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 or her 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.
ESOP popularity
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 percent 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 his or 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 percent capital gains rate. Even if the owner sold
his or 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 percent capital
gains rate.
An owner of a "C" corporation, however, who has owned his or her
company shares for at least three years can sell at least 30
percent of his or her shares in the company to the ESOP and elect
to defer capital gain on the sale so long as he or she invests an
amount equal to the sale proceeds in "qualified replacement
securities" within three months before, or 12 months after, the
sale. This obviously presents a significant tax benefit to the
company's owner who may effectively be able to sell his or 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.
The Authors
Steven M. Burke is a shareholder, director
and chair of the Tax Department at McLane, Graf, Raulerson &
Middleton, Professional Association. His practice focuses on state
and federal tax matters, including tax strategies and planning for
businesses and individuals. He has also served as counsel for
companies, fiduciaries and sellers in more than 30 ESOP
transactions.
Donna L. Killmon is a tax attorney at
McLane, Graf, Raulerson & Middleton, Professional Association.
Her practice focuses on state and federal tax matters, including
tax strategies and planning for businesses and individuals. She
assists corporate and individual clients throughout Massachusetts
and New England in structuring transactions in the most
tax-efficient manner possible.