ESOP's Tale
ESOP's Tale by an ESOP Advisor.
It is no surprise the baby boomers, born between 1946 and 1964, are looking to retire as they turn age 65 at a rate of 10,000 a day for nearly the next two decades.
Sixty-two percent of U.S. companies are planning to sell all or some of their stock within the next fi ve to six years, according to a recent PricewaterhouseCoopers report.
It is projected to be the biggest transfer of wealth in U.S. history, estimated at $15 trillion or more during the next 15 years.
Pennsylvania is the sixth-largest economy in the country, with about 14,000 businesses in Butler County alone.
Many of these Pennsylvania companies fall in this baby boomer-owned category and are considering how to transfer their businesses and enjoy the fruits of decades of hard work.
An Employee Stock Ownership Plan, or ESOP for short, is an often overlooked method of business transfer as boomers look to do so in a way that best suits their families’ goals and objectives.
Many are family operations that would like to perpetuate the business into the next generation or to key management personnel but giving the business away is not a viable option, and the next generation often cannot afford or even borrow the purchase price.
The owner also faces considerable taxation on stock sale proceeds, including capital gains tax on the gain portion of the sale proceeds.
As of Jan. 1, 2013, the federal capital gains tax burden on a selling shareholder increases from 15 percent to 20 percent, plus 3.07 percent Pennsylvania capital gains tax. Additionally, the recently passed health care legislation imposes a 3.8 percent tax on the gain portion of a business sale, effectively making the combined federal and state capital gains rate on a sale of a business 27.5 percent.
ESOPs have unique procedural and tax benefi ts that are not affected by the tax law changes. Certain ESOP structures might not be subject to the underlying affected capital gains or income taxes at all. Therefore, ESOPs, in the right situation, can be one of the best and most tax-effi cient ways for a business owner to transfer a business and often provide the most net after-tax proceeds to the seller as compared to other transfer methods.
ESOPs defined
In practical terms, an ESOP is a highly tax advantaged, immediate or gradual exit strategy for business owners desiring liquidity or to simply take “chips off the table.”
The ESOP is a “ready and willing” buyer of the seller’s stock that keeps out unrelated third parties and allows corporate control to remain unchanged. It retains the seller’s existing perks while providing signifi cantly enhanced retirement benefi ts to all eligible employees who will have a benefi cial ownership interest in the stock sold to the ESOP.
Technically, an ESOP is a defined contribution, tax-qualifi ed retirement benefi t plan under Internal Revenue Codes 401(a) and 4975(e)(7) and overseen by the IRS and the U.S. Department of Labor designed to invest “primarily in employer stock.”
How an ESOP works
Only ESOPs are allowed to borrow the funds required to buy the desired shares at fair market value from the selling shareholder.
Typically, the ESOP borrows funds from a bank, or the seller takes back a note.
The company makes tax-deductible contributions to the ESOP, which uses the funds to repay the loan incurred to buy the stock until the debt is repaid. The shares purchased by the ESOP are allocated to the employees of the company in proportion to their compensation as the loan is repaid.
Seller advantages
- The selling shareholder may indefi nitely defer/eliminate all capital gains on the sale proceeds.
- The seller enjoys an immediate buyer of some or all of the seller’s stock at fair market value.
- The seller can retain personal salary, perks, benefi ts and control without the interference of outside interests until ready to hand over the reigns.
- The seller retains personal and corporate legacy in the town in which he has built his livelihood and substantially contributed.
Corporate advantages
- The company receives a dollarfor- dollar income tax deduction on the entire stock sale price.
- An ESOP company can be 100 percent federal and state income tax exempt.
- ESOP companies may outperform their peers with increased productivity and higher return on investment.
The largest study to date regarding ESOP performance was a 2000 Douglas Kruse and Joseph Blasi of Rutgers University study that found that ESOPs increase sales, employment, and sales/employee by about 2.3 percent to 2.4 percet per year over what would have been expected absent an ESOP.
A more recent study in the Journal of Employee Ownership Law and Finance published in 2006 showed the return on equity of the ESOPs companies studied was 5.6 percent higher than comparable non-ESOP companies. It also found that the “net” profit margin was 10.3 percent greater in ESOP companies.
Employee, community advantages
- The employees enjoy enhanced retirement benefi ts of company stock with no out-of-pocket costs.
- An ESOP’s orderly internal transfer of the company creates a more stable and reliable community employer.
- The company remains an important contributor to the community.
Governance, control
Stock ownership and control are not synonymous in an ESOP company.
In an ESOP company, the shares outside the ESOP appoint the board, which names the ESOP trustee. An ESOP trustee is usually a “directed trustee” voting as the board directs without the input of the employees.
The employees have no minority shareholder rights, access to financial information or voting rights.
Therefore, control can be maintained by a 1 percent owner even if the ESOP owns the other 99 percent.
Control is easily and affordably transitioned by gifting or selling the 1 percent, in this example.
ESOP’s legacy
Many owners want their children and/or key management to eventually run and own the business, but those individuals cannot afford to purchase the business nor obtain adequate financing.
An ESOP’s “legacy full circle” increases direct ownership to the next generation over time without personal fi nancing and the potentially confl icting goals and interference of outside unrelated interests.
As employees leave the company for any reason, the company may repurchase the shares from the participants and retire the shares into treasury. This reduces the overall outstanding shares and increases the percentage of ownership that is held outside the ESOP by the children and/or key management.
In theory, when the last share is repurchased and retired, the shares held outside the ESOP represent 100 percent of the value of the company.
An ESOP is a ready and willing buyer and highly tax-advantaged business transition tool that is often overlooked because of perceived complexity or lack of knowledge.
An ESOP may be the ideal method to transfer a business on the seller’s timetable to the next generation without the interference and costs of outside parties.
As the window of record low capital gains rates are set to expire on Dec. 31, boomer business owners owe it to themselves to explore their options.
