Using an Employee Stock Ownership Plan (ESOP) for Business Continuity in a Closely Held Company
Congress designed ESOPs to be the most cost-effective means for both owners and companies to provide for business transition. There is also no better way to preserve the legacy of your business and keep your options open for your role in the company going forward.
One of the most difficult problems for owners of closely held businesses is finding a way to turn their equity in a business into cash for retirement or other purposes. The decision to sell is more than an economic one, however. After putting years into a business, an owner develops a strong feeling of identity with the company. At the same time, the owner often has a sense of loyalty to the employees and would like to see them have a continuing role in the company.
For some business owners, the answer to these problems will be to turn over the company to an heir or sell to a competitor. But many owners do not have heirs interested in the business, and outside buyers are not easy to find. Even if they can be found, they may want to buy the company for its customer lists, technology, or facilities, or may just want to put a competitor out of business.
ESOPs (employee stock ownership plans) can be a very attractive and tax-favored alternative. For the owner of a C corporation, proceeds on the gain from the sale to the ESOP can be tax-deferred by reinvesting in the securities of other domestic companies. If these securities are not sold prior to the owner's death, no capital gains tax is ever due. If the company is an S corporation, LLC, or partnership, it can convert to a C corporation before the sale to take advantage of this tax deferral. If the company stays S, the owner does pay capital gains tax on the sale, but reaps all the other benefits of selling to an ESOP. The most important of these is that the owner's shares are bought in tax-deductible dollars, either from company contributions or plan borrowings. (The 2017 tax bill limits net interest deductions for businesses to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) until 2022, at which point the limit decreases to 30% of EBIT (not EBITDA)). In other words, starting in 2022, businesses will subtract depreciation and amortization from their earnings before calculating their maximum deductible interest payments.
The sale can be all at once or gradual, for as little or as much of the stock as desired. For the employees, no contributions are required to purchase the owner's shares. The owner can stay with the business in whatever capacity is desired. The plan is governed by a trustee who votes the shares, but the board appoints the trustee, so changes in corporate control are usually nominal unless the plan is set up by the company to give employees more input at this level.
An ESOP is a kind of employee benefit plan, similar in many ways to qualified retirement plans and governed by the same law (the Employee Retirement Income Security Act). ESOPs are funded by the employer, not the employees. Stock is held in a trust for employees meeting minimum service requirements and allocated to employees based on relative pay or a more level formula, then distributed after the employee terminates. ESOPs cannot be used to share ownership just with select employees, nor can allocations be made on a discretionary basis.
Financing an ESOP
The simplest way to use an ESOP to transfer ownership is to have the company make tax-deductible cash contributions to the ESOP trust, which the trust then uses to gradually purchase the owner's shares. Alternatively, the owner can have the ESOP borrow the funds needed to buy the shares. In this way, larger amounts of stock can be purchased all at once, up to 100% of the equity. Normally, the bank will loan to the company, which then reloans to the ESOP, not necessarily on the same terms. In some cases, such as when the total debt would exceed current book value, the bank may also want a personal guarantee, or may be willing to loan only part of the total sought. In that case, the ESOP would buy part of the shares now, and part after some of the debt has been paid.
Perhaps half of all ESOPs, however, are funded instead by a seller note. The ESOP acquires the shares then pays back the seller at a reasonable rate of interest (not more than what a commercial lender would charge for loans of similar risk.) Sellers often like this idea because not only do they get their shares sold, but they get a reasonably good rate of return on the note. In this scenario, however, the rollover would apply only to what is reinvested in the first year. The entire amount of the sale could only be reinvested, therefore, if the seller has other funds available or, as normally happens, the seller borrows money from a bank to buy special ESOP bonds that qualify for this kind of sale (an increasingly common approach). The seller then repays the banks with the proceeds of the note. However the money is obtained, the price is set by an independent appraiser, as discussed below.
If the company is a C corporation and the owner has held the shares for at least three years, once the ESOP owns 30% of the company's shares, the owner can reinvest the gains in the securities of other U.S. companies (other than real estate trusts, mutual funds, and other passive investments) within 12 months after or three months before the sale, no taxes are due until the replacement securities are sold. If the owner buys income-yielding securities and lives on the proceeds, giving them to an estate at death, no capital gains tax is due. If part of the securities are sold, tax is due only on a prorated basis. (This tax incentive is not available for S corporation owners.)
Tax Benefits of Selling to an ESOP
Compare the ESOP buyout to two other common methods of selling an owner's shares: redemption or sale to another firm. Under a redemption, the company gradually repurchases the shares of an owner. Corporate funds used to do this are not deductible. A $3 million purchase in a redemption would normally require over $4 million in profits to fund once taxes are paid. Moreover, the owner must pay tax on the gain, at capital gains or dividend rates. In a sale to a C corporation ESOP, the money made is considered a capital gain, not ordinary income, and taxes can be deferred. Even more important, the company only needs $3 million to fund the $3 million purchase, something that applies as well to sales to ESOPs in S corporations. Or consider the second alternative, selling to another company or individual. In a cash sale, taxes would be due immediately. If the sale is for an exchange of stock in the acquiring company, taxes can be deferred until the new stock is sold, but 80% of the company must be sold all at once and the owner ends up with an undiversified investment for retirement.
How the Price the Selling Owner Receives Is Determined
The price the ESOP will pay for the shares, as well as any other purchases by the plan, must be determined at least annually by an outside, independent appraiser. The appraiser's valuation will be based on several factors. Most appraisers try first to find comparable public companies and use their price/earnings ratio, price/assets ratio, and other guides for setting a price. Discounted cash flow, book value, the company's reputation, future market considerations, and other factors will be considered as well. The appraiser will try, as much as possible, to determine how much the business would be worth if there were a market for it. The appraiser is assessing what a financial buyer would pay, one who would operate the business as a stand-alone entity. A strategic buyer, such as a competitor, by contrast, might pay an additional premium because when the target company is acquired, there are perceived operational synergies that make the target more profitable to the buyer than it would be as a stand-alone entity. The ESOP cannot match this price because it cannot generate these synergies. Sales to synergistic buyers do trigger capital gains taxes, however, and often come with numerous contingencies.
How Employees Get Stock
ESOPs are much like other tax-qualified retirement plans. At least all employees who have worked at least 1,000 hours in a plan year must be included. They receive allocations of shares in the ESOP based on relative pay or a more level formula. If there is an ESOP loan, the shares are allocated each year based on the percentage of the loan that is repaid that year. The allocations are subject to vesting for as long as six years. Employees do not receive a distribution of shares until they terminate, and then the distribution can be delayed for five years if for reasons other than death, retirement, or disability. The plan is governed by a trustee appointed by the board; employees only have very limited required voting rights (they do not have to elect the board, for instance), although companies may provide additional rights.
It is important to understand that ESOPs do not allow employers to pick and choose who can get stock or to make allocations based on discretionary decisions. It is also critical to remember that ESOPs do not entail employees using their own money to buy shares. The company funds the plan. The ESOP trust holds the shares, and the ESOP trustee is the shareholder of record for the company stock in the plan; the participants are beneficial owners who have accounts in the ESOP.
S Corporation ESOPs
If a company is an S corporation, the profits attributable to the ESOP are not taxable. So if the ESOP is a 30% owner, income taxes are not due on 30% of the profits; if it is a 100% owner, no taxes are due, a rule that has led to the rapid growth of 100% S corporation ESOPs, often conversions from C corporation companies with ESOPs after they make the final purchase of shares.
Making the Decision
All of this may sound appealing, but it is not feasible for every company. Several factors must, at a minimum, be present:
- The company is making enough money to buy out an owner. The company must be generating enough cash to buy the shares, conduct its normal business, and make necessary reinvestments.
- Payroll must be adequate to cover the purchase. Because there are some limits (albeit generous ones) on how much can go into the ESOP each year, if a business has an exceptionally high value relative to its payroll, it may not be a good ESOP candidate, although this is an unusual scenario.
- If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan. Similarly, the company must not have bonding covenants or other agreements that prohibit it from taking on additional debt.
- If the seller wants to take the tax-deferred rollover, the company must be a regular C corporation or convert from S to C status. S corporations can establish ESOPs, but their owners cannot take advantage of the tax-deferred rollover described above.
- The seller(s) must be willing to sell their shares at fair market value, even if the ESOP pays less than an outside buyer would. An ESOP will pay the appraised fair market value based on a variety of factors, but sometimes an outside buyer can pay more for a company if it has a particular fit that creates synergies that go beyond what the company is worth on its own.
- Management continuity must be provided. Banks, suppliers, and customers will all want to be persuaded that the company can continue to operate successfully. It is essential that people be trained to take the place of departing owners to assure a smooth transition.
For many owners of closely held companies, an ESOP is an ideal solution. For others, it simply will not work. To make a decision, create an initial business plan, factoring in legal costs, the costs to buy the shares, and the company's cash flow. If that looks encouraging, talk to an accountant about your figures. If things still look promising, have a valuation done. Your valuation specialist will tell you how much your stock is worth and should also give you a more detailed idea about the practicality of selling these shares. If things still look good, hire a qualified ESOP attorney to draft your plan. As you consider an ESOP, find some other ESOP company executives to talk to, attend an ESOP meeting or two, and finalize your plans with all the key players.
For a book-length discussion of this subject, see Selling to an ESOP.