How About Using an ESOP in Your Succession Game?
Pros and cons revealed.
December 5, 2011
When considering succession options, some business owners are intrigued with the idea of having their employees become successor stockholders in their business. Many entrepreneurs recognize that their employees have been instrumental in their success over extended periods of time. As trusted advisers and confidants, many CPAs have witnessed situations in which the owner’s “work family” relationships and the associated gratitude of employees may be more meaningful than their blood relationships. All of these dynamics can make employee ownership of a company appealing on a nonfinancial level. The most popular form of employee ownership is the Employee Stock Ownership Plan (ESOP).
How Does an ESOP Work?
As CPAs, most of us are familiar with ESOPs as a tax-qualified defined contribution (DC) employee benefit program in which the stock of the business is the primary investment. The mechanics of how an ESOP is typically created and funded are outlined in the figure below:
* (Note: The above figure assumes that a bank is used to fund the ESOP. ESOPs are the only employee benefit plans that can borrow money.)
Employees are not taxed on the value of their share of the ESOP or on the increase in the ESOP’s value; then the employee pays tax on the value of the stock when he or she retires, dies, or becomes disabled. A 100-percent ESOP-owned company does not pay any federal income tax.
Tax Benefits to the Selling Owner
Aside from the many tax benefits to an operating company (which are not really the focus of this article) and the spirit of fairness and generosity that may cause an entrepreneur to embrace an ESOP, there are also some significant advantages to the owner who sells stock to the ESOP. The biggest benefit is that the gain on a sale of stock to an ESOP connected to a C corporation is tax deferred or eliminated under Internal Revenue Code Sec. 1042, provided that the sales proceeds are invested in qualified replacement property (QRP). Domestic stocks and bonds are the essence of what is meant by QRP. The QRP must not be stock of the company creating the ESOP (or in the same controlled group) and it generally must not be stock of a company with passive investment income that exceeds 25% of its gross receipts.
If the proceeds of the ESOP sale remain reinvested in the QRP until the owner’s death, there is a step up in the basis of the QRP that essentially eliminates tax on the gain. This tax savings alone can be pretty inspiring for owners, even if they have to forego the opportunity to sell to a strategic buyer who may have been willing to pay a premium for the stock.
What Set of Circumstances Make an ESOP a Good Fit?
Ideally, a company that opts for an ESOP would have stable profitability and a strong enough balance sheet to weather any storms. ESOP contributions are tied to a maximum percentage of payroll and determined annually, so being part of a company that is experiencing a growing bottom line and good cash-flow is very desirable. Being able to share good news makes the annual meeting with ESOP participants a lot more fun, not to mention the positive impact on share value.
Company size is also a consideration. In some of the literature, advisers suggest that having 15 employees is sufficient to consider an ESOP plan. My advice would be a number closer to 50 or 100 employees, given the high administrative cost (at least initially) and complexity of compliance. Companies that are a little larger typically have sophisticated in-house resources to deal with some of the more challenging issues and people who are used to working with outside professionals to efficiently resolve matters that may arise.
Another aspect of having an ESOP is more information sharing with employees than may have taken place in the past (unless the business has embraced open book management). Based on my experience, I would also recommend that the company have a board and management team that operate in a unified fashion to ensure the ESOP is not constantly being challenged with opposing needs and philosophies. Spending a lot of time in conflict and seeking legal advice is counterproductive to the real intent of an ESOP.
In What Circumstances Is an ESOP a Bad Fit?
Companies that have extremely volatile earnings are not a good choice for an ESOP. Typically a unionized business is also not a great candidate (unless management/employee relations are extremely good) nor is a company in which employees’ trust of management is at a low level. Other situations in which you should think twice about implementing an ESOP include:
In the end, even the best financial scenario for an ESOP can be derailed by problematic human dynamics in the business. Like any good succession plan, it takes good leaders, strong levels of trust and administrative finesse to have everything go well. A well designed and implemented ESOP program creates a more productive workforce and also serves as a significant employee attraction tool. The number of ESOPs in the U.S. continues to grow dramatically as the baby boomers transition ownership of their businesses, so it’s definitely an option worth exploring.
Some additional websites worth checking out if you are considering an ESOP for your client include:
In an upcoming article, I will reveal the good, the bad and the ugly of selling to key employees. In the meantime, keep in mind that solving the succession puzzle can be a lot more about people than numbers.