As discussed at the beginning of this publication, owners who sell to an ESOP and then discover their decision-making power is gone may become very upset. For many owners, the issues that come up when facing a transition are less dramatic but no less important. In the fairly recent past, people who reached age 65 could expect to live about 10 years, and some of those would likely not be in the best health. Now life expectancy at 65 is 20 years, and retirees are often a lot more vigorous. They want to stay engaged and active in some way, not infrequently by keeping some role in their company. That's a good decision. Research definitively shows that people who are mentally, socially, and physically engaged after retirement live longer, happier, and healthier lives. But how can you avoid being another grumpy ex-owner? And what can you do to find some appropriate role that can help preserve the legacy you have built in your company? When do you become a nuisance instead of a resource? This issue brief addresses the many issues that arise, including choosing a successor, transitioning out of leadership, protecting the seller's financial interests, what to do after the transition, investment strategies, and more. Multiple real-life case studies are combined with an essay on investment strategies for owners selling to an ESOP.
Table of Contents
Transition Case Studies
Central States Manufacturing
Geil Enterprises Inc.
Harrell Remodeling Inc.
Succession Missteps and Solutions in a Software Company
Manfred Hoffmann: A 50-Year ESOP Development
Investing After You Sell Your Business to an ESOP
Essential Facts of the Case
Will It Be Enough?
Defining Core Capital
How Do We Choose an Asset Allocation?
What Is the 1042 Tax Deferral?
The Buy-and-Hold Dilemma
An Active Approach to Investing in QRP
When Sellers Finance the ESOP
Should We Take the 1042 Deferral?
What Are Our Options for Donating to Charity?
Tying the Plan Together
About the Authors
About the NCEO
From "Transition Case Studies"
The most prominent challenge for me during the transition was giving my successor and his team the room to develop on their own without my insistent voice. One of my weaknesses at shared governance was that I was the habitual arbiter of all things large and small, and I needed to remove myself from that role.
At the same time we were going through the transition, our niche industry was experiencing a slowdown as our clients' source of revenue and financing shrunk in the growing recession. A few years before the transition, we shifted our sales focus from smaller users in our industry to larger players. The sales strategy for large customers was succeeding, but we lost a significant number of smaller customers to price pressure from competitors in the downturn. We were also experiencing our share of problems scaling up to meet the needs of the larger contracts.
In 2012, two years after rolling out the succession plan, we kicked off the ESOP when it purchased 30% of the company shares. Six months before the event, I had met with all employees in groups of four to discuss the long-term plan to create an employee-owned company with a 100% stake. I also took this opportunity to answer lingering questions about my role in the day-to-day management. The questions showed me that there was still work to do on the succession plan.
Although we had been an open-book company for many years before the transition, the organization seemed slow to acclimate to a new leadership voice. As I look back, the leadership team itself was not completely ready or open to a new voice. I think my successor's style was to be more open than me, and he pushed the decision-making into the leadership ranks more than I did. But although the succession plan transitioned my authority to the new president, not all of the leaders were on board with it. I realized that I had not achieved the level of shared accountability in the leadership ranks that I had thought before starting the succession plan. And I had also left behind a leadership team that was not completely prepared for the challenges ahead.
From "Investing After You Sell Your Business to an ESOP" (footnotes and tables omitted)
For John and Jane, the issue wasn't the timing of the gift, but the best vehicle to use. They considered two vehicles that are attractive today and would potentially fit their situation: a donor-advised fund and a charitable remainder trust.
A donor-advised fund is an account that the donor creates with a sponsoring charitable organization. The donor funds the account with cash or securities that can be sold and reinvested in a tax-free environment. Over time, the donor uses these funds to make grants to charities. The donor-advised fund can be an excellent way to pre-fund charitable gifts the donor intends to make over the next many years, while receiving an income tax deduction today.
In a charitable remainder trust (CRT), by contrast, the donor contributes low-basis assets to a trust that can sell and reinvest without immediate tax consequences, and the trust makes a taxable distribution to the donor each year. The donor receives an upfront charitable income tax deduction based on the actuarial value of the assets that will pass to the charity at the termination of the trust, which usually occurs at the death of the donor and spouse.
John and Jane chose to use the CRT because it gave them greater confidence that they could meet their retirement spending needs and because it offers very attractive tax benefits.
Today's higher, more progressive tax rates make CRTs more attractive than they have been in recent years. While selling a valuable low-basis asset would almost certainly push business sellers into the top bracket, a CRT can spread this gain over many years of distributions. As California taxpayers, John and Jane can save nearly $80,000 in tax by running $1 million of realized capital gains "through the brackets," instead of paying top marginal rates.
To estimate how much the CRT would help John and Jane, we assumed that they sell the $10 million business to the ESOP and make a 1042 election, choose the active 1042 reinvestment strategy for only 75% of the sale proceeds, and contribute the other 25%, or $2.5 million of low-basis assets, to a CRT. We also assumed that the couple is willing to take more risk inside the CRT than in their personal portfolio to maximize cash flow: They decide to invest 70% of the trust assets in stocks and 30% in bonds. We then evaluated CRTs with three different unitrust payout rates: the 5% minimum, 8%, and the 10.6% maximum allowable for people their ages.
As table 4 illustrates, the CRT would increase their median projected personal wealth in year 30, regardless of the payout rate. With the 5% CRT, the personal wealth advantage is quite small, but for the 8% CRT it grows to $1.25 million.
When we add in the trust assets that will pass to charity, the total wealth created with the CRT strategy increases meaningfully. The 5% CRT maximizes the charitable remainder and total wealth created (since less money goes to the couple). Over 30 years, the 5% CRT produces 27% more wealth than the ESOP 1042 strategy alone, and 79% more wealth than paying the tax on the upfront sale.