerships)
- Generally practical only for larger businesses (typically annual sales exceeding $10 million)
- Costly and complex to establish and maintain
- Requires an annual independent valuation of the business
- Owner as trustee has a fiduciary duty to employees — creates a potential conflict of interest
- Annual contributions to repay the ESOP loan can become a burden on the business
- Must be established during the owner’s lifetime to serve as a succession tool