While every business owner’s situation and experience during the COVID-19 pandemic has been unique, the experience has mobilized a significant number of owners to reflect on their priorities. Many business owners were besieged by unprecedented uncertainty and anxiety, leading them to recognize the magnitude of risk they have tied up in their business and the vulnerability of their personal financial security. The combined effect of President Biden’s proposed tax and regulatory policies, along with the ‘pandemic effect’, has jolted business owners out of complacency in terms of exit planning. For some, this has led to an expedited timeline to an exit from the business. For others, it has simply led to a more focused and resolute effort to create a plan that will help address and mitigate key business and personal risks into the future. Depending on the condition and readiness of your business as well as any number of personal factors, now may not be the right time to sell. Regardless of the specific timing and form of a future transition of ownership, the global crisis underscored that the time is right to prepare.
There are several options for owners to consider as they assess an appropriate path to liquidity and ownership transition. Selling to your employees via an Employee Stock Ownership Plan (ESOP) is one option. ESOPs help owners address several key priorities that many of the alternatives do not. Most importantly, ESOPs allow retiring owners of closely held businesses to pass on their business in a controlled yet flexible way, while ensuring the security of their valued workforce through ownership in the business. As part of an owner’s exploration, it is important to understand the key priorities that are addressed by each alternative to determine which is the best fit.
Selling to an ESOP is a flexible way to diversify your wealth. Many third-party buyers have limited or no interest in buying a minority position in a privately held business. However, with an ESOP you can sell any amount to employees, allowing you to ‘take chips off the table’ while still maintaining the level of control you desire. By maintaining a larger share of the ownership, you can keep governance control and continue to participate in future value creation while leaving the option open for a future sale of the business to either a third party or to the ESOP.
ESOPs Are Resilient
While the tax benefits (discussed later) can be compelling, it’s often the case that business owners choose the ESOP option for reasons that go well beyond the economics. Protecting employees and legacy while fostering an ownership mentality leads to better business performance. Many studies have demonstrated the positive correlation between employee ownership and business performance and the positive impacts for employee-owners. The most recent example, drawn from the economic downturn spurred on by the COVID-19 pandemic, exemplifies why ESOPs are attractive to owners who place a high value on the future success of their business and employees.
In a new study by Rutgers University and the Employee Ownership Foundation, ESOP companies validated, again, that they are highly resilient. The study concludes that companies that are majority owned by their employees through an ESOP weathered the pandemic crisis better than non-employee owned businesses when it came to job retention and pay thereby providing employees greater income and job stability. Specifically, the study concluded that during the pandemic (through the publishing date of October 2020):
- ESOP companies’ decline in employment was ¼ that of non-ESOPs, at all levels.
- ESOP companies were significantly less likely to cut employee hours than non-ESOPs and were far less likely to cut employee pay.
- ESOPs outperformed other companies even when you isolated the analysis to essential versus non-essential businesses.
- ESOPs were more effective than government assistance at retaining employees. ESOP companies that received no funding from the Paycheck Protection Program (PPP) laid off employees at a rate over three times lower than companies without majority ESOPs that did receive PPP funding.
To leave a lasting legacy, it is important that the transition of ownership does not negatively impact the employees or the community in which they live. How ESOP companies have performed through the pandemic demonstrates their resiliency and the social and economic benefits that result from employee ownership models. These outcomes reflect the values and objectives that many owners espouse to ‘take care of’ their employees who have contributed to the value creation in the business and they do so in a lasting way.
To understand whether an ESOP is an appropriate fit you must undergo an extensive education that both contemplates the economic factors (e.g. relative value, liquidity, taxes, transaction costs and ongoing administrative costs) and the qualitative factors (e.g. employee impact, legacy, risk, and degree of control). The most prominent barrier to ESOPs is lack of awareness and access to professionals with sufficient expertise and acumen in ESOPs to appropriately educate and advise them to this solution. While an ESOP is not appropriate for every owner, it is appropriate to consider all options in the context of your own objectives to understand which alternative is most suitable to help achieve your near- and long-term goals.
Biden Administration's Tax Proposal
ESOPs advantages may be propelled by changes in the tax code. ESOPs have always enjoyed certain tax benefits that are attractive to both owners and to the companies who sponsor them. On the personal side, many owners find the ability to defer their capital gains taxes on sale proceeds (under IRC Section 1042) particularly compelling. In a 1042 Rollover, if the owner sells C Corporation shares directly to the ESOP and invests the proceeds in qualified replacement property (QRP) within one year of the sale, then the selling shareholder can defer capital gains taxes on the sale. QRP consists of securities issued by a domestic operating corporation. A key element of the 1042 Rollover strategy (under current tax law), is that owners receive a step-up in basis upon their death (if still holding the QRP) and thus avoid paying capital gains taxes on the original sale when the assets transfer to the heirs.
There are a few key ways in which the Biden administration’s tax proposal, American Families Plan, would impact ESOPs. Importantly, the plan proposes to significantly increase capital gains taxes for wealthy individuals – almost doubling the rate from 20% to 39.6%. Historically, the 1042 Rollover transaction structure had positioned ESOPs as a favorable option to alternative exit strategies given the ability to defer or avoid capital gains tax on the sale. Under a scenario where capital gains rates are substantially higher than today’s levels, ESOPs would be poised to become an even more attractive option for ownership transition and liquidity – at least from a tax perspective.
Although ESOP transactions could become more attractive should capital gains rates increase, the strategy is particularly beneficial when the step-up in basis occurs at death. Since the American Families Plan proposes to eliminate the step-up in basis for inherited capital assets, the 1042 Rollover strategy would become substantially less impactful in the long-term. While the selling shareholder could defer capital gains tax, they would not be able to altogether avoid capital gains tax unless the tax provision allowing for the step-up at death is reinstated. As an alternative to a 1042 Rollover transaction, an owner who sells to an ESOP could elect to pay capital gains tax using the installment sale treatment. Or an owner may prefer to avoid the steps necessary to defer capital gains tax under IRS Section 1042 and pay the capital gains immediately before rates potentially rise under the Biden administration. In these cases, time will be of the essence to close a transaction before rate increases go into effect.
At this point in time, there is not enough information to form an opinion as to which aspects of the American Families Plan are likely to be passed into law and whether such changes will be retroactive to a date that precedes the passing of the new law. The plan is light on details and is yet to be drafted into legislation. Prior to becoming a law, the legislation would most certainly evolve further as provisions would be subject to congressional debate and negotiation. No matter the outcome, the President’s proposed plan will likely have a net positive impact on new ESOP formations should any provisions of the plan described above be enacted into law notwithstanding the potential setback for certain aspects of the 1042 Rollover strategy.
In further support of the positive outlook for ESOPs, there is a piece of pro-ESOP legislation in congress now, the “Securing a Strong Retirement Act”, that would extend the same favorable capital gains tax treatment of IRS Section 1042 to S Corporation ESOP sales (currently only applicable to C Corporation sales). And in January 2021, President Biden named economist Jared Bernstein to the White House Council for Economic Advisors. The significance of this appointment is promising for ESOPs as Bernstein had published a study on employee stock ownership plans titled “Why Aren’t There More” in January 2020. With significant evidence-based support that ESOPs are beneficial to the economy and to employees, ESOPs are likely to continue to enjoy bi-partisan support from congress well into the future.
Ready to Help
Ask how PNC’s ESOP Solutions group helps companies transition to an ESOP structure and assists existing ESOP clients in maximizing performance. Contact Julie Williams at firstname.lastname@example.org or 616-771-8864.