ESOPs + Business Succession Planning

As most business owners spend their time focused on the daily operations of building their companies, a generation of more seasoned owners find themselves with something new to consider—retirement. With retirement comes the question of how to best transition the business, oftentimes the most valuable asset in a portfolio. Couple the uncertainty of the pandemic with a white-hot M&A market, it’s no surprise that many are considering “taking the chips off the table” right now.

Thankfully, a variety of options can help you meet your transition goals. When selecting a transition process, you should generally consider three criteria, and how each aligns with your goals, including the:

• Liquidity provided,
• Associated risk to the shareholders, and
• Need or desire for ongoing control of the enterprise.

Each will vary in degree depending on which transition path an owner chooses. One such transition option considered by many business owners is an Employee Stock Ownership Plan, more commonly referred to as an ESOP.

Simply defined, an ESOP is a device that stands ready to buy company stock from an owner. It is an employee benefit plan that gives workers ownership interest in the company. They provide the sponsoring company, the selling shareholder, and participants various tax benefits, making them qualified plans, like a 401(k).

ESOP stock purchases are typically debt-financed by either a bank or the seller. In bank financing, the bank lends based on a company’s credit, including a standard credit review. Then, as payments are due, the company will make fully deductible cash contributions to the ESOP, so the ESOP can pay off the loan. In seller financing, the ESOP issues a note to the seller, and the payment structure follows the same configuration as bank financing.

Structures are relatively flexible, with many variations. Let’s look at a common example:

1. We’ll assume XYZ Co. is worth $10 million.
2. XYZ Co. establishes an ESOP, to which a bank loans $3 million, to be repaid over five years.
3. The ESOP uses the money to purchase 30% of the company from owners.
4. In the ESOP’s first year, the company contributes cash to the ESOP.
5. The ESOP uses the money to pay off 20% of the loan, plus interest.
6. 20% of the shares purchased by the ESOP are allocated to the accounts of employees in proportion to salary.

Note that all of the money going toward the bank loan repayment is fully tax-deductible, including the money going toward the principal. Another perk—if the selling shareholder is an employee, they can receive an allotment of shares in his ESOP account, just like other employees.

Since shares bought by the plan are allocated based on W-2 reported pay, the selling owner may get more shares than anyone else—even though they were paid for those shares.

One key driver motivating some clients to use the ESOP option is the so-called “1042 transaction,” which allows sellers to defer capital gains tax on shares sold to the ESOP. Certain rules must be met to realize deferred tax treatment, including:

• Shares must have been acquired at least three years earlier, and sellers must not have received the stock due to a compensatory stock option or a distribution from a qualified retirement plan.
• ESOP must hold at least 30% of the company’s outstanding shares following the sale, and adhere to rules limiting stock allocation to sellers, family members, and 25% owners.
• Within 12 months after the sale, sellers must reinvest the proceeds in Qualified Replacement Property (QRP), generally domestic corporate equity and fixed-income securities.

Whereas a traditional sale will trigger a capital gain, proceeds under a 1042 transaction may be reinvested tax-free and further deferred until sold, often years later. And with rumors of an impending capital gain income tax increase circulating, it’s no wonder why this has become a hot topic for business owners.

As with other transition options, such as a sale or recapitalization, an ESOP has various pros and cons that owners need to consider.

Finally, a few best practices may help you decide if an ESOP makes sense for your business. Start by asking yourself four simple questions:

1. Do you have a low basis in the company stock (generally a C-Corp, but not always)?
2. Are you located in a high tax state (such as California or Oregon)?
3. Do you operate a lower multiple business (less than 7-8X EBITDA)?
4. Is your business financeable (banks will lend a fair amount of money due to cash flows and assets)?

Our experience with the many stages of a business’s life helps us keep the big picture in mind for you throughout our advising process. The Aldrich Capital Advisors team is here to help you enhance your business’s value and manage your company’s financial future. Reach out today to discuss strategies for adding value to your business.