A large, demographic shift is occurring. The baby boomer generation is now experiencing significant wealth accumulation and its inevitable distribution. Many business owners from the “boomer” generation are now in the position to turn over the reins of their businesses to the next generation or to the highest bidder. However, what if the business owner wants to see his or her enterprise continue as he or she rides off into the sunset? What if the business owner is concerned about the future of his employees’ vocations after a sale is consummated? What if the business owner wants to liquidate only a portion of his business and maintain control for the foreseeable future?
One strategy that has been gathering favor that supports those objectives and allows the business to continue operating is a Tax Qualified Employee Stock Ownership Plan (ESOP). There are advantages and disadvantages to this approach, and developing such a plan will inevitably require an appropriate lending mechanism. An ESOP is most ideal for the business that has: 1.) A sustainable operation as a going concern; 2.) qualified leadership for the next business generation; and 3.) a work force that will embrace becoming a shareholder and value the future benefits. Understanding if an ESOP is feasible and how to best implement it requires collaboration among qualified legal counsel, your tax advisor, a business valuation expert and your wealth advisor.
Here is how it works. Assuming a business is structured as a C-Corporation, the basic steps to implementing a leveraged ESOP are:
- Engage a valuation firm and a commercial lender to agree on the value of the business.
- Obtain a lending commitment from the commercial bank for 30%, or more, of the value of the business.
- Secure the loan with the assets of the business and establish an appropriate term such that the timing of the principal payments will be fully treated as tax deductible qualified retirement plan contributions.
- The owner will receive his commensurate percentage value of the business from the proceeds of the loan.
- Under IRC 1042, the owner may be able to defer the capital gain recognition of this sale transaction if certain qualifications are met.
- As the business satisfies the loan over the term, shares of company stock are allocated to eligible participants of the ESOP.
- The business will need a professional valuation, at least annually, to adjust the share price and each ESOP participant will receive an annual statement to reflect the value of their respective account.
- As ESOP participants retire, the company can buy back the shares in a lump sum or over a period not to exceed five years. Alternatively, once the shares of stock are fully allocated among the ESOP participants, the company can make cash contributions to the ESOP, purchase the shares directly from the ESOP, and covert the ESOP to a qualified profit-sharing plan.
The steps above might sound relatively easy, but the details and rules regarding qualified retirement plans, valuation fairness and cash flow management can be difficult ¾ one of the largest concerns for the successor leadership of the business is paying back the loan. The loan amount should not have a material, detrimental effect on the company’s cash flow. In addition, even when the loan is satisfied, the ESOP shares will inevitably be liquidated as participants exercise their diversification rights or apply for a distribution. Careful planning regarding cash flow and the use of leverage is of utmost importance in managing a company with an ESOP. The successor leadership of the company needs to understand that they will have a fiduciary responsibility to the participants in the plan, which adds an extra level of accountability regarding the share price.
Here’s how the creation of an ESOP can look in the real world: five years ago, a 62-year-old owner of a pipe and supply company had a valuation completed on his business. The business was valued at $20 million. The company secured a 5-year commercial loan at 3.7 percent, and the bank extended the loan for $6 million (or 30 percent of the company’s value). The $6 million was invested in “Qualified Replacement Property,” as defined under IRC 1042. As a result, there wasn’t a capital gain tax assessed to the owner at the time of sale. The owner was able to build a diversified portfolio of domestic stocks and bonds and realize capital gains in a more modest fashion.
The company loan was paid back after five years and the ESOP participants were allocated all of the stock, or $6 million, as originally valued. The original share price, upon the ESOP implementation, was $50. At the end of 2015, the share price was $72.80, representing a 46 percent cumulative return over the five year period. The successor leadership is now continuing to make cash contributions to the ESOP and retiring some of the allocated shares as Treasury Stock to increase the share price through the anti-dilutive process and to allow employees to diversify their accounts into mutual funds.
There are many considerations involved in selling a business. Implementing an ESOP can be the right solution, but only if it makes sense for the ongoing success of the company, and fits into the comprehensive estate plan for the business owner.