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Advantages of Utilizing an ESOP In a Transition Strategy

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When building a strategy to transition out of your business, you’ll have to address some of the following questions:

  • Who will run the business after I leave?
  • How will the business change when I’m gone?
  • Will my employees be taken care of?

An employee stock ownership plan (ESOP) may be the solution you’re looking for. ESOPs eliminate much of the uncertainty inherent in business transitions, making them beneficial to the company, your employees, and to business owners. Let’s explore the benefits of utilizing ESOPs in a transition strategy.

Financial Advantages

ESOPs, when used as part of an exit plan, provide a handful of financial benefits.

Capital gain deferral for C corporation shareholders.

If organized correctly, exiting shareholders can defer gain recognition from the sale of their ownership interests by transferring their stock into an ESOP. For this technique to work, a few things must happen.

  1. The company must be a C corporation. Capital gain deferral is not an option for S corporation owners.
  2. The departing owner must sell shares of company stock to the ESOP, and they must have owned those shares for at least 3 years prior to the sale.
  3. The departing owner must invest their proceeds from the stock sale in qualified replacement property (which typically includes common stock, preferred stock, or bonds of another corporation) within 12 months of the stock sale.
  4. After the stock sale, the ESOP must hold at least 30% of outstanding company stock.
  5. The departing shareholder must make a Section 1042 election on their tax return.

If each of these things happens, the departing shareholder can defer gain recognition on their stock sale until they liquidate their qualified replacement property. If they hold that replacement property until death, they may even be able to exclude their gain permanently.

Preferential tax treatment for all selling shareholders.

If your business is an S corporation or you choose not to make the Section 1042 election, you won’t be able to defer your gain, but you will qualify for preferential tax treatment. When you sell your shares to the ESOP, you’ll recognize a capital gain. Right now, capital gains are taxed at preferential rates, at a maximum rate of 23.8% (20% capital gains tax rate, plus a potential 3.8% tax on net investment income). In many other exit strategies, the sale of your ownership could be considered a sale of assets, which may be taxed as ordinary income.

Shares are guaranteed to transfer at fair market value.

When you sell your shares to an ESOP, the ESOP is required to pay fair market value – no more, no less. In a third-party sale, price is not guaranteed. The buyer may be able to negotiate a discount on your stock shares, causing you to lose some of the value you’ve built into your business.

Of course, it’s also possible that a third-party acquisition could yield a higher sales price. For example, a purchasing entity may want to pay a premium for your business if they anticipate owning your operations will create synergies within their organization. However, to many business owners, an ESOP may still be the preferred route. To be guaranteed an on-demand divestiture at fair market value, they are more than willing to forego the prospect of a sale that exceeds fair market value.

Non-Financial Advantages

Using an ESOP to transition out of your business can provide non-financial benefits, as well.

Establishes a market for company shares.

A difficult part of exiting your business is finding a suitable buyer. When you establish an ESOP, you’re essentially building a market for your shares.

This holds true even if your company already has an ESOP established prior to your exit. Employees retiring from an ESOP company will be granted shares of company stock as part of their retirement portfolio. The company is required to repurchase those shares at fair market value within a certain time frame after the employee leaves or retires.

Ownership transfers to those with a vested interest in the business.

Finding an external buyer of private company stock is difficult, and even if you do find a willing buyer, their motivations may not align with the goals you have for your company. Selling your shares to an ESOP ensures that company shares will be owned by those with vested interests in keeping your business running: its current employees.

Owners can continue to have control over the business.

In some instances, former business owners can continue to influence the company even after they’ve sold their shares. When selling shares to an ESOP, exiting shareholders may accept a note from the ESOP trust in lieu of cash. This effectively transforms them from being a shareholder to being a lender. When coordinating this deal, the selling shareholder can help draft the debt repayment plan to benefit them financially, but more importantly, they’ll continue to hold stake in the company in the form of debt rather than equity.

Other Considerations

ESOP companies are a bit different than non-ESOP companies, so if using an ESOP in your transition strategy sounds appealing to you, we encourage you to learn a bit more about how they operate. Please see the following blogs to learn more:

Reach out to us to discuss further. Our Meaden and Moore advisors understand the tax, legal, fiduciary, and fiscal requirements of ESOPs and can help ensure yours will benefit you, your company, and your employees in the long run.

Hillary is a Senior Manager in Meaden & Moore’s Assurance Services Group and has been with the firm since 2007. She provides public accounting services to a wide variety of clients in various industries including service, manufacturing, communications and employee benefits.

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