When facing a business transition, owners have two basic options. Sell the company to outside parties or to inside parties (other owners and employees). While there are numerous variations of the two, basically the owner can sell to an outside group, which may be a strategic buyer (someone in the industry already), or a financial buyer, which may be a private equity firm or other investor that wants to own the company. An internal buyer is either a sale to some or all of the employees directly, or through the use of an Employee Stock Ownership Plan (ESOP). ESOPs are usually very cost competitive and many times may pay the highest price. Sale to the employees individually is with “after tax” dollars and can be very tax inefficient.
Until 1974, Employee Stock Ownership Programs were almost unheard of. However since then, they have increased in popularity. In fact in 2014, there were 13.5 million workers in the United States who were covered under ESOPs.
There are many reasons as to why employers offer these types of programs. While some people think ESOPs are used to save companies that are about to go bankrupt, this usually isn’t the case. It’s a great way to transfer ownership from one generation to the next without needing a financing plan.
As an added benefit, these programs tend to be offered as a way to motivate and reward employees. Of course, there are the numerous tax advantages to be gained too. For the most part, market shares are given to workers and they don’t have to purchase them.
How Does an ESOP Work?
When a company chooses to create an ESOP, funds are set aside in a trust fund. The monies are used to buy new shares of stock. Additional funds are contributed to buy new shares as well as to pay back any funds that are borrowed from the ESOP to buy additional market shares. It does not matter how the company pays for the shares, the contributions are tax-deductible as long as certain requirements are met.
Within the trust there are individual employee accounts. The company, of course, decides who has the right to take part in the ESOP. For the most part, however, all employees who work full-time and are at least 21-years-old have the right. An employer decides how the market shares are distributed to each employee’s individual account, with many companies operating on a vested basis, meaning workers with more seniority are given more market shares than those who have less seniority.
Employees receive the cash value of their stocks when they leave the company (most companies mandate that the employees work for them for at least five years), or when they retire. The amount of money that they receive for the stocks is based on their fair market value at the time.
Employer Benefits of Executing an ESOP
For business owners without an established plan to transfer direct ownership to either children or trusted personnel, ESOPs are a strategic way to increase direct ownership to the following generation without having to purchase it outright.
With the establishment of an ESOP, there are significant tax savings to be gained. In 1974 ERISA, or the Employee Retirement Income Security Act, created the modern ESOP as well as a whole host of other retirement vehicles that incentivize companies and employees directly through tax incentives to save money for retirement. Since the government sees a positive social purpose for ESOPs, it provides extraordinary tax incentives for an owner and a company to use an ESOP as a business succession and liquidity tool. Some of these tax advantages include: 1
The seller of the stock may meet the requirements to defer and then avoid paying state and federal Capital Gains tax on the sale of their stock regardless of basis (i.e. IRC § 1042 exchange). It allows the seller to exchange the proceeds from the sale of stock to purchase stocks, bonds, notes or U.S. Domestic Securities (this includes, stocks, bonds or notes) that meet certain qualifications. Once the exchange is established and the owner maintains the exchange, upon death the seller receives a “stepped up basis” and the capital gains tax evaporates.
The company receives a dollar for dollar annual deduction for every dollar’s worth of stock that is sold by the sellers. If the company buys $500,000 of stock, the company can realize a $500,000 tax deduction. This is realized on the tax return of the company as they pay for the stock, and is subject to certain limitations.
The company can either be a “C” or an “S” Corporation to install an ESOP. There are some advantages and disadvantages to both structures, but ultimately, if the company is or becomes a “S” Corporation, and is 100% owned by the ESOP, the annual K-1 would then go to the ESOP, which is a State and Federal tax exempt trust, similar to a 401(k) and as such is no longer subject to State and Federal income tax. This makes the company “tax free” and can more than double cash flow, and places the company in an optimal operating platform. As they compete with other market players that are paying tax, they have a distinct financial advantage which they can leverage into getting jobs at lower prices and still maintain margins.
Another advantage of an ESOP is that the sellers can maintain control of the company even after the sale, as the ESOP has a Trustee that can be “directed”. This directed Trustee is directed either directly by the Board, or by the ESOP Administrative Committee, which is a Board committee. Effectively, the day-to-day control of the business doesn’t change and control can be left with the selling owners until they receive all their money or control can be placed with whomever they direct, such as senior management, etc.
Rewarding Employees with Market Shares
In addition to the above tax benefits, offering employees company ownership helps establishes professionalism and lines up owner goals with that of the employees. First-rate job candidates are attracted to companies that they know appreciate and reward their workers. Also, when a company shows it is interested in helping its workers succeed, it’s much more likely to retain its key employees. More so is the fact that the employees will strive to make the company succeed because they will want their market shares to be worth more money.
It’s also with an ESOP that an employer can reward its workers without draining its cash flow. Instead of giving cash bonuses, market shares are issued. Furthermore, an ESOP comes with the benefit of the employer being able to strictly decide who gets the market shares and how much. With fringe benefits, specific selection is mostly prohibited.
Next Steps
Although an ESOP has significant tax advantages and provides a mechanism for current owners to exit the business at fair market value, the process requires the work of an experienced team in the creation and execution of an ESOP. Because of this, you should work with a group of advisors experienced in implementing an ESOP.
This article was originally published in Valuation Viewpoint, February 2015.
Footnote
1 Business Transition Advisors
