The Employee Stock Ownership Plan (ESOP) is a one-of-a-kind method for selling ownership in a private business. Congress created the ESOP tax incentives in an effort to foster broader employee ownership of companies and nudge business owners to provide retirement plans for their employees. The incentives are provided to both the sellers and buyers involved in the ESOP transaction. Therefore, an ESOP is a way that a business owner may sell his or her business to employees and receive tax benefits for doing so.
Typically, the business owner forms an ESOP trust, a legal entity created with the help of a lawyer. The newly formed ESOP trust then takes out a loan to purchase the owner’s common stock. The loan is collateralized by the purchased shares and often a seller guarantee. The company then contributes a portion of its monthly cash flow to the ESOP, deducts the amount as a retirement plan contribution, and the ESOP uses the funds to repay the funds that it borrowed. If the ESOP does not use leverage, then the payments go directly to the seller as payment for his or her shares. In either case, shares are then allocated over time to employees as they earn the benefit and meet vesting requirements. In this way, the owner’s stock in the company is purchased by the ESOP and distributed to the employees.
The advantages of the ESOP begin with the seller’s ability to defer capital gain tax. This can be done if the business is a C-corporation, owns a 30% or greater stake in the business, and the seller(s) invest their proceeds in domestic corporate securities within the first 12 months. In addition, company payments to the ESOP to repay borrowed funds, both principal and interest, are tax deductible. Moreover, if the company is 100% owned by the ESOP and elects to be treated as an S-corporation for tax purposes, all of the earnings of the company are exempt from federal income taxes, just like a qualified retirement plan. Finally, employee ownership not only may improve company performance but may allow management and employees to maintain their independence.
But the benefits described above come with strings attached. First, ESOPs are costly. Some practitioners say that setup fees, much like real estate commissions, run between 4% and 7% of the total value of the business. Annual administrative fees for yearly business valuation and required recordkeeping run in the five to low-six figures. Second, most ESOP buyouts must be funded with debt, which raises the business’ financial risk and cash flow burden. Only companies with strong cash flow need apply.
Next, few buyouts can be effected with 100% leverage. As such, the seller must seller-finance and/or agree to sell blocks of stock over time (i.e., years). This also brings into play the prospect that some portion of the seller’s shares will be for minority blocks, which will suffer a minority interest discount price. Finally, as mentioned, some lenders may require the seller to personally guarantee the ESOP debt and/or pledge the ESOP proceeds until some amount of the borrowing is paid off.
In summary, the ESOP offers powerful and compelling benefits – but it’s not for every person or every company. It adds an ongoing layer of cost and usually involves the use of leverage, so good candidates will have healthy profits and cash flow. It also often requires that the seller accept a buyout over time and bare some ongoing financial exposure to the business – at least for a few years. If these aren’t deal killers, you may have a lot to gain from an exit by ESOP.
Ms. Carol Mayo Cochran of REDW Business and Financial Resources, LLC (www.REDW.com) contributed her considerable expertise for this article. You can reach her at firstname.lastname@example.org.
This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2014.
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