As a farm-business owner, your business is likely your most important asset, and a substantial source of wealth.

This raises two questions: 

1) What is your transition plan? 

2) How can you diversify a portion of your wealth?

Identifying potential successors and implementing strategies to ensure a smooth ownership transition requires much thought and deliberation. Often, it requires a willingness to give up some control, notes David Chlus, senior vice president of investments with Smith Barney in Utica, N.Y.

For agri-business owners who wish to diversify their ownership while maintaining continuity and deferring taxes, employee stock ownership plans are a good option.

“ESOPs facilitate the transfer of some or all ownership from business owners to their employees,” says Chlus. “When you sell shares to the ESOP, the employee-participants receive proportional ownership of the company and you receive cash.”

An ESOP can be tailored to your needs, but it’s important to remember that it is an employee benefit plan. Therefore, it must meet the rules for employee eligibility, participation and vesting. Consequently, you need to evaluate such factors as the farm’s financial condition, employees’ eligibility to participate, stock allocation and vesting schedules before you even set up the plan.

An ESOP requires a formal valuation of the farm business. That means evaluating profits, cash flow, market conditions and outlook, assets and any other relevant factors.

Next, you have to choose how to fund the ESOP. Chlus point out two options:

A leveraged ESOP borrows funds to buy company stock. The ESOP can borrow funds directly, using the purchased stock as collateral. More frequently, funds are borrowed at the corporate level then lent back to the ESOP. This helps make some of the debt repayment deductible.

Unleveraged ESOPs buy stock without debt financing. The funds can come from Treasury stock, the farm’s contributions, employee contributions or other profit-sharing plans the farm has established.

Once the plan is operating, a trustee assumes the responsibility to oversee it. You can serve as trustee, but an outside individual or corporate trustee also can be hired for that role.

For agri-business owners, an important benefit of an ESOP is the ability to diversify tax efficiently. The mechanics are straightforward. “You sell stock to the ESOP, and it buys your shares for cash at the valuation price,” says Chlus. “Internal Revenue Code section 1042 permits a taxpayer who sells shares in a privately held company to an ESOP to defer paying taxes on any capital gain from the sale of those shares.”

That is provided the following requirements are met:

You (or any other seller) must have owned the shares for at least three years and cannot have received the shares as a form of compensation.

The ESOP must own at least 30 percent of the company following the sale.

 You (and other sellers) must reinvest the sale proceeds in “qualified replacement securities” within 12 months of the sale to the ESOP.

“By reinvesting the proceedsin qualified replacement securities within 12 months of selling your shares to an ESOP, you receive cash for your otherwise illiquid shares,” notes Chlus. “Then, you can use these proceeds to diversify your overall investment portfolio.”

Qualified replacement securities are generally defined as stocks and bonds issued by a U.S. domestic operating company. Several types of investments, including mutual funds, certificates of deposit, government securities and real estate, will not qualify.

However, there are multiple strategies for reinvesting ESOP-related proceeds. “A thorough discussion of these approaches with your advisers, including the related pros and cons, is important,” he says.

So, when developing your business-succession and wealth-diversification plans, ask your advisers whether an ESOP would be a wise option for you and your business.