Eventually, the ownership of every privately-held business will be transitioned in one way or another. There are many options available to transfer ownership, but they basically fall into one of the following categories:
- Sale/transfer to family
- Sale/transfer to other current owners
- Sale to outside parties
- Give to charity
- Initial public offering (i.e. “go public”)
- Sale/transfer to employees
This article will focus on the last item, the sale or transfer to current employees. Selling to employees can often be a challenge due to limited funds available in current employees’ hands. While bonuses, profit-sharing plans, and other arrangements might work may eventually alleviate the cash shortfall, these options typically take a long time to complete the transition of ownership. Another option with employees that might provide a shorter term of ownership transition and provide for liquidity for the current owner(s) is an Employee Stock Ownership Plan or ESOP. ESOPs are very technical in nature, so the following is intended to be a very basic summary.
An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. The company sets up an Employee Stock Ownership Trust (ESOT) fund (think of the ESOT as a retirement plan) and funds it, typically with contributions of cash (similar to employer contributions to a 401K plan). Alternatively, the company could utilize a leveraged ESOP, whereby the ESOT can borrow funds in order to purchase company stock on behalf of the employees.
Some of the Tax Benefits of an ESOP
ESOPs have a number of significant tax benefits, the most important of which are:
- Cash contributions are deductible: A company can contribute cash to the ESOP on a discretionary basis year-to-year and take a tax deduction for it. These contributions can be used to buy shares from current owners or to build up a cash reserve for a future, larger purchase. In the leveraged ESOP context, cash contributions which are used to make debt service payments are deductible as well. In practice, this enables an operating company to deduct both the principal and interest payments on the loan, allowing the company to finance the sale using pretax dollars.
- Sellers in a C corporation can get a tax deferral: In C corporations, as long as the ESOP owns 30% of the shares immediately following the transaction, the seller can reinvest the proceeds of the sale in qualified replacement securities and defer any tax on the gain. There are other criteria that must be met to qualify for this deferral, but it can provide a huge tax benefit to the seller when it works.
- In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well): The ESOP generally doesn’t pay tax on the income it receives; therefore, any income allocated to the ESOP from an S-corporation operating company won’t incur any federal (and more than likely state) income tax.
- Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates: The employees can roll over their distributions in an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. The income tax portion of the distributions, however, is subject to a 10% penalty if made before normal retirement age.
Some Non-Tax Reasons for Considering and Using an ESOP
- To buy the shares of a departing owner: Owners of privately held companies can use an ESOP to create a ready market for their shares. Because the company is creating an ESOP to facilitate the purchase, there are no adverse parties or negotiations, nor is there time spent trying to find a buyer or worrying about post-transaction culture changes. Many times, the business simply continues on as it had before the ESOP. Additionally, an ESOP can do a partial (less than 100%) redemption, allowing the seller(s) to take some money off the table while retaining an equity stake in the company.
- To create an additional employee benefit: By either purchasing shares from the existing owners or issuing new shares to the ESOP, the company is giving its employees an ownership interest in the company. Many companies find this increases employee satisfaction, reduces turnover, and encourages all employees to work towards common goals. Frequently, companies will see improved operating performance, cost savings, and growth in revenue and profits.
Cautions Regarding the Use of ESOPs
While we have discussed many of the advantages of ESOPs, they are a complex solution that should be considered carefully with your advisors. ESOPs are not the best fit for every situation, but when utilized properly, they can be a great fit for both owners and employees of companies. If you have any questions or would like to discuss ESOPs further, please reach out to Brad Minor or your local Blue & Co. advisor.