Small business owners can use an ESOP to sell their business for its market value. They can do so gradually over time through regular annual tax-deductible company contributions to the ESOP, or in a single set of transactions using a “leveraged ESOP.”
As described in a prior article (see Employee Stock Ownership Plans (ESOPs) and Small Business | Thomas H. Gray), the ESOP then uses these funds to purchase shares from the company or from some or all of its stockholders.
The previous article defined the advantages and disadvantages of an Employee Stock Ownership Plan (ESOP) for employees, the company, and the owner of a small business. In this article, we will consider how an owner can use a leveraged ESOP transaction to sell some or all of the owner’s shares at once, as an exit strategy for the owner.
Leveraged ESOP Definition
A simple or basic ESOP uses regular annual company contributions to buy the company’s stock. However, an ESOP can also borrow money to finance the purchase of shares of the company’s stock. When it does so, it is referred to as a “leveraged ESOP.”
While a “direct” loan to the ESOP might be appropriate in certain cases, banks more commonly prefer to loan funds to the company rather than directly to its ESOP. The company then re-lends the funds to the ESOP. This is sometimes called a “Back to Back Loan” and the company’s relending of the bank loan proceeds to the ESOP is called the “ESOP Loan.” Often, the ESOP Loan will have different repayment terms than the terms of the bank loan, such as lower interest rates and longer amortization.
Although beyond the scope of this article, it is worth noting that since the stock purchased by the ESOP is held in a “suspense account” and allocated to participants’ individual ESOP accounts only as the ESOP Loan is repaid, the company has the flexibility to structure the repayment period of the ESOP Loan so as to provide equity ownership to employees that may be hired well into the future and not just to its current employees.
Use of Funds
The ESOP must use these borrowed funds solely to purchase “employer securities.” In most privately-held companies with only one class of shares outstanding, these will be the shares of the company’s common stock. However, when there is more than one class of common stock or series of preferred stock, the stock that can be purchased by the ESOP must have the “highest and best” dividend and voting rights of all classes of the company’s stock.
ESOP Loan Repayment
The ESOP Loan is repaid to the company using the annual tax-deductible contributions made from the company to the ESOP. These company contributions are then returned to the company in the form of payments on the ESOP Loan. Companies are limited by Federal tax law in the amount of tax-deductible contributions it can make to its qualified employee benefit plans (e.g., 401(k), profit sharing plans, ESOPs, etc.). The general limitation is 25% of a company’s payroll per year. However, over and above this general 25% limitation, companies may make a contribution of an additional 25% of payroll per year if this additional contribution is used to fund the repayment of an ESOP Loan.
Owner’s Sale and Tax Benefits
The owner achieves the maximum tax benefit by selling at least 30% of his company stock to an ESOP and re-investing the proceeds of his share sale into stocks and bonds of US companies (called “replacement property”), as noted in the earlier article.
The share price that the ESOP pays to the owner for his shares cannot exceed the fair market value of the shares to be sold to the ESOP. An owner might receive a higher price by selling to an unrelated party (rather than to an ESOP) who, as a result of synergies gained from acquiring the company, might be willing to pay an acquisition premium, perhaps as high as 20-30% above the appraiser’s determination of the fair market value of the shares if sold to an ESOP.
However, in such a non-ESOP sale, the purchase proceeds that the owner received would be subject to contemporaneous payment of Federal and state income taxes. If that deal was structured as a “stock swap” to avoid such taxes, when the owner sold the buyer’s stock to diversify, again Federal and state income taxes would have to be paid.
In contrast, if the owner sold his shares to an ESOP, by complying with certain requirements he or she would be able to defer and possibly avoid entirely paying any Federal or state income taxes on the gain realized from the sale.
The “tax deferral” referred to above is only available to “C” Corporations. Thus, if the company were an “S” Corporation and wished to remain so, while ESOP solutions are still feasible, the owner’s tax treatment might be less advantageous.
Maximum Tax Benefit: the “Home Run” Scenario
The “home run” transaction is for the owner of a “C” Corporation to sell his or her shares to an ESOP, elect to defer taxes on the gain by reinvesting in qualified replacement property, and then have the company elect to be taxed as an “S” Corporation after the transaction.
Why does this produce the maximum tax benefits? As we discussed in the previous article, an “S” Corporation does not pay Federal (and most state) income taxes. Instead, the income, losses, gains, etc. are “passed through” to the shareholders of the “S” Corporation and they have to pay ordinary income tax on their share of the company’s taxable income and gains.
Ordinarily, an “S” Corporation would make a cash distribution to its shareholders that would, at a minimum, enable them to pay these taxes. However, the ESOP Trust is a “tax exempt” entity. Thus, if the ESOP has purchased all the owners’ shares and has itself become the owner of an “S” Corporation, since the ESOP doesn’t have to pay any Federal (or most state) income taxes, the company would not have to make these annual cash distributions to the ESOP Trust.
This cash would then be available for other corporate purposes, such as repaying the company’s bank loans that funded the ESOP Loan.
In this “home run” scenario, owners have sold the company and the ESOP is the new owner. The owners, if continuing to be actively employed, can continue to collect salaries (and bonuses). If they do not elect the “tax deferral” option, they can also participate in the ESOP on the same basis as all other employees.
If they elect the “tax deferral” option, they could choose to use the investment income earned on the “replacement property” purchased with their sale proceeds to supplement (or, if they do not remain actively employed, replace) the income they previously received from the company.
This extra cash retained by the company can be used to pay off debt, purchase appreciating property, make acquisitions and otherwise grow the company, or pay dividends to its owner – the ESOP. All these uses increase the value of the shares in the individual employee ESOP accounts.
Getting Started with an ESOP
The main requirement to use a leveraged ESOP exit strategy is that the company (or the ESOP) has the credit capacity to get the loan to fund the large share purchase.
What steps would a small business owner take to find out if an ESOP exit strategy fits for him and his company? This quote from Using an Employee Stock Ownership Plan (ESOP) for Business Continuity in a Closely Held Company sums up the process:
“Create an initial business plan, factoring in legal costs, the costs to buy the shares, and the company’s cash flow. If that looks encouraging, talk to an accountant about your figures. If things still look promising, have a valuation done. Your valuation specialist will tell you how much your stock is worth and should also give you a more detailed idea about the practicality of selling these shares.
“If things still look good, hire a qualified ESOP attorney to draft your plan [Editor’s Note: and to help structure the ESOP transaction to fit with your objectives]. As you consider an ESOP, find some other ESOP company executives to talk to, attend an ESOP meeting or two, and finalize your plans with all the key players.”
The next article in this three-part series summarizes the experience of one small business owner who sold his independent insurance agency to the company ESOP.
This article relies heavily on advice from Robert Schatz, Partner, ESOP Plus®: Schatz Brown Glassman Kossow LLP, 1007 Farmington Avenue, Suite 4, West Hartford, CT 06107, 860-231-1054, www.ESOPPlus.com, email@example.com, but Tom Gray is solely responsible for any errors in properly expressing that advice.
Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or firstname.lastname@example.org. See www.tom-gray.com