An ESOP can be a powerful succession planning tool for your business. But relatively few advisors in the marketplace know enough about ESOPs to give you the information you need. We’ll give you a head start. Here are five ways an ESOP can fit, or even drive, your succession planning.
1. An ESOP can be a ready buyer for your stock when you’re ready to sell.
You can install an ESOP and sell your stock in stages or sell it all at once. Tax rules require an ESOP to be primarily invested in your company’s stock, but how much you sell to the ESOP, and when, are up to you. This scenario may be more attractive than the usual options: transferring ownership to family, selling to management, or selling to a third party. Family isn’t always interested in taking over. Management may have trouble coming up with the cash you’d like to get out of the sale. And, in the real world, third-party buyers that meet a seller’s initial expectations are rare. An ESOP is not only a good way to drive employee output and company growth, but it can also be the buyer you’re looking for when you’re ready to sell. You’re in control of your exit from the company. That’s tougher to pull off with a third-party sale.
2. You can defer your capital gains taxes on the sale to an ESOP – maybe permanently.
In addition to controlling the timing of your exit from the company, you may also be able to control the timing of your tax bill. If you sell at least 30% of your company’s total outstanding stock to the ESOP, you can defer your federal capital gains tax by investing the proceeds in U.S operating company stock or bonds (for example, most publicly traded stock). If you don’t want to tie up all of your proceeds in the replacement investment, you can borrow against the portfolio for the cash you need. You won’t pay capital gains tax until you sell stock in the portfolio. And if you leave it there, your heirs can inherit the portfolio without paying tax until they sell. And even then, they’ll only pay tax on the increase in the value of the portfolio from the time they inherited. That means that the tax on the gain from your initial sale to the ESOP is effectively eliminated. This tax deferral strategy is known as a “1042 exchange” after the Internal Revenue Code section that permits it. It is not currently available for sales of S corporation stock, but for some owners and companies, revoking the S election to facilitate a 1042 exchange may make sense.
3. You can use pre-tax dollars to pay for your shares.
The company’s contributions to the ESOP are tax-deductible, similar to the tax deduction your company gets for contributions to a 401(k). The ESOP then uses that “pre-tax” money to buy your shares. This feature can be incorporated into one of the most gradual and controlled transitions available – the steady sale of a fixed dollar amount of shares to the ESOP over a number of years. It’s similar to the “dollar cost averaging” investment approach – but with a 30% boost because the cash that would have been paid out as taxes in a C corporation, or to shareholders as tax distributions in an S corporation, can be used to buy your shares instead. The dollar cost averaging transaction structure is just one of many, but the end result is the same – buying you out at a lower cost to the company.
4. Maybe management can’t afford to buy the whole company, but they can afford part of it.
You can combine an ESOP with a management-led buyout to reduce the cost of the purchase to your team. If the ESOP buys part of your shares (maybe 30% so you can make a 1042 election), management may be able to pull off a purchase of enough of your remaining shares to get control.
5. Maybe you do have family interested in taking over.
An ESOP works well, here, too. Maybe your kids do want to take over the company, but the idea of tying up everything they own in the business for the foreseeable future is not appealing. By combining the 1042 exchange with a transfer of shares to your family members, you put control of the company in your family’s hands and provide them with liquidity through your estate. To do this, you would sell at least 30% of your stock to the ESOP and transfer the remaining majority of your stock to family. You would then make a 1042 election to defer your capital gains and leave the sale proceeds parked in the replacement investment until after your death. The result is that your family owns a controlling share of the company and also benefits from a tax-free transfer to them of the value of the minority interest that was sold to the ESOP. Your kids get to run the company but also have a financial cushion in case they need it.
Every one of our clients has different goals and expectations for their exit from the company. We have over thirty years of experience guiding business owners through the process of determining whether an ESOP would be a good fit for their succession planning. We’d be happy to do the same for you.
Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660.