If you're transitioning your business to an ESOP, here's everything to know about Employee Stock Ownership Plan structures, tax advantages, and more.
For a business owner, an ESOP can be a means of transitioning ownership while generating potential tax advantages and providing employees with the incentive to perform at a higher level. This article delves deeper into the primary structure of an ESOP, the various tax advantages it provides, the industry professionals who are typically involved throughout the process, and where to find financing.
The Basic Structure of Employee Stock Ownership Plans
An ESOP is a qualified employee benefit plan that primarily invests in employer company stock. The company creates a trust to purchase shares of stock from the selling shareholder(s) and allocates shares to eligible employees’ accounts over time, subject to vesting requirements. The transfer of ownership may be financed in two different ways:
Non-Leveraged ESOP: The company contributes new shares of its own stock or cash to buy existing shares
Leveraged ESOP: The ESOP borrows money to buy the company’s shares
In a leveraged ESOP structure, an inside loan is established between the company and the ESOP Trust. This inside loan is typically amortized over 15-30 years. Similar to other qualified retirement plans, the company makes cash contributions to the ESOP Trust (up to 25% of the qualified payroll). These contributions are then used by the Trust to pay down the inside loan. As the inside loan gets paid down, shares are allocated into participants' ESOP accounts. These cash contributions are expensed “above the line,” thereby reducing the company’s taxable income.
Assuming the inside loan is still in place, the ESOP Trust uses the cash from these contributions to make payments to the company on the inside loan, effectively making the contributions a non-cash expense. This provides additional cash flow to the company that may be used to repay debt or reinvest into the company.
Tax Advantages of ESOPs
One of the primary benefits of ESOPs for businesses and business owners is the potential tax advantages. In addition to the reduction of taxable income described above, for a C-Corporation, the selling shareholder has the ability to utilize a 1042 rollover. As outlined in the Internal Revenue Code Section 1042, the selling shareholder has the ability to defer capital gains tax on the sale of stock if 30% or more of the company is sold to the ESOP, and the transaction proceeds are invested in Qualified Replacement Property (stocks or bonds of U.S. operating companies) within 12 months of the transaction.
For an S-Corporation, the shares owned by the ESOP are exempt from federal and most state income taxes. For a 100% ESOP-owned S-Corporation, this means the company need not make any tax distributions. This results in more cash flow for the company. The tax advantage is not tied to employee benefits, has unlimited duration and offers long-term tax relief.
A company has the ability to change its corporate status from a C-Corporation to an S-Corporation, or vice versa if desired, for certain tax advantages. Note that it may be subject to a waiting period before switching.
Professionals and Their Roles
Many companies utilize an advisory firm/investment bank to assist throughout the ESOP process. In addition to performing a feasibility study to determine whether an ESOP is right for the business, the advisor firm may assist with the development of the ESOP and with obtaining financing. The trustee is hired by the company’s board of directors to represent the newly formed ESOP Trust. The trustee negotiates the sale price with the selling shareholder(s) and utilizes a financial advisor (valuation firm) to determine the fair market value of the company.
Similar to merger and acquisition transactions, attorneys play a critical role in ESOP transactions. Typically, the selling shareholder(s), company, trustee and bank (if leveraged) have legal counsel for an ESOP transaction.
It is vitally important to utilize attorneys who have Employee Retirement Income Security Act (ERISA) knowledge with significant ESOP experience to achieve a thoughtful and economical outcome.
Sources of Capital
If the selling shareholder is looking for liquidity from the transaction, there are multiple capital sources. Capital from a commercial bank is typically senior to all other forms of capital and represents the lowest cost of capital.
Mezzanine capital may also be available to the company, but will have a higher cost, as it will be junior to the commercial bank debt. Recently, private equity firms have also begun to recognize the value of ESOPs and are beginning to partner with ESOPs to acquire companies.
While other forms of capital exist (e.g., employee capital), the most common form comes from the seller. Yields to the seller vary. In almost all cases, seller debt is subordinated to the commercial bank debt and is junior to mezzanine debt, if any.
Businesses should work with a team of seasoned commercial lending experts who understand current market dynamics and the complexities of an ESOP.
An ESOP is a financial tool that delivers many benefits for the business owner and his or her employees. Owners are able to remain active in the companies they’ve created while accessing more liquidity and enjoying tax advantages. Employees acquire a stake in the company’s future, which leads to deeper engagement (studies show that productivity and performance increase as a result of ESOPs). Yes, it takes planning and attention to detail, but with the right team behind you, an ESOP is an attractive and flexible business transition alternative.