Understanding ESOPs as an Ownership Transition Alternative

As a business owner, you have a variety of options to achieve your liquidity and ownership transition/business exit objectives, including an IPO, a sale to a third party outside buyer, or a sale to a related party such as a family member or management.

A sale to an ESOP is one transition option that can often be overlooked.

ESOPs allow owners to attain liquidity and address transition objectives in a tax advantaged manner. Whether your goal is to diversify while staying actively involved in the business or to execute on a complete sale of the business, an ESOP can accomplish either, among other objectives.

What is an ESOP?

An ESOP is a qualified retirement plan that differs from other qualified plans in two key ways: (1) they are permitted to borrow money and (2) they are designed to invest primarily in the stock of the sponsor company. These features make it possible for ESOPs to acquire shares of stock from selling shareholders and facilitate the transfer of ownership to employees over time. ESOPs serve as a corporate finance vehicle that can provide liquidity to selling shareholders while transforming employees into owners.

How do ESOPs work?

In a traditional leveraged ESOP, the company borrows money from lenders (which may be third party sources or selling shareholders themselves), and then loans the proceeds to the ESOP trust for the purpose of acquiring shares. The shares purchased by the ESOP are allocated to employee accounts over time as the ESOP repays its loan to the company. The end result is that employees obtain beneficial ownership in the company.

Employees have a right to receive a distribution from the plan upon separation from the company by reason of retirement, termination, disability or death. The amount that the employee is entitled to is the value of their account; the current value of the stock allocated to their account.

Intangible Benefits to Owners

ESOPs allow the owner to steadily transition from CEO to board member to full retirement as desired. Many owners value the opportunity to be a part of a successful handoff to the employees, setting the company and the employees on a course that is congruent with their goals for both parties.

Tax Benefits

The tax advantages of ESOPs can be significant for companies that sponsor ESOPs as well as for the selling shareholders who opt to transact with them. Congress enacted certain tax incentives under the premise that employee ownership enhances company productivity, marketplace competitiveness and employee job security, satisfaction and motivation.

Seller tax benefits: Under certain circumstances, sellers can defer or eliminate capital gains tax on the sale of stock to an ESOP (utilizing Section 1042 of the Internal Revenue Code) and therefore may achieve higher after-tax proceeds compared to a sale to a third party.

Company tax benefits: There are several avenues through which a company can realize tax benefits associated with ESOP ownership. Most significant is the case where the ESOP owns 100% of the company’s stock and the company is an S Corporation.

The ESOP trust is a tax exempt entity — once the trust owns 100% of the company’s outstanding equity, the company no longer is required to make tax distributions on earnings attributable to ESOP shares, federal income tax, and in most cases, state and local income tax.

ESOPs are not appropriate for every situation. Still, it is worthwhile to consider whether an ESOP could be used as a tool to realize the financial, tax, organizational and personal benefits of ESOPs.

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