Using an ESOP as a Tax-Advantaged Succession Strategy for Closely-Held Businesses

I will never forget the time I sat down with a founder who had built his manufacturing business over thirty years and was so anxious about selling it to a competitor who would ruin the culture and fire all of the people he trusted and relied upon to help him grow the business for three decades. After we had come up with an Employee Stock Ownership Plan (ESOP) for him, seeing how relieved he was, that was more valuable to me than doing the transaction itself. This was not just a transaction; this was a legacy.

 

The Problem: Founders of private companies experience a “liquidity trap” when they wish to retire (liquidate their interest in the company) but cannot find a buyer who thinks as highly of their company’s culture as they do, or one who is going to provide them with a fair, tax-efficient way of exiting the company.

 

The Constraints: There are also constraints associated with this liquidation process. On one hand, you need access to immediate cash in order to retire, while on the other hand, you are concerned about the long-term health of your business and your responsibility’s associated with IRS compliance and fiduciary duties.

 

The Solution: An ESOP succession plan for private company owners enables you to sell shares of your company to your employees, defer paying taxes, legal counsel, and have a high degree of confidence that the culture you took decades to build/maintain will continue to live on in the company as long as you structure the transaction properly.

 

Prerequisites and Context

 

Before going forward, you will need a few ‘tools’ to have in your toolbox:

 

• A qualified valuation firm: You cannot estimate the value of your company; you need a qualified valuation firm to prepare a binding document.
• Legal counsel: You will need an ERISA attorney to help you with all legal aspects of the transaction.
• Financial data: You will need at least three (preferably five) complete years of clean, audited financials.
• A “Trustee”: You will need an independent trustee to represent the employees in the transaction.

 

The Strategic Case for Employee Ownership in Private Enterprises

 

Many owners believe their only option is a strategic sale to a larger company. However, a sale frequently results in layoffs and a loss of the company’s identity. An employee stock ownership plan allows employees who work at a given company to become shareholders in that business. When employees are shareholders, their interests align with achieving company success which typically results in increased productivity and decreased employee turnover.

 

Navigating the ESOP Succession Plan for Private Company Transitions

 

Assessing Readiness and Business Valuation Fiduciary Standards

 

When creating an ESOP, one of the most important decisions to make is what will be the valuation of shares sold to the ESOP since this is done prior to implementing an ESOP. The ESOP will not pay less than “fair market value” for the shares as per the US Department of Labor. To determine this amount for an ESOP, an independent ESOP valuation fiduciary will need to be engaged. If the valuation price is too high, the ESOP may be disqualified; conversely, if the shares are sold to the ESOP for less than they are worth, you would have effectively left money on the table.

 

Balancing Seller Liquidity with Long-Term Corporate Sustainability

 

Owners frequently make mistakes when withdrawing cash from their companies, specifically attempting to withdraw too much in cash at once. Depleting the working capital of the business to withdraw cash will result in challenges to the businesses’ viability, so instead try to identify a “sweet spot” that gives you something for cash while allowing adequate cash for future growth.

 

Structuring the Deal: Leveraged ESOPs and Seller Financing

 

Mechanics of the Leveraged ESOP Structure

 

A leveraged ESOP involves the borrowing of money to purchase the shares you have sold to an ESOP. Subsequently, the ESOP receives tax-deductible contributions to the extent of the loan from the company to pay off the loan. Using seller financing can be a great way to fund a purchase with money that isn’t taxed.

 

Optimizing the Seller Financing Note for Cash Flow Stability

 

Often times a bank won’t lend you all the money you need. That’s when you can use a seller financing note. In essence, you become the bank and lend the seller part of the money to make the deal happen.

 

Comparative Cash Flow Impact Table:

 

• 100% Bank-Financed: More expensive interest rates, stricter loan covenants, quicker out for the seller, but much higher risk to the functioning of the business.
• Hybrid Seller-Note Structure: Cheaper interest rates; more flexible terms of repayment; better for long-term cash flow; but seller remains “in the game” much longer.

 

What Didn’t Work For Me

 

An early client of mine was able to get the maximum amount of leverage out of their company during my career. We got the founder all the cash available from the company and then two years later a small downturn in the market happened, and there were no cash reserves, so they couldn’t pivot and defaulted on the seller note. I found out the hard way that if you don’t leave enough “meat on the bone” for the business to run, your seller note is just a worthless piece of paper. Always think of the balance sheet of the business before you think of what you will get as cash now.

 

Tax Efficiency and the Section 1042 Rollover

 

Qualifying for Deferred Capital Gains Tax Benefits

 

C-Corps may utilize the Section 1042 rollover to defer Capital Gains Tax, indefinitely. Essentially, upon sale of any business, an owner will use all proceeds to purchase “Qualified Replacement Property” (QRP) as a means of reinvesting in a similar-type business as a 100% qualifying use business.

 

Navigating the Qualified Replacement Property (QRP) Requirements

 

The IRS guidelines define QRP requirement guidelines very clearly and these guidelines will dictate what is considered QRP. In general, if the asset you wish to exchange is not a stock or bond of a domestic operating company, it is not considered QRP. You will need to add to QRP by utilizing cash or cash equivalents like bank savings or real property.

 

Managing the Long-Term Repurchase Obligation

 

Forecasting Future Liquidity Needs for Departing Employees

 

An employer must repurchase stock from ex-employees upon the termination of their employment through retirement, death, or other reasons. This is the repurchase obligation planning phase. You will need to have a qualified professional perform an annual “repurchase study” to project your expected liabilities.

 

Integrating Repurchase Obligation Planning into Annual Budgeting

 

Repurchase obligations must be viewed as an expense. They will be treated like payroll or rent as part of your annual budget. If you fail to include them in your budget, you may find yourself without enough cash to fund your repurchase obligations when a group of long-term employees retire.

 

Edge Case: Evaluating the Employee Ownership Trust (EOT) Alternative

 

When to Choose an EOT Over a Traditional ESOP

 

The employee ownership trust alternative requires less paperwork to establish than an ESOP and has a less strict ERISA reporting requirement. Employee owners will, however, not be able to enjoy certain tax benefits, such as a 1042 rollover.

 

Regulatory Differences and Governance Flexibility in Trust-Based Models

 

An EOT has the ability to provide a more flexible governance structure. If having a distinct organizational leadership style and/or social purpose is critical to you, EOTs may be more appropriate than a very regulated employee stock ownership plan (ESOP).

 

Best Practices for Maintaining Compliance and Culture

 

Mitigating Fiduciary Risk During Annual Valuations

 

To perform annual valuations, you must hire a reputable firm. Annual valuations serve two purposes: compliance and transparency. When employees see their share price move, they will start to see how much their work influences the bottom line.

 

Aligning Employee Incentives with Post-Transition Growth

 

You must communicate the value of the ESOP to your workforce. You should use a dashboard that tracks key performance indicators (KPI) such as revenue per employee or EBITDA growth. When employees see that their day-to-day actions increase their retirement plan account balance, the organizational culture will transition from “just a job” to “ownership.”

 

Frequently Asked Questions

 

How does a Section 1042 rollover impact the long-term tax basis of the replacement property?

 

When you purchase a qualified replacement property (QRP), you will reduce your tax basis in that property by the amount of gain you were able to defer through the Section 1042 rollover process. If you hold the property until death, your heirs could potentially receive a “stepped-up basis,” thereby eliminating your tax liability entirely. You can learn more about these tax implications via the NCEO.

 

What are the primary risks associated with the repurchase obligation for a closely-held business?

 

The largest industry risk associated with the repurchase obligation is liquidity risk. If the company has a poor year and cannot generate enough cash flow to repurchase shares, the company will be at risk of violating its ESOP plan document, which can result in significant penalties or even disqualification of the ESOP.

 

Can an employee ownership trust provide the same tax advantages as a qualified ESOP?

 

No—there are wonderful governance and cultural benefits to EOTs; however, EOTs do not provide the same federal tax-deferred benefits like those provided by a qualified ESOP in accordance with the Internal Revenue Code.