Douglas Pugliese, Alpha Architect; Peter Abrahamson, ESOP Structuring Specialists; Tabitha Croscut, Devine Millimet
ESOP companies have been very active acquirers of other companies—and with good reason: Acquisitions can add value to ESOP companies and their participants, above and beyond those enjoyed by non-ESOP companies. Incremental cash flows can drop to the bottom line, especially in S corporation ESOPs, which enjoy significant income tax benefits. That cash can be used to buy more company stock and/or repurchase shares, raise employee benefit levels, as well as cushion borrowings and add protection from creditors.
To understand the range of ESOP company advantages in the context of strategic acquisitions, it is important to appreciate the key criteria across which sellers evaluate competing bids for their companies:
ESOP companies enjoy an edge in each of these criteria, as the table below outlines:
In general, sellers prefer to exit their companies via a stock sale to an acquirer. This enables a cleaner exit from legacy concerns, such as contingent environmental liabilities. The seller enjoys generally more beneficial tax treatment because there is no double taxation on both asset and stock price appreciation. Stock sales create enhanced estate planning and charitable giving options for sellers. Stock sales do, however, require greater buyer due diligence, since the risks of contingent liabilities must be fully understood.
Buyers, on the other hand, prefer to acquire assets versus purchase stock. Asset deals leave potential legacy liabilities with the seller. Asset deals also step up the acquired assets’ basis, enhancing the acquirer’s depreciation tax shield after closing. Sometimes, a stock sale can be done in combination with a Code §338(h)(10) election by the buyer, which treats the transaction as an asset sale for the acquirer even though it was actually a stock sale. This provides benefits to both parties but is available in more limited situations and requires that the seller be an S corporation at the time of the transaction.
Asset purchases typically work better for C corporations and for less–than-100% S corporation ESOPs. The target’s assets receive stepped‐up tax basis, greatly enhancing the acquirer’s depreciation tax shield. The structure can help in offsetting limitations in interest deductions under new tax laws. Pass‐through voting is required if target is an ESOP company.
Finally, the acquisition can be done via a merger. In mergers, the deal is generally structured to be tax‐free to buyers and sellers. Since the seller receives stock in the combined entity, a merger may not provide as clear a path to exit for retiring owners of closely held companies—especially if they need to stay on for operational reasons.. Also, pass‐through voting is required by the target as well as acquiring ESOP company.