ESOPs: An Exit Plan for the Retiring Business Owner

An Employee Stock Ownership Plan, or ESOP, offers a tax advantaged way for a business owner to get liquidity from the business while sharing the benefits of ownership with the employees.

Due to the complexity of ESOPs and the endless ways to customize ESOPs, this article is very high level and has overgeneralized many details.  We highly recommend specialized ESOP and ERISA legal counsel in the opening innings of thinking through an ESOP.

Benefits of an ESOP

Continuity

Many business owners are emotionally attached to their business and the employees that helped them along the way.  Selling the business to the ESOP can provide financial security to business owner, while providing continuity to employees. It is an effective way to sell and transition control of the company to key employees, allowing the business owner to take an active role in the business during the transition, and even after the sale is complete if they wish.

Employee Ownership

Due to their ownership, employees are incentivized to have an interest in the long term growth of the company. The ESOP is funded only by employer contributions. Employees do not have to defer their compensation to receive the benefits of ownership, and they are not taxed on the stock allocated to them in the ESOP until they begin taking distributions. Like other retirement plans, their distributions can be rolled to an IRA, where income can continue to be deferred until age 70.5.

Tax Benefits

If constructed properly, the proceeds from the sale of the business can be invested in Qualified Replacement Property and the gains from the business sale can be deferred indefinitely.  In addition, a portion of the profits of the business that will be owned by the ESOP will be able to go to the employees on a tax deferred basis as well.  The tax benefits, and structure of a sale to an ESOP vary significantly on whether the business is an S or C corporation.

Drawbacks of an ESOP

No Windfall Sales Price

The actual ESOP will be run by a Trustee and, as a fiduciary, they will ensure that the price paid is fair market value.

Administrative Burden

There is significant initial and ongoing administrative maintenance to the ESOP and to protect all stakeholders from liability.  The transaction will require Appraisers, Auditors, Attorneys, and financial planners; which all cost money and your time.

How does an ESOP work?

Business owners considering the use of an ESOP in their exit plan should start planning a few years before a potential exit. There are administrative, fiduciary, and legal costs associated with the setup and maintenance of the ESOP.  Ultimately, an ESOP is a qualified retirement plan governed by the Internal Revenue Code and fiduciary and disclosure rules set by ERISA.[i]

Simplified Example:

The owner will sell their shares to an ESOP trust.  The ESOP Trust borrows money from a bank[ii], which it uses to pay the Seller.  The Seller will also generally take back a note for a portion, as the bank will not lend on the entire amount.

In this example, our fictitious business owner Earl is selling his engineering company “Earl’s Engineers”.  Earl’s Engineers makes $1m per year and, although he thinks he could sell to a competitor for $5m, the Trustee of the ESOP that he set up had it appraised and it was valued at $4m.  As Earl loves his employees and wants to see Earl’s Engineers thrive he accepts the $4m.  A bank was willing to lend $3m and, for simplicity in our fictitious world they were generous enough to give a 10 year term at 0% interest.  Earl takes a note back for $1m, also on a 10 year term with 0% interest.

Earl’s Engineers Financing Transaction

The next year; Earl’s Engineers makes another $1m and the money essentially flows like this; with the ESOP paying down its debt and the employee owners benefiting from that.

Next month:  ESOP Example: We’ll examine the basics of why and how our client J.D. Flaherty was able to share the benefits of ownership with the Columbus based Construction Systems, Inc.

Resources:

ESOP Tax Incentives and Contribution Limits

Benefits of an employee stock ownership plan in succession planning

ESOPs: A Tax Advantages Exit Strategy for Business Owners

The Benefits of an Employee Stock Ownership Plan

Employee Ownership: Is an ESOP Right for Your Company?

[i] ESOPs: A Tax Advantages Exit Strategy for Business Owners

[ii] This is a simplifying discussion: Most banks will not lend directly to an ESOP trust, therefore they will lend to the company, which will then lend to the ESOP.