ESOPs: The Undiscovered Estate Planning Tool

July 2010Newsletters

Business owners, like most other baby boomers, will be retiring in large numbers in the next 10 to 15 years. However, few have considered the effect of supply and demand when it comes time to sell their businesses. Simply put, demographic trends are likely to result in more sellers than buyers with commensurate decreases in sale prices. As a result of these trends, Employee Stock Ownership Plans (ESOPs) are a more viable alternative than ever as a business succession technique, and one that should be seriously considered by every business owner contemplating retirement.

In concept, a sale to an ESOP is simple. Instead of the owner selling his business to a third party, a business owner sells to a trust established and operated by the company. In order to purchase the shares, the plan borrows from a financial institution or from the business owner himself. The shares of the company serve as collateral for the loan. As the company continues to operate, it makes contributions to the ESOP and the loan is repaid. As the principal of the loan is reduced, part of the collateral is released and allocated to the accounts of participants. With few exceptions, participation may be extended to all of the non-union employees of the company. However, the ESOP may be structured so employees never directly own company shares and are never entitled to access to the company's finances.

In order to encourage broader employee ownership, Congress has enacted powerful tax incentives for employers that establish ESOPs and for the owners who sell their shares to ESOPs. In a properly structured transaction, the owner can avoid payment of capital gains tax that would normally occur upon the sale of the business. The values of this incentive will be enhanced when the capital gains rates rise in 2011. In addition, both principal and interest on the loan to purchase the company is repaid with pre-tax dollars because the repayments are made by the ESOP itself, which is funded with tax-deductible company contributions. In other words, the government is paying 40 percent of the cost of the sale in the form of enhanced tax deductions. But that is not the end of the tax benefits. Once the ESOP owns all of the stock in the company, it can elect Subchapter S status. By doing so, the company can pass through its profits to its tax-exempt ESOP shareholder and operate as a tax-free company.

With all of the available tax incentives, it is surprising that ESOPs are not more common. In all probability, it is because the benefits of selling company shares to an ESOP are not widely known or understood by business owners and their business advisors. Undoubtedly, ESOPs are subject to numerous statutory and regulatory requirements. A sale of company stock to an ESOP must be handled as an arm's length transaction. However, the complexity should not necessarily deter a business owner from implementing an ESOP if it is the correct strategy. However a set of knowledgeable professionals are a must for any company interested in adopting an ESOP.

So when should an ESOP be considered by a business owner? There is no one-size-fits-all answer to that question, but the following factors should be considered:

  • The company should have a management team or at least two to three individuals (other than the owner) capable of transitioning the role of operating the company.
  • The company should be of a sufficient size (usually, minimum of $2 million value).
  • The current owner(s) want to remain involved in the business and slowly transition to less active status.
  • The owner is psychologically able to relinquish control of the business.
  • The owner wants to reward employees for their loyal years of service by giving them control over the business.
  • The business has been profitable in recent years and/or has strong prospects of achieving and maintaining profitability in future years.
  • The company has a workforce that would be incentivized by ownership in the company.

Again, the factors listed above are not a comprehensive list, and no one factor or set of factors is determinative as to whether an ESOP is appropriate. What is clear is that most business owners contemplating retirement in the next five to 10 years should consider whether an ESOP is right for them. Fox Rothschild's Employee Benefits & Compensation Planning Practice Group is thoroughly familiar with ESOPs and ready to assist any business owner contemplating a sale.

For more information, please contact Harvey M. Katz at 212.878.7976 or [email protected].