What are some of the tax and financial advantages that you have by forming an ESOP?
First is capital gains treatment on the sale. Since an ESOP transaction is a stock sale, the seller’s going to pay capital gains tax instead of ordinary income tax on the gain. Better yet, the seller may be eligible to defer that tax indefinitely if the requirements of a ‘Section 1042 rollover’ are met. Either way can be a big advantage relative to an asset sale.
If the seller is willing to finance the transaction itself instead of going to the bank and borrowing money, the seller has the opportunity to earn a fair interest rate on the loan it gives to the ESOP to buy shares. In these tough times, earning some fair interest rate, such as 8 or 10 percent, may be attractive. You can ‘lock in’ that rate rather than gambling in the stock market.
Depending on the transaction structure, it may be possible for the selling shareholder to stay and participate in the ESOP, and have some shares allocated to him or her. Even though they’re selling the business, they can actually accumulate shares in the plan, and cash those shares in for fair market value down the road.
A key advantage of ESOPs is that a business owner can sell virtually any percentage of his or her ownership — they don’t have to sell it in one big piece, but in chunks. Many business owners prefer to sell 30 to 49 percent, thus maintaining voting control of the company. Perhaps the most compelling benefit of an ESOP is that once a company is an ESOP, assuming it is an S corporation, the portion of company that the ESOP owns is exempt from income tax. The shareholder is the ESOP, which is a tax-exempt trust. If you can achieve 100 percent ownership by the ESOP in an S corporation, you can effectively create an income tax-free entity. That’s one of the reasons ESOPs typically outperform non-ESOP companies, because they’re keeping every dollar they make, instead of sending it off to the government or making distributions to shareholders to cover the personal tax associated with S corporation income. There’s no personal tax to cover in ESOPs.
Why do ESOPs make sense?
You can preserve your company, your legacy, and not have to worry about employees or jobs going elsewhere if the company is sold. An ESOP is a good fit if you want to sell to your employees. You need to have a positive, participative type of culture and a strong management team to get the benefits of an ESOP.
An ESOP can be a great succession planning option, because you can sell the company in pieces, instead of 100 percent at once. This allows you to have more control than if you sold it to a third party.
Since employees in ESOPs are owners, they often act like owners and do things to improve the company and its value. Companies with a positive employee-oriented culture are often good candidates for an ESOP.
Brian Bornino, CPA/ABV, CFA, CBA, is the director of valuation services at GBQ Consulting LLC. Reach him at (614) 947-5212 or [email protected].
