Like most other baby boomers, business owners will be retiring in large numbers in the near future. However, few have considered supply and demand when it is time to sell the companies. Simply put, demographic trends may pressure these sellers as buyers are scarce, and commensurate decreases in sale prices may result.
As a result of the business environment, Employee Stock Ownership Plans (ESOPs) can be a great option as a succession strategy. It should be seriously considered by every business owner close to retirement.
What is an ESOP?
In concept, an ESOP is a simple concept. Instead of selling the company to an independent third party, the owner simply sells it to a trust established and operated by the company. The ESOP borrows the funds needed from a bank or financial institution to complete the purchase. Alternatively, they can borrow directly from the owner. The company shares can actually be collateral for the loan.
As the company continues to operate, it contributes to the ESOP, and the loan is repaid. Part of the collateral is then released and allocated to the participant accounts as the loan principal is paid down. Participation can generally be extended to all of the non-union employees of the company. However, the ESOP can be established, so the employees never directly own the company shares and are never entitled to access the company’s finances.
To encourage employee ownership, Congress enacted significant tax incentives for employers to set up ESOPs and business owners who sell their ownership shares to ESOPs. In a properly structured plan, the business owner can avoid paying capital gains tax that would typically occur upon a traditional business sale.
The value of ESOPs will increase with higher capital gains rates. Another advantage is that both principal and interest on the acquisition loan are repaid with pre-tax dollars because the ESOP makes the repayment itself with tax-deductible company contributions. Said differently, the government pays 40% of the sale cost thanks to the tax deductions.
But the tax benefits don’t end there. When the ESOP owns all of the company stock, it can elect Subchapter S status. By doing so, the company is then allowed to pass through profits to its tax-exempt ESOP shareholder and then operate as a tax-free company.
Considering other estate planning strategies, it is surprising that ESOPs are not more popular. In most situations, it is because the benefits of ESOPs are not widely known by tax and legal professionals or by the business owners themselves. The plans are complex and are subject to many regulatory and legal requirements.
The ESOP thus provides a vehicle for the controlled sale of a closely held business (or another private firm), either gradually or all at once, whichever suits the particular organization’s needs. Ideally, it inspires increased loyalty and commitment to the company among the employees plus higher productivity. It is their company.
All stock and cash acquired by the ESOP are allocated to the accounts of the participating employees—generally in proportion to their annual compensation. The employees hold these allocations in a trust established under a written agreement.
What About Vesting?
Generally, the vesting benefit of an employee is determined by a vesting schedule. Like most employee benefit plans, an ESOP should be structured to benefit those employees who have remained with the firm the longest and who have contributed most to its success.
In companies with younger or middle-age owners/managers, the ESOP will ordinarily acquire 10%-30% of the stock. However, older owner-managers looking toward retirement may be willing to offer a more significant share of the ownership and its benefits.
Owners who can benefit from an ESOP
So when should a business owner consider an ESOP? There is no one-size-fits-all answer to that question, but the following factors should be considered:
- The business should have a quality management team aside from the owner that can oversee the company’s operations.
- The business should be of reasonable size, with a minimum value of $2 million.
- The current owner wants to remain with the company (in a limited capacity) slowly transition to a less active role.
- The owner desires to reward employees for loyal years of service by ultimately controlling the business.
- The company is profitable and has expected strong profitability in the future.
- The company employees are incentivized by ownership of the company.
What are the pitfalls?
The following companies should think twice about setting up an ESOP:
- The company has no critical management or business continuation plan.
- The company has a limited future due to the nature of its product line, geographic location, or management team.
- The company is subject to significant cyclical variations in profitability.
Notably, the most significant risk to an ESOP is the emerging liability that will come due when terminated or retired participants (or their estates) wish to sell their shares. This liability can be especially burdensome if several long-time senior managers who were also significant stockholders decide to cash out within a short period. It is wise to maintain either a conservative balance sheet (good liquidity) or provide for the segregated sinking fund to cover this liability in the planning.
The factors noted above are not exhaustive. The owner should carefully review all aspects to determine if an ESOP is the best planning option. A business owner considering retirement soon should consider if an ESOP fits their needs.