Structuring a Sale to an Existing ESOP

The buyer may use cash in reserve to finance the deal. That is almost always the case in smaller deals. In other cases, the buyer may borrow money from a lender, usually a bank or non-bank debt in very large deals.. This is supplemental and junior to the bank debt and carries a higher interest rate. Finally, the buyer may ask you to take a note for some part of the deal and pay you off at a negotiated rate over time.

No matter how this is done, your company’s employees become employees of the buyer and will become participants in the buyer’s ESOP and other benefit plans. The process of integrating benefit plans will usually take some time to complete, often a year or more. 

There will be a number of issues to work out in the sale. If you have both common and preferred stock, all the shares typically need to be converted into common stock. If the buyer is an S corporation (as most ESOPs are), any shares with voting rights different from common stock will need to be converted prior to the sale. 

A key decision is whether the sale will be an asset or stock sale. If your company is a C corporation, and your sale is structured as an asset sale, the company first has to pay taxes on appreciated assets, and you have to pay capital taxes on any gain from the sale of those assets. Buyers like asset sales because they do not inherit the liabilities of the seller, and the purchasing corporation can step up the basis of the assets. The buyer may be able to depreciate the assets as well, generating a deduction. This depreciation opportunity does not work for 100% S Corp ESOP companies, since they pay no federal or state income tax. A stock sale does not incur potential double taxation for the seller and thus may be preferable to the seller, but the buyer has to assume any potential liabilities of the target company in a stock sale. In negotiating the deal, some buyers may offer a lower price for a stock sale as a result.

A second key issue is whether the sale to the ESOP company can qualify the owner(s) of the target for the Section 1042 tax deferral opportunity (the ability of the seller to defer capital gains treatment by reinvesting in stocks and bonds of U.S. operating companies). For this to work in a direct sale to the buyer (as opposed to the buyer’s ESOP), the buyer must be a C corporation, and its ESOP must own at least 30% of the stock. The transaction must be a share purchase, not an asset purchase. 

To qualify the seller for the tax-free rollover, one of two structures is normally used.

Direct Sale to the Target

Under this option, the seller would exchange all their stock for newly issued stock of the buyer. The buyer needs to be a C corporation that owns at least 30% of the buyer’s shares. The sellers would then sell all of these new shares to the buyer’s ESOP. The buyer will use existing cash or will borrow funds to make the purchase. In some cases, the financing might come from the seller taking a note, but this is much less common. Because the seller has sold to an ESOP in a qualified C corporation, the sale qualifies for the Section 1042 rollover.

The Two-ESOP Approach

Most ESOP company buyers, however, are not C corporations, but rather 100% ESOP-owned S corporations. These companies pay no income tax and often accumulate substantial cash. But a sale to an ESOP in an S corporation does not qualify for Section 1042.

The way to solve this problem, usually practical only for larger deals, is for the target to set up an ESOP that is financed by the buyer. The target company first sets up its own ESOP. If not a C corporation, the company would first convert to one. The target company's owner sells to the target ESOP in a transaction that may be financed by the acquirer (or often seller notes) and takes 1042 treatment. Immediately thereafter, the acquiring company's ESOP merges with the target's ESOP. If the seller took a note to finance the sale, then the buyer will usually pay off that note after the sale is completed.

Because this approach involves setting up an ESOP in the target, then taking the additional steps necessary to complete the merger, it involves more legal costs and time, hence why it is usually only worthwhile in larger deals.