by Steve Goodman
CPA, MBA – President & Chief Executive Officer
Contact Steve today for more info.
When a business owner begins to consider an exit strategy, the universe of strategies includes several options:
- Give the business to the children
- Sell the business to the children
- Sell the business to company management
- Go public
- Sell to a financial buyer (private equity or private investor)
- Sell to a strategic buyer (competitor, supplier, or key customer)
The decision process needs to consider the facts surrounding the sale. If there are no children, or the children have no interest in running the business, then these options are void. If the company is a participant in a mature industry with modest growth prospects or if economic conditions are unfavorable for going public or a buy-out, then these options are not attractive. Additionally, the costs of going public or engaging a broker to help sell the business can be considerable. Rarely does company management have the funds and credit to buy the company from the owner?
Then there are the non-financial aspects of selling the business that a business owner considers. Will the family name remains on the door? How can the owner share some of the sales with those who played key roles in building the business? How can the business owner protect continuing employment in the community? Is the business owner comfortable sharing trade secrets and proprietary information with potential competitors, especially those who later decline to buy the business?
One exit solution that has shown significant growth in the last two decades is the ESOP – Employee Stock Ownership Program.ESOP’s are available to C corps and S corps. Congress established ESOP programs and later enhanced them to provide a means for employees to share in the profits and growth of their employer. Numerous studies have shown that companies owned by employees are more productive and profitable than their non-employee owned competitors.
To encourage business owners to participate, Congress granted attractive tax incentives. Recent statics provided by The ESOP Association indicate over 10,000 US ESOPs that cover 10.3 million employees, roughly 10% of the private sector workforce.
How it Works
ESOPs involve the sale of the company stock to a trust for the benefit of employees. A variety of sources can fund the trust. These include company cash, bank loans, loans from the business owner, and even warrants from private equity firms. Most ESOPs involve a series of loans and loan guarantees. The sale of company stock can be conducted over a series of years or it can happen all at once.
The process begins when the company board, at the behest of the primary owner(s), decide to sell the business to the employees through an ESOP. Upon making the decision and working with advisors to identify the costs and benefits, three actions are set in motion:
- The company forms an ESOP trust and appoints an independent trustee to manage the trust.
- The company hires an independent valuation firm to provide a valuation of the company on the basis of an on-going business.
- The company and the trustee begin to evaluate financing options to purchase company stock.
The ESOP trustee is independent, yet the trustee is appointed by the company board. The company board, typically controlled by the business owner, retains the right to replace the trustee. Until the trust owns a majority position in the company and provided the trust is granted the ability to vote on such items until the sale is complete, the company owner maintains effective control over the trustee. In practice, this is infrequently a problem, though the potential for a series of short-term trustees is present.
The company requires an initial valuation with an annual update once the process begins. The initial valuation sets the price for the initial share sale. Employee stock buybacks and on-going share purchases from the company, as applicable, require an annual valuation. As employees leave the company and seek to cash out their non-marketable shares (assuming a privately held company), the trust needs to identify a price at which to buy back the shares.
The trust and the company need to consider a financing scheme for the transfer of shares from the owner(s) to the ESOP. This often involves a bank. Banks, however, are reluctant to lend directly to an ESOP trust due to regulatory complexities and filing requirements. They will lend money to the company using company stock, and often, the business owner(s) personal guarantee as collateral. In ESOP terms, this loan is known as the ‘outside loan’.
If there is an ‘outside loan’ then it makes sense that there must be an inside loan. The following diagram identifies the structure of a leveraged ESOP transaction.ESOP trusts that have sufficient cash do not require external financing (bank). These are non-leveraged ESOP’s. Most ESOPs begin as leveraged transactions.
The company is the focal point of the transaction. It will arrange for the outside loan. It then lends the proceeds of the loan to the trust in exchange for an IOU, the ‘inside loan’.The trust then purchases stock from the owner using the available cash sometimes supplemented by a seller note.
When put in place, the trust owns some or all of the stock of the company. The trust enjoys the benefits of the company’s earnings and its ability to pay dividends (C corp) or distributions (S corp). These payments are set by the company board after making the required periodic payment to the bank. The trust will use some of the dividend/distribution to pay down the seller. The balance will be retained to pay off employees who have a right to ‘put’ their shares to the ESOP for redemption. Most redemptions are due to employees leaving the company for a variety of reasons including new jobs, termination, retirement, etc.
The ESOP trust holds the shares that the ESOP trust purchases from the seller on credit in a ‘suspense account’.This account grants the trust ownership of the shares but with restrictions concerning the trust’s ability to issue the shares to employees. As the trust pays down the loan to the seller, The ESOP removes tranches of shares from the suspense account. They become available for employee allocation.
The company can expect a significant cost for all the work required to institute an ESOP. Additionally, there are annual expenses. Each year, the valuation requires updating while the trustee continues to be paid. When compared to the cost of selling the company, the brokerage fee alone can be considerably more expensive than the initial ESOP cost.
One significant difference between selling a business to a 3rd party and selling the business to an ESOP is the time required to complete the transactions. A 3rd party sale can be sometimes complete in 6 months or less.ESOP transactions can take years, just to begin the process. The company and its advisors typically want to accumulate cash to minimize the loans required. Fewer loans mean a higher likelihood of bank approval and faster payoff of loans requiring the seller’s personal guarantee.
There are numerous tax incentives available for business owners to enter into ESOPs.There are some significant differences between C and S corporations, such that some companies will change their incorporation status just to take advantage of the tax benefits. This paper considers the topic of tax incentives in four sections; a brief review of C and S corporation taxation, ESOP benefits available to C and S Corps, C Corp specific regulations and incentives, and S Corp specific regulations and incentives.
Non-ESOP Related Tax Regulations
- S Corps pay no income tax. They are known as ‘pass thru’ organizations. The owners of the S Corp stock will add their share of the company’s profits to their personal income for tax purposes. The owners’ personal tax brackets determine how much tax is due on the S Corp earnings.
- The Tax Cuts and Jobs Act of 2017 made both S Corps and C Corps subject to an interest deduction limitation of 30% of adjusted pre-tax income. The definition of adjusted pre-tax income changes in 2022. The change will primarily affect capital intensive businesses.
ESOP Benefits Available to C and S Corps
- Stock contributions by a company to an ESOP are tax deductible. A company issuing 100,000 treasury shares to its ESOP at $10/share valuation can deduct $1 million from its pre-tax income.
- Cash contributions by a company to an ESOP are tax deductible. Often a company will reserve cash for several years in anticipation of establishing an ESOP. When the funds’ transfer is to the ESOP, the company can take the transferred funds as a deduction.
- Contributions made by the company to directly repay the ESOP trust’s stock purchase loans are deductible – both interest and principal. Typically, the trust is paying the seller for a note to purchase the seller’s stock.
- Employees benefit from company stock additions to their accounts with the trust, but they pay no tax at the time of crediting. When the employee cashes out his/her shares by selling them back to the ESOP trust, the employee can treat the cash as a long-term capital gain or roll it over into an IRA.
Specific C Corp Rules
- Once the ESOP owns 30% of the shares in the company, the seller can reinvest all subsequent proceeds from share sales in qualified domestic stocks and bonds while deferring capital gains taxes. Mutual funds, REITs, and government securities are not qualified replacement property. When the owner dies, all remaining shares from the portfolio transfer to the owner’s beneficiaries with a step up in basis to the market value on the day of death. This allows the beneficiary to sell upon receipt and incur no tax on the sale.
- Dividends issued by the company to the ESOP trust used to repay the trust’s loan, or used to redeem employee shares, or used to purchase more stock are tax deductible. The IRS requires that the dividend amount be consistent with ongoing operations.
- C Corps can deduct up to 25% of qualified payroll for all the defined contribution plans they offer their employees, including ESOPs.With limitations, interest payments made on leveraged ESOP payments do not count towards the 25% limit.
Specific S Corp Rules
- Many owners will convert their S Corp to a C Corp to take advantage of the capital gains tax deferral as presented in the Specific C Corp Rules section. Companies transitioning from S to C must wait 5 years to transition again back to an S Corp.
- ESOP trusts are not taxable entities. Any distributions received by the ESOP trust from the company are not taxable.
- S Corps can also deduct up to 25% of qualified payroll for all the defined contribution plans they offer their employees, including ESOPs.Unlike C Corps, interest payments made on leverage ESOP debt does count towards the 25% limit.
A quick review indicates that business owners need to model the benefits of a C Corp or an S Corp before entering into the ESOP transaction.C Corp offers the opportunity to defer significant capital gains taxes. The S Corp pays no federal taxes and often minimal state taxes. The incremental cash flow allows the bank loan and the seller’s note to be paid off faster. Many banks require sellers to offer a personal guarantee for any bank loans.The faster these loans are paid down, the faster the seller can be released from the personal guarantee.
Criteria of an ESOP
Not every company is a good candidate for an ESOP.
- Federal laws restrict employees from owning over 10% of the company shares in their accounts.As a rule, a company with under 15 employees is not a good candidate.
- Companies with significant debt (as a percentage of total capital) are not good candidates.Banks will be hesitant to extend additional loans to these companies due to repayment risk.
- Companies in economically sensitive businesses tend not to be good candidates per ESOP experts.Yet, the second largest group of ESOP participants are in the construction industry.
- Companies need to show growth.Stagnant businesses tend to suffer diminishing cash flows over time.ESOP debt added to the company capital structure results from ina greater risk of default in future years.
An ESOP is a qualified retirement vehicle. As such, it falls under ERISA, the Employees Retirement Income Security Act. This Labor Dept. enforced law places strictly guidelines on the actions of the trust and the rights of the employees. The trustee must be unaffiliated with the company, its outside counsel, accountant, and any other vendor of products of services to the company. The same holds true for the trust’s accountant, attorney, and valuation analyst. All must be free and clear of any conflict of interest.
Most ESOPs allocate shares on the basis of proportional employee pay. Anyone who is at least 21 years of age and meets certain service hours eligibility will participate in the plan. As a rule, ESOP’s do not cover unionized employees. Union members have a separate bargaining agency that represents their interests concerning retirement programs.
The company cannot use its discretion to determine who can and who cannot participate in an ESOP per ERISA regulations. Two methods are available for employee vesting. The company must select one or the other for all employees.
- No vesting for two years of service with full vesting at the end of the third year.
- No vesting in Year 1 with 20% vesting each year in Years 2 through 6.
Employees reaching a certain age must be granted diversification options such that their entire plan does not consist of stock in one company. Many companies will continue a 401K plan when they implement an ESOP.
Employees may own the company, but they do not control it. The company board of directors continues to guide the business, appointing or approving of key management personnel. Upon full payment of the notes, the trustee determines who sits on the board. Until such time, the board effectively runs the company without oversight.ERISA guidelines provide for a relatively few instances in which the employees have a vote. These instances include the sale of the business, relocation, dissolution, mergers, and related large-scale events that will ultimately affect the employee group.
Company management does not need to make detailed financial statements available to the employee base. Company management does not need to disclose officer salaries.
ESOP Trusts that incur no debt or pay off their debt quickly can run into a problem. As the trust’s debts are paid down, the seller’s suspense account shares become available to the trust. The trust will allocate the shares to existing employees. Once the ESOP has allocated all shares, net new employees are subject to receive minimal shares. As the employee base grows, new employees become eligible for shares. Some shares become available as employees leave, selling their shares back to the company. For growing companies who have paid off their ESOP loans, new employees can tax the trust’s ability to treat the new employees equitably.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.