Business owners approaching retirement face a complex set of succession planning decisions, such as how to find a buyer for the business and how to properly position the company for post-transition success. Whatever the owner’s ultimate succession planning goal, an employee stock ownership plan (“ESOP”) should be considered as one potential solution.
An ESOP is a tax-qualified retirement plan designed to invest primarily in stock of the sponsoring employer. In a typical ESOP transaction, a business owner sells shares to the ESOP in exchange for a partial cash payment combined with a note that will be repaid over a period of time (typically 5 – 15 years, although longer payoff terms may be necessary if the transaction involves outside financing). Note payments are financed by contributions from the sponsoring company, and shares held by the ESOP are gradually released to the accounts of ESOP participants – the company’s employees – as the note is repaid. Upon maturity, the seller will have received full payment of the sales proceeds and beneficial ownership of the shares will have been transferred to the employees, who qualify to receive cash payments for the shares allocated to their accounts upon retirement. An ESOP thus presents a potential “win-win” solution for both the owner and the employees of the company: the ESOP empowers the owner to cash out of the business without the need to attract an outside buyer, and also provides employees with a retirement benefit that can serve as a powerful retention and performance incentive.
In addition, an ESOP transaction also presents opportunities for tax and estate planning. If eligible for tax deferral under Section 1042 of the tax code, the owner can defer taxation on any gain realized from the sale of shares to an ESOP by reinvesting the sale proceeds in qualified replacement property. If the reinvested sale proceeds are held through the owner’s death, the replacement property passes to the owner’s heirs with stepped-up basis, effectively eliminating any taxation on the ESOP sale altogether. An ESOP also presents certain tax advantages to the company, since contributions to fund note repayments are tax-deductible. In addition, companies organized as S corporations can experience substantial tax savings, since an ESOP holding S corporation shares is not taxed on any K-1 income passed through from the business.
While a powerful succession planning tool, ESOPs are not appropriate in every situation. The following table summarizes some of the variables that factor into deciding whether an ESOP transaction may be appropriate.
May Not Be Appropriate
May Be Appropriate
Desired transition candidate
Owner wants to keep business in family.
Owner wants to transition ownership to employees.
Timing of sale proceeds
Owner wants the bulk of sale proceeds to be paid up-front.
Owner is willing to take a seller note that stretches sale proceeds over a period of years.
Current workforce not qualified to successfully run the business in the owner’s absence.
Current workforce includes capable and qualified management candidates.
Volatility of company performance
History of volatile performance, with unpredictable cashflow year over year.
Steady performance with predictable cashflow.
Company anticipates substantial capital expenditures in near term.
Company does not anticipate substantial capital expenditures in near term.
Size of workforce
Small workforce; 25 or fewer employees.
Larger workforce, preferably 50 or more employees.
Availability of outside financing
Company is maxed-out on available credit and would have difficulty obtaining outside financing to fund the ESOP transaction.
Company is able to obtain additional financing to fund at least a portion of the ESOP transaction without violating existing lender covenants.
For all their potential benefits, ESOPs also come with certain drawbacks that should be considered carefully. ESOP transactions tend to involve significant up-front costs that may not be required in connection with alternative forms of transaction. Typical ESOP-related costs include the need to conduct a feasibility study to ensure the company’s ability to service ESOP debt, and the cost of retaining independent trustees, appraisers and other advisors as required to comply with applicable prohibited transaction exemptions. Another potential drawback is that an ESOP may not be able to offer transaction terms - such as share price and the interest rate and payment term of any deferred portion of the sale proceeds - as generous as those offered by outside buyers. (Note, however, that any less-favorable transaction terms can be at least partially offset by the issuance of warrants to the seller in conjunction with the ESOP transaction.)
If you have any questions about whether an ESOP might be an appropriate solution for your business succession planning, reach out to Jason Lumpkin or Shad Fagerland from the Retirement Solutions group.
You’ve heard our thoughts… We’d like to hear yours
The Schneider Downs Our Thoughts On blog exists to create a dialogue on issues that are important to organizations and individuals. While we enjoy sharing our ideas and insights, we’re especially interested in what you may have to say. If you have a question or a comment about this article – or any article from the Our Thoughts On blog – we hope you’ll share it with us. After all, a dialogue is an exchange of ideas, and we’d like to hear from you. Email us at [email protected].
Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.
Learn more about the potential challenges surrounding Exit and Succession Planning under Biden's Administration Federal Tax Proposals specific to Capital Gains Tax Rate, Gift and Estate Asset Transfers and PPP. ...