(article originally published in Business NH Magazine, May 2010)
An ESOP may be the buyer of choice for selling your company in a recovering economy
Many baby boomers and other business owners who are hoping to retire soon are exploring options to sell their company. They have worked hard all of their lives and now want to enjoy the fruits of their labor. These business owners are stymied, however, by the lack of liquidity in the credit market and the resulting decrease in potential buyers for their company. Even if a buyer were found, they may feel a sense of guilt when they plan to leave their company and valued employees in the hands of strangers. What is the solution? One may be to establish an employee stock ownership plan or ESOP. In addition to incentivizing employee performance and providing employees with a retirement benefit, an ESOP can provide a buyer for these companies and be used to promote management succession.
What is an ESOP?
From a distance, an ESOP looks like a traditional defined contribution retirement plan, like a 401(k) or profit-sharing plan. The difference is that an ESOP is designed to invest primarily in the stock of the company that established it, instead of in the securities of other entities. Here is how it works: The ESOP would be the buyer of the company and purchase the exiting owner’s company stock for fair market value as determined by an independent appraiser. Employer contributions, or the equivalent amount of employer stock, are allocated to individual employee accounts in the ESOP based on the proportion of an employee's salary to the total of all employee salaries. Employee eligibility to receive an allocation can be dependent on working a specified number of hours during the year and/or employment at the end of the year. An employee generally will vest in the stock allocated to his account over a set time frame of up to six years of service. At a specified time after termination of employment, or immediately after retirement or death, an employee or his or her beneficiary is entitled to receive the fair market value of the vested balance in the employee’s account.
Establishing ESOPs has steadily increased in New England and in other parts of the country. The ESOP Association (www.esopassociation.org) estimates that there are about 10,000 ESOPs in the United States today and about 1,500 created each year as business owners view the ESOP as a win-win for themselves, their business and their employees. An ESOP will increase a company’s cash flow by reducing its taxes. If your company is taxed as an “S” corporation and the ESOP owns 100% of the shares of the company, corporate income may be exempt from federal taxation. This reduction in taxes will result in an increase in the value of the company’s stock.
ESOP as Buyer
An ESOP is a natural buyer for an owner’s stock in her company. The question is where does the ESOP get the money to pay for it? One way the purchase may be financed is for the company to borrow money from a bank and then loan the money to the ESOP. In these still tough economic times, however, bank financing may not be that easy to come by. Another financing option to consider is for the selling owner to loan the money to the ESOP in exchange for a promissory note. By taking the loan from the selling shareholder instead of a bank, the ESOP and the company will avoid paying loan-related bank fees and increased lawyer fees incurred in negotiating a third-party loan. If loaning money from the selling shareholder is not an option, banks may be more willing to lend in connection with an ESOP transaction as there is greater security in knowing that the loan will be repaid with pre-tax dollars as discussed below.
As a condition to making the loan, the lender or selling owner typically takes a security interest in the company’s assets, a loan guaranty from the company and a pledge of the ESOP stock. The employer makes annual contributions to the ESOP to enable the ESOP to repay the loan. A valuation firm should be retained to perform a “feasibility study” to determine if the company’s ongoing cash flow will be sufficient to enable it to make contributions to the ESOP which, in turn, would make the required loan payments.
ESOP as Employee Incentive
An ESOP also can help ensure a company’s success by helping it retain its most dedicated employees; ESOP benefits will provide them with an additional financial incentive to remain with the company as the benefits can only be realized after the employee completes a specified number of years of service. Thus, an ESOP-owned company is likely to suffer lower employee turnover and a concomitant reduction in related expenses and inefficiencies. Finally, an ESOP provides a powerful incentive for employees to become more productive in order to drive up the value of the company’s stock. Although employees own the company’s stock, a selling shareholder can still maintain control over the ESOP stock by becoming one of the ESOP trustees (officers of the company can also serve as ESOP trustees). For all but a few specified matters, such as a sale of substantially all of the employer's assets, the ESOP trustees have the right to vote all shares of stock in the ESOP and thus still control the company.
Tax Benefits of an ESOP
An ESOP provides federal tax benefits to the company, the employees and the selling shareholder. Contributions the employer makes to an ESOP to pay down an ESOP loan may be tax deductible, and thus the ESOP may be able to repay the entire loan with pre-tax dollars. Because the ESOP is a qualified retirement plan, however, the employer’s ability to deduct contributions to the ESOP in certain cases is limited based on the amount of employee compensation.
Employees will have their ESOP retirement benefits grow tax free and will only be taxed on their ESOP accounts at the time benefits are distributed to them. They can defer this tax by rolling over their ESOP payments to an IRA.
Since it appears possible that the capital gains rate will increase in the near future, if business owners are contemplating retirement, they may want to sell their shares soon in order to lock in the 15% capital gains rate. Even if the owner sold her stock in the company for a promissory note from the ESOP, resulting in installment treatment for the purchase price, the owner could elect out of this installment treatment and pay tax on the gain from the stock sale at the current 15% capital gains rate.
An owner of a “C” corporation, however, who has owned her company shares for at least three years can sell at least 30% of her shares in the company to the ESOP and elect to defer capital gain on the sale so long as she invests an amount equal to the sale proceeds in “qualified replacement securities” within three months before, or twelve month after the sale. This obviously presents a significant tax benefit to the company’s owner who may effectively be able to sell her company tax-free.
How to Get Started?
Implementing an ESOP should be a winning solution for business owners, their companies and their employees as it will provide tax benefits, improved cash flow and, hopefully, lower employee turnover and increased employee commitment. The tax rules and regulations governing ESOPs, however, are complex, and there are many “traps” for the unwary. A company should seek out the expertise of an experienced valuation firm to value the company’s stock and perform a feasibility study, as well as attorneys to assist in the design of the transaction and draft the necessary documents.
Steven M. Burke is a Shareholder, Director and Chair of the Tax Department, and Donna L. Killmon is a tax attorney, at McLane, Graf, Raulerson & Middleton Professional Association, a full-service, multi-disciplinary law firm with offices in Concord, Manchester and Portsmouth, New Hampshire as well as Woburn, Massachusetts.