Transfers to Key Employees

Business succession planning for owners of closely held businesses can take many paths. For multiple reasons, a business owner may want to sell a business to key employees. Selling a business to a family member is a complicated process. Yet in comparison to the thought and preparation that accompanies a transfer to key employees, the transfer to a son or daughter is easier in terms of comfort level, legalities, and time needed to plan and implement the sale process.

The key differences in selling to a family member versus selling to key employees include the following:

• Intrafamily transactions typically seek the lowest legal valuations. Transfers to key employees may not warrant a top dollar valuation, but generally, transact at a price higher than a family transfer.
• Intrafamily transactions assume the sale price will be paid. There is a blood relationship between buyer and seller. In a sale to key employees, one would hope that trust exists, but only a well-crafted legal agreement provides any real guarantees that the final price will be paid as anticipated.
• When transferring a business to a future generation of the family, one has no expectations that the new owners have the capital to provide a significant down payment on the sale. In the case of a transfer to key employees, a business owner’s comfort level increases with a sizable down payment. In many cases that down payment is only available through a deferred compensation plan requiring years of planning.

For those considering how to transfer a business to key employees, or those in a position to acquire a business, this article offers several strategies. This article cannot hope to provide the level of detail required for a full understanding of the strategies discussed. Nor can this article cover the universe of sale strategies. The goals of this article are to serve as an introduction to commonly considered strategies and to serve notice that the transaction can require considerable legal and financial planning.

The content of this article sources from Steve Goodman’s 2014 book Business Succession Planning.Mr. Goodman, CPA is a Long Island, NY based estate planning professional with 25 years of family wealth and business succession planning experience.

Business Succession Planning
Sale to a Key Employee or Core Group of Key Employees

There are a lot of reasons why a business owner may want to consider selling his or her business interest to a group of employees/managers:

• These are often the individuals who have helped make the business a success, so there may be a desire to reward them for their contributions.
• You can reduce the time and expense it takes to find a buyer. (No need for a business broker or investment banker.)
• They already have a solid understanding of the day-to-day operations that may allow for a smoother transition than bringing in a third-party buyer.

Unfortunately, there is also one characteristic that is common among key employees that may throw a monkey wrench into your plans. They typically do not have enough money, nor do they have the capacity (collateral) to obtain sufficient lending, to buy a business. While there may be exceptions, this generally means that the transaction will need to be structured as an installment sale over a period of years and the buyers will need to use the profits from the business to meet his or her obligations. As the seller, you will want to limit the duration of the installment period, as buyers will want to stretch it out. As the seller, you will want some amount of payment up front—some “skin in the game” by the employees, so to speak. As buyers, they will want to limit any up-front payments. So, if you require a substantial payment up front, or if you don’t have confidence that the buyers have the ability to generate sufficient profits over an extended period of time without your continued involvement, selling to a group of key employees may present some challenges.

The most pressing concern is that the business will fail to produce sufficient profits for the buyers to meet their obligations under the installment purchase agreement. The planning process should start by considering ways in which you can make the transaction more feasible for the buyers and then move on to explore ways to mitigate the risks.

One way to make the sale more feasible would be to establish a nonqualified, deferred-compensation plan for the benefit of the current owner prior to the sale. A nonqualified, deferred-compensation plan is simply a promise by the employer to pay compensation to an employee at some future date. As long as the agreement complies with IRC section 409A, the compensation will be taxable to the employee when paid, not when the promise is made. Unlike qualified retirement plans that must avoid discrimination rules (i.e., they can’t discriminate in favor of highly compensated employees), nonqualified plans may provide benefits to a select group of key employees, or for purposes of this discussion, to just the business owner (as long as they are an employee). The promise to pay becomes a liability on the books of the business and correspondingly reduces the value of the business. In addition, payments made to the owner are deductible by the employer. These two factors make the transaction a bit easier for the buyers by providing for a lower sales price and making a portion of the payments deductible.

There are several steps you can take to mitigate the risks involved with a sale to key employees. For example, you may include a “buy-back” provision in the purchase agreement, which gives you the right to buy back the business at a stated (typically reduced) price, should certain triggering events occur. These triggering events will be tied to the financial performance of the business. For example, you may retain the right to buy back the business based on a discounted fair-market value formula should EBITDA (earnings before interest, taxes, depreciation, and amortization) drop at least 10 percent for three consecutive years. This is obviously not a perfect solution since your goal was to exit the business, but at least it provides a means to protect your financial interests. You may also want to include an acceleration provision that forces the buyers to pay any remaining balance at an accelerated pace, should they fail to achieve certain financial targets.

Another way to mitigate the risks would be to sell the business in stages. The first step would be the sale of a minority interest to the employees. This would provide an income stream to you, provide the employees with an ownership interest and additional incentive to perform well, and allow you to retain control over the operations of the business. The sales agreement may include terms regarding the eventual sale of the remaining ownership interest, or it could be silent, and you could leave your options open. If you are concerned about transferring stock that comes with voting rights, prior to the sale, you may recapitalize your shares into voting and nonvoting shares and then sell only the non-voting shares to the employees. After a period of time has passed and the employees have gained experience as shareholders, and you feel confident in their ability to run the business, you can then sell them the voting stock.

If you do decide to transition your business in stages, an important step to keep in mind is that you will want to include the new owners in a buy-sell agreement that lays out each owner’s rights and options with regards to transfers of their interests. These agreements often cover different triggering events, such as the death, disability, termination of employment, divorce, or bankruptcy of an owner.

As minority owners of a business, the key employees may want to consider including provisions in the purchase agreement that will protect their interests. For example, they may want the agreement to include a “tag along” provision that states that if the majority owner tries to sell his or her interest, the buyer would be required to purchase the minority owners’ interests at the same price if the minority owners elect to sell.

An alternative to an installment sale purchase by key employees is the leveraged management buyout. This strategy is often more acceptable for the business owner who desires an up-front payment in full or is unwilling to accept the risks associated with an installment sale. There are many different versions of leveraged buyouts, but in general, they involve a management team using borrowed funds to buy out a business owner. The leverage may come from a typical lender with the buyers securing the loan with business assets, or it may come from venture capitalists or private equity firms who provide the funding while taking on equity interest in the business. These arrangements are more complicated to arrange, but for the business owner who truly wants to sell the business and walks away, yet wants to involve key employees in the sale, they may be worth exploring.

A point worth mentioning regarding a sale to key employees is that there are those who advocate that a business owner should distribute all or substantially all of the cash prior to selling the business to key employees. The reason for this advice is to limit the owner’s/seller’s exposure to nonpayment by the purchasing employees by reducing the value of the business and therefore the price the employees are obligated to pay. The risk here is that in many businesses, cash is king. Cash is needed to pay suppliers, pay interest on lines of credit, pay for research and development, etc. By stripping out all the cash, you leave the new owners strapped for cash. And if that causes the business to underperform, the seller may end up losing in the end because the business may not generate sufficient profits for the buyers to meet their installment payment obligations.I would not consider this a valid rule of thumb, as every business is different. It is certainly something to consider but do so with a bit of caution.

Transfers of Ownership as Compensation

Publicly held companies often provide compensation packages for their executive-level employees that include some form of stock ownership. These may be in the form of a stock reward program, restricted stock, stock options, or a stock purchase plan. Closely held businesses generally do not provide these types of benefits as compensation, but there are several ways to use such benefit programs, or similar programs, as part of a broader business succession plan.

But first, a word of caution. Compensating employees with actual stock ownership, stock options, or rights to purchase stock may have a detrimental impact on your ability to sell your ownership interest to an unrelated third-party buyer in the future. When a potential buyer runs through its due-diligence checklist and discovers that they would not be purchasing 100 percent of the business and that there are minority owners, their advisors will throw up a red flag. This may not prevent the sale from occurring, but it may cause a potential buyer to reduce the price it is willing to pay as it will be fully aware of the issues presented by minority shareholders discussed in chapter 6. If you are certain that you will be selling your majority interest to these same key employees, the stock granted as compensation will not be an issue.

If your business succession goals do include a transition of ownership to employees, implementing a stock-based compensation program may provide a means for slowly testing the waters to make sure those particular employees have what it takes to transition from an employee to an owner. The most common types of programs include stock reward programs, stock options, and restricted stock awards. Stock reward programs and stock options are fairly common and well understood. Restricted stock awards are an award of company stock granted to an employee but with a restriction that qualifies as a “substantial risk of forfeiture” under IRS rules. IRC section 83(a) provides that property transferred to an employee as compensation for services is taxable to the employee on the earlier of the date the property is not subject to a substantial risk of forfeiture by the employee or the date it is transferable by the employee. The most common restriction placed on the stock is that the employee must return the stock if they do not remain employed by the employer for a stated period of time. The main advantage of such a program for an employer is that the employee will have the incentive to increase the value of the stock and they will have the incentive to stay with the employer. From the employee’s perspective, the advantage is that they feel they have the benefits of actual stock ownership, yet they do not have to pay taxes on the value of the stock received until the risk of forfeiture lapses.

In my experience, closely held business owners who are considering a stock-based compensation plan should always explore an alternative compensation program that conveys the financial rewards of stock ownership without actually creating additional minority shareholders. There are several such programs including stock-appreciation rights and phantom-stock plans.

A stock appreciation right (SAR) is an award that provides the holder with the ability to profit from the appreciation in value of a set number of shares of company stock over a set period of time. The valuation of a stock appreciation right operates exactly like a stock option in that the employee benefits from any increases in stock price above the price set in the award. However, unlike an option, the employee is not required to pay an exercise price to exercise them but simply receives the net amount of the increase in the stock price in either cash or shares of company stock, depending on plan rules. Stock-appreciation rights are granted at a set price, and they generally have a vesting period and an expiration date. Once SAR vests, an employee can exercise it at any time prior to its expiration.The proceeds are normally paid out in cash, although the plan may give the employee the right to a distribution of stock.

Example

Stock Units Granted: 1,000

Stock Fair-Market Value/Share on Grant Date: $750/Share

Current Stock Fair-Market Value/Share: $900/Share

Current Value of SAR Award: $150,000

One of the great advantages of these plans is their flexibility. But that flexibility is also their greatest challenge. Because they can be designed in so many ways, many decisions need to be made about issues such as who gets how much, vesting rules, liquidity concerns, restrictions on selling shares (when awards are settled in shares), eligibility, rights to interim distributions of earnings, and rights to participate in corporate governance (if any).

Many forms of employee benefits, such as qualified retirement plans, require that the employer not discriminate in favor of highly compensated employees. This means that the employer will need to make the benefits available to the vast majority of its employees. On the other hand, there are other forms of employee benefits, such as nonqualified deferred compensation plans, that actually require the opposite. These plans may only include a select group of management or highly compensated employees (referred to as a “top hat” group). A properly designed SAR plan escapes both of these requirements and may be offered to whichever employees the employer so desires to include.

Employees are taxed when the right to the benefit is exercised. At that point, the value of the award, minus any consideration paid for it (there usually is none) is taxed as ordinary income and is deductible to the employer.If the award is settled in shares (as might occur with a SAR), the amount of the gain is taxable at exercise, even if the shares are not sold. Any subsequent gain on the shares is taxable as capital gain.

The American Jobs Creation Act of 2004 changed many of the tax rules that pertain to deferred compensation arrangements (new IRC section 409A). There was some initial concern that SARs would be considered deferred compensation arrangements and therefore be required to comply with these new tax laws. In December 2005, the IRS and Treasury clarified their position on SARs.They stated that these plans would not be considered “nonqualified deferred compensation” if the awards are granted with an exercise price that is equal to or greater than the fair market value of the underlying stock on the date of grant, and if it does not include some feature of deferred income other than the right to exercise the option. If the business has a valuation formula that is to be used to value any future transfer of shares (buy-sell agreement) and is to be used for all valuations of the entity’s stock, it may be used as a valuation method under section 409A.

A phantom-stock plan is similar to a SAR, but instead of the employee only receiving the financial value of the appreciation on a certain number of shares of stock, the employee actually receives the financial equivalence of the full value of several shares of stock. You can think of a phantom-stock plan as similar to the restricted stock award program described above, but instead of granting actual stock, the employee receives the financial equivalent of the stock. They will only receive the benefit if they remain with the employer for a stated period of time, similar to the restricted stock award program. A phantom-stock plan may need to comply with IRC section 409A to defer taxation until the date the employee is vested, but that simply means you’ll need to work with advisors familiar with the provisions of 409A. It doesn’t take away from the benefits of the program.

Similar to grants of actual stock, restricted stock, or stock options, a SAR or phantom-stock plan may be utilized to test out the employees and see how they respond to having a portion of their compensation dependent upon corporate performance. These programs are not only available to businesses established as corporations. Businesses that are established as an LLC or partnership may implement similar programs.

Sale to an Employee Stock Ownership Plan (ESOP)

An ESOP provides a tax-advantaged means for a business owner to sell his or her business to the employees of the company. In situations where finding a buyer may be difficult or the owner simply has no desire to sell to a third party, an ESOP can be a viable alternative. Technically, the business is sold to the ESOP plan itself, which is a qualified retirement plan with the employees as the participants. The sale is often accomplished through what is referred to as a leveraged ESOP, where the ESOP borrows funds sufficient to purchase shares from the business owner. To the ESOP, the employer makes deductible contributions (within certain IRS limits), which are used to repay the outstanding loan (interest and principal).

Pursuant to IRC section 1042, a business owner who sells shares to an ESOP may defer (and possibly avoid) capital gains tax on the sale if the ESOP owns 30 percent or more of each class of outstanding stock or of the total value of all outstanding stock and the proceeds from the sale are invested in “qualified replacement property.”

“Qualified replacement property” is defined as stocks and bonds of US operating companies. Government securities and shares in mutual funds do not qualify as replacement property. There are numerous rules that need to be complied with in order to take advantage of IRC 1042. Owners of S corporations may not utilize IRC 1042 to avoid capital gains tax. A typical leveraged ESOP buyout would have the business owner initially sell 30 percent of his or her stock to the ESOP, to test the waters and qualify for the deferral of capital gains tax. This is followed sometime later by a sale of an additional 19 percent (to retain 51 percent of the stock and therefore control of the business), and finally the sale of the remaining 51 percent of the stock.

The plan will be required to make distributions upon the death, disability, retirement, and termination of a participant’s employment. In addition, the plan must provide participants with the opportunity to diversify a portion of their share account balance after the participant attains the age of fifty-five and has been in the plan for ten years. When there is a distribution of stock, the participant must be given an opportunity to sell the shares back to the plan sponsor. The company is obligated to repurchase these shares from the participant at a fair-market value within a stated amount of time. This is known as a repurchase obligation. The ESOP and the business management need to determine how they are going to fund this obligation and whether or not they are going to set aside funds. (Investment portfolios or corporate-owned cash value life insurance are often utilized). The ESOP trustee should be aware of the employer’s plans, but it is the employer’s responsibility.

Conclusion

Before leaving the conversation on transferring ownership of a business to key employees, it is important for business owners to understand that adding a minority owner must be done only after fully understanding exactly what that means. Many of the ideas discussed above (and in the chapter on transferring your business interest to family members) involve selling a portion of your ownership interest or transferring a portion of your ownership interest as a gift or as compensation. Minority owners have rights, many of which are granted through state laws enacted to protect them. Interested readers will find additional information on minority shareholders in the Business Succession section of this website.