Selling a closely held business can be an incredibly complex process that requires a lot of thoughtful planning. For business owners, two challenges often come to the forefront: finding a buyer and creating a liquidity event for the business owner. Selling a business to an employee stock ownership plan (ESOP) can address both of these issues while also creating an incentive for employees. Here’s a look at the advantages and considerations that come with selling a business to an ESOP.
What is an ESOP?
An employee stock ownership plan is an employee benefit plan similar to a retirement plan or a 401(k) program. It is essentially a trust into which a business sells company stock or cash, and then allocates stock to individual employees on a vesting schedule. An ESOP can be used to reward employees for their service and create a shared incentive to see the company succeed.
How selling a business to an ESOP works
An ESOP can be used to buy the shares of a departing owner and create a liquidity event while simultaneously establishing a vision for the future of the business. ESOPs can also be an attractive strategy, providing more money to the seller after tax.
First, an ESOP needs to be established and funded. A company can fund an ESOP with cash contributions that are tax-deductible, or by issuing new shares of stock or treasury shares that are also tax-deductible. ESOPs can also borrow money to purchase existing shares and then make tax-deductible contributions to the trust in order to repay the loan. The result is that both the principal and interest on the loan are tax-deductible.
When an employee leaves the company, including the original owner, the ESOP purchases their stock at market value. This is how funding an ESOP essentially creates a buyer for an owner’s share of the company when they might not otherwise have a robust market.
There are many rules and restrictions around using an ESOP to sell a business. So, it may be helpful to consult with a team of financial advisors who can outline the process in detail and help formulate a comprehensive succession strategy using an ESOP.
Tax benefits of an ESOP
Business owners often prize the liquidity that comes from selling a business to an ESOP above all else. But for the company itself and its employees, there are also some significant tax benefits that come with an ESOP strategy. Those tax advantages include:
Contributions to an ESOP are tax-deductible
- As mentioned above, contributions made to an ESOP either in the form of stock, cash, or from loans taken out by the ESOP are all tax-deductible. This means that funding an ESOP is essentially always completed with pretax dollars.
No income tax on ESOP’s ownership percentage for S corporations
- For S corporations, the amount of company stock owned by an ESOP is not subject to federal income tax, and often isn’t subject to state income tax as well. This means that if an ESOP owns 50% of a company’s stock, there will be no federal or state income tax on 50% of the company’s profits. This also means that if 100% of a company is owned by an ESOP, it is not subject to any federal or state income tax.
Tax deferrals for sellers in C corporations
- When an ESOP for a C corporation reaches 30% ownership of all company stock, a seller can take proceeds from the sale of company shares and reinvest that money into other types of securities while deferring any tax on subsequent gains.
- Dividends from company stock that are passed to employees, reinvested by employees in more company stock, or used to repay a loan taken out by the ESOP are all tax-deductible.
Employees only taxed on distributions
- Employees aren’t taxed on contributions to an ESOP, only distributions. An employee can either elect to rollover distributions from an ESOP into an IRA or other retirement plan, or they can pay ordinary income tax on the distribution. If they do, any growth on those assets that accumulates in the future is taxed at capital gains rates.
Important considerations when selling to an ESOP
Here are some other important factors that should be considered before selling a business to an ESOP:
- It is prudent for business owners to give an ESOP time to accumulate value. So, five to seven years before retirement is an ideal time to start implementing a business succession strategy involving an ESOP.
Limitations based on corporate structure
- Professional corporations and partnerships are not allowed to use an ESOP. S corporations have lower contribution limits and cannot make use of all rollover opportunities. Private companies are required to repurchase shares from all departing employees and must complete an annual valuation to determine purchase price.
- The cost of establishing an ESOP and ongoing administration fees can be significant. So, contrary to a belief shared by some, this strategy is unlikely to be used to “save” a failing company and is often much more attractive to successful organizations.
- Although selling a business to an ESOP is essentially a transaction between business owners and employees, there is nothing preventing a third party from buying stock from an ESOP. In certain cases, this can actually create an attractive M&A position because buying from an ESOP offers investors unique tax benefits that may not be available in other corporate structures.
Succession planning for successful futures
Selling a business to an ESOP is an effective way to transfer the value of the company to employees and create liquidity for a parting owner who might not otherwise have a market for their business. But it’s also not a magic bullet that instantly creates a succession plan for the future of the company. Comprehensive succession planning will require careful consideration to ensure the financial health of the business and the departing owner is protected. By understanding how ESOPs work and with guidance from experienced financial advisors, business owners can create a future pathway to success for themselves, their employees and their business.
Are you a business owner looking for more ways to maximize the value of your portfolio? Contact Granite Harbor Advisors to schedule a complimentary consultation with our team of experienced financial professionals.