Entrepreneur Rollover Stock Purchase Plans

Financing a business start-up can be a challenge. Most traditional lenders require that a business be operational for at least a year before they will provide small business loans. Moreover, venture capitalists are quick to reject most start-up proposals and if the venture capitalist is willing to fund the start-up they typically demand a significant ownership stake in the business. This has caused many entrepreneurs to look for alternative means for financing business start-ups. The entrepreneur rollover stock purchase (ERSOP) plan is one such financing alternative.

The idea behind the ERSOP is to use the entrepreneur's 401(k), IRA, or other qualified plans to fund the start-up. The ERSOP process looks something like this: establish a legal entity; get a taxpayer identification number and checking account for the entity; set up a trust and get a taxpayer identification number and a checking account for the trust; (hopefully) get a determination letter from the IRS specifying that the trust qualifies as an everyday employee stock option purchase plan (ESOP); roll the entrepreneur's retirement accounts over to the trust checking account and then to the entity checking account; the entity transfers entity stock into the trust. At that point the money is in the business checking account and the business stock is in the ESOP.

Most transactions such as this are disseminated via financial planners or via the large accounting firms; however, it appears that very few of those advisors are actively recommending the ERSOP. Instead the ERSOP seems to be being pushed by the professionals who help facilitate the transfer of franchise businesses. There are a number of businesses on the internet that claim to specalize in handling these types of transactions (see, e.g., http://www.ERSOP.com).

The main problem with the ERSOP is that it involves pulling money out of retirement accounts to fund speculative business ventures. This is a particularly risky undertaking given today's diminishing government safety net and increasing government regulation.

Other problems involve violating the self-dealing rules required for ESOPs, volunteering for additional accounting and compliance requirements and costs, limiting future business structuring by creating a near permanent stock ownership arrangement, possibly limiting the entrepreneurs' rights if the business goes under or if the entrepreneur wants to sell the business in the future, and placing the business in a vulnerable position with respect to future changes in the law.

While these drawbacks will probably preclude the use of an ERSOP in most cases, this does not mean that the ERSOP would never be appropriate. A client who is going to start a business using other risky financing methods (such as taking on credit card debt), who is fully advised of the consequences and requirements, and who is fully willing to comply with the requirements and willing to take the risk might be a viable candidate for the ERSOP. The ERSOP may be particularly attractive for clients who have significant wealth that is held outside of their retirement accounts, but it is currently illiquid.

A tight money supply and tougher underwriting mandates from Congress will probably help fuel the popularity of ERSOPs and other alternative financing arrangements in the near future. However, long-term, ERSOPs will probably be legislated out of existence or will continue to be passed up for simpler financing alternatives.

Basic Estate Administration and Taxes: Elections & Timing

This post is written to remind non-tax attorneys who administer estates of a few basic tax issues that must be considered in administering estates. From a tax perspective, estate administration is all about making elections and timing distributions, income and expenses.

The first group of elections involves selecting tax years. IRC § 441 defines a taxpayers "taxable year" as the taxpayer's annual accounting period that may be a calendar year or a fiscal year. IRC § 441(e) defines a "fiscal year" as any period of 12 months ending other than in the month of December. IRC § 441(d) defines a "calendar year" as a tax year as ending in December. The second election that the estate attorney must consider is whether to elect a "short period." With some exceptions, IRC §§ 443 and 7701(a)(1),(14) provides that a "short period" is a period of less than 12 months. These elections essentially allow the estate attorney to terminate the tax year when it will result in the least amount of tax.

The second group of elections involves timing the receipt of income and flow through and allocation of tax attributes. Most states have adopted some version of the Uniform Principal and Income Act, which allows the fiduciary to elect to elect to allocate capital gains to principal. Similarly, Treas. Reg. § 1.643(a)-3(b)(1) permits the fiduciary to treat certain capital gain receipts as income for trust accounting purposes, IRC § 663(b)(2) permits the fiduciary to elect to treat certain distributions as having been made during the prior year, IRC § 645 permits the fiduciary to treat a revocable trust as part of the estate, IRC § 642(g) permits the fiduciary to elect to deduct administrative expenses, and IRC § 643(g) permits the fiduciary to treat estimated tax payers as made by beneficiaries.

There are a number of other decisions that fiduciaries must make that are not elections per say, but are in essence elections. For example, fiduciaries are often able to time distributions, to make distributions under residuary clauses versus specific distribution clauses in wills, to make in-kind distributions in lieu of specific distributions, and to allocate deductions and expenses to certain beneficiaries or property.

This combination of elections presents fiduciaries administering estates with a number of planning opportunities. For example, the fiduciary may elect a short fiscal year for the first tax year and then have the estate terminate and deductions or other tax attributes flow through to the heirs' tax returns in the second tax year. This is possible because IRC § 642(h) specifically provides that certain carryovers and excess deductions pass through to the beneficiaries if they arise in the year that the estate is terminated. This can be particularly useful where the estate is entitled to significant depreciation or depletion deductions, which would otherwise be lost because the estate had deductions in excess of income. Similarly, in other cases these flexible election rules may permit the fiduciary to time distributions so that the heirs receive distributions and expenses in years where the heirs have other offsetting tax attributes or income.

Of course, tax minimization is often not the main consideration in administering an estate. However, the rules sufficiently flexible and present the fiduciary with a number of tax minimization opportunities. Fiduciaries administering estates should not inadvertently pass up these tax minimization opportunities.