Employee Stock Ownership Plans, or ESOPs for short, are gaining momentum as “baby boomers”, who are turning age 65 at a rate of 10,000 per day for nearly the next two decades, look to retire. Many owners are looking to transfer their businesses to the next generation or key management, but do not wish to give the business away. And the next generation often cannot afford to pay, or even borrow, the purchase price.
Many owners find that an ESOP may be the ideal solution to their liquidity and succession needs. Sale proceeds of a proper ESOP structure may not be subject to the capital gains taxes normally due on a sale of a business and 100% of future profits become federal and state income tax exempt. Therefore, an ESOP is one of the best and most tax-efficient ways for a business owner to transfer a business and often it provides the most “net” after-tax proceeds to the seller than any other transfer method.
Employee Stock Ownership Plans Defined:
In practical terms, an ESOP is a highly tax-advantaged, immediate, or gradual exit strategy, for a business owner desiring totally liquidity or to simply take some “chips of the table”. The ESOP is a “ready and willing” buyer of the seller’s stock that keeps out unrelated third parties and allows corporate control to remain unchanged. It retains the seller’s existing perks while providing significantly enhanced retirement benefits to all eligible employees who will have a beneficial ownership interest in the stock sold to the ESOP.
Technically, an ESOP is a defined contribution, tax-qualified retirement benefit plan under Internal Revenue Codes 401(a) and 4975(e)(7) and overseen by the Internal Revenue Service and the U.S. Department of Labor designed to invest “primarily in employer stock”.
How an ESOP Works:
Typically, either the ESOP borrows funds from a bank or the seller takes back a note, or a combination of both. The ESOP uses the loan proceeds to purchase some or all of the owner’s stock. The company then makes annual tax-deductible contributions to the ESOP, which uses the funds to repay the loan. The shares purchased by the ESOP are allocated to the employees over a period of years.
Seller Advantages:
- The selling shareholder may indefinitely defer/eliminate all capital gains on the sale proceeds.
- The seller enjoys the advantage of having an immediate buyer of some or all of the seller’s stock at fair market value.
- The seller can retain personal salary, perks, benefits and control, without the interference of outside interests, until ready to hand over the reins.
- The seller retains a personal and corporate legacy in the town and community in which he/she has substantially contributed.
Corporate Advantages:
- Profits of an ESOP company can be 100% federal and state income tax exempt.
- The company receives a dollar for dollar income tax deduction on the entire stock sale price.
- ESOP companies have been shown to outperform their peers with increased productivity and higher returns.
Employee and Community Advantages:
- The employees enjoy enhanced retirement benefits of company stock with no out-of-pocket costs.
- The ESOP’s orderly internal transfer of the company creates a more stable and reliable community employer than the unknown intentions of an outside buyer.
- The company remains an important contributor to the community’s social and economic fabric.
Corporate Performance and Control:
ESOPs have been studied in depth for nearly 40 years. These studies have proven that ESOPs can dramatically increase company performance in many key areas. They foster an “ownership culture” in the company, which can make employees feel and act more like owners and less like employees, but without giving away control. Even in a 100% ESOP-owned company, control can be maintained or designated to family or key management by the seller, regardless of the amount of stock sold to the ESOP. Since many owners want their children and/or key management to eventually run and own the business, but those individuals cannot afford to purchase the business nor obtain adequate financing, proper structuring can increase direct ownership to the next generation, over time without personal financing.
Summary:
An ESOP is a ready and willing buyer and highly tax-advantaged business transition tool that is often overlooked due to perceived complexity or lack of knowledge. An ESOP may be the ideal method to transfer a business, on the seller’s timetable, to the next generation, without the interference and costs of outside parties. Before selling the business outright or submitting to the terms of private equity firms, business owners owe it to themselves to explore the lesser-known yet powerful ESOP option.
Pittsburgh Business Succession Planning Attorney
Dan Lynch routinely helps business owners with the transition of their business. Please contact Dan if you have questions about ESOPs or other business transition strategies. You can reach him by calling (724) 776-8000 or via email at dlynch@lynchlaw-group.com.
