One of the most difficult challenges for owners of family-owned businesses is finding a way to turn their equity in the business into cash. Also, after putting years of hard work into a business, owners often have a desire for the company legacy to continue when they leave. They often want their employees to have an opportunity to continue working and growing the business after they have retired.
For some business owners, the answer to these issues will be to turn over the company to a family member or sell to a competitor. However, many owners do not have family members interested in running the business, and outside purchasers may be difficult to find. Furthermore, even if they can be found, many buyers will only want to buy the company for its assets and have no desire to continue the business, or they may want to continue the business in a way that is not consistent with the owner’s objectives.
Employee stock ownership plans (ESOPs) can be an attractive and tax-favored alternative for a family-owned business looking for an exit strategy. For the owner of a C corporation, proceeds on the gain from the sale of stock to the ESOP can be tax-deferred by reinvesting them in the securities (including both stocks and bonds) of other domestic companies, subject to certain requirements. If such replacement securities are not sold prior to the owner’s death, no capital gains tax is ever due on the gain recognized by the sale of the company stock to the ESOP. Unfortunately, this deferral opportunity is not available to the owners of S corporation stock. However, if the company is an S corporation, limited liability company, or partnership, it can convert to a C corporation before the sale in order to allow the selling owner(s) to take advantage of such tax deferral.
Following a purchase of company stock, for a C corporation the full amount of the loan incurred to finance the purchase (including both interest and principal) can be paid with tax-deductible dollars using company contributions to the ESOP. For an S corporation (100 percent owned by the ESOP), the corporation will not pay any federal income taxes, and the additional cash flow will help fund the repayment of the loan.
ESOP sales can be accomplished all at once or gradually. For the company employees, no contributions are required to purchase the owner’s shares, as the ESOP loan will be repaid by annual company contributions to the ESOP. The owner will ordinarily stay with the business. The ESOP stock is owned by a trustee who votes the shares; however, the company’s board appoints the trustee, so changes in corporate control are usually nominal.
An ESOP is a special kind of tax-qualified profit sharing plan, similar in many ways to a 401(k) plan, and is governed by the same law, the Employee Retirement Income Security Act. Company stock purchased by the ESOP is held in a trust for employees meeting minimum service requirements and generally allocated to employees based on relative pay. Accounts are distributed after the employee terminates, although there are rules that can extend the time for distribution including while the loan incurred to buy the company stock is being repaid.
Good ESOP candidates are generally companies with sufficient cash flow to pay the debt obligation incurred for the purchase of company stock and with adequate payroll to make contributions sufficient to pay such debt. However, it is important to know that ESOPs are not simple arrangements. There are a number of complex issues that need to be addressed in any ESOP transaction, and ESOPs are not right for every company. The company cannot be precluded under the covenants governing its existing debt obligations from incurring the additional debt necessary to affect the ESOP transaction. The owners must be willing to sell their shares at fair market value, as determined by an independent valuation firm retained by the ESOP trustee, even if an outside (strategic) buyer might pay more. Management continuity is also very important.
An ESOP may be a good exit strategy for your business.