Ownership Transition of Large Distribution Company - Case Study

Ownership Transition of Large Distribution Company by Herbert Kalman an ESOP Advisor.

The Problem

In 1975, our client acquired one of the largest distribution companies in their industry. He had been the sole owner of this Houston-based company for 42 years, built a strong management team, and structured the organization as a C-Corporation. The organization owned both the business and the real estate on which the business operates.

At 70 years old and in excellent health, our client wanted to continue working but also needed an exit strategy. Because his children were not interested in taking over the business, he required a unique solution that would enable him to sell the company and still maintain some control.

The Solution

GBH suggested a structured sale of his stock to company employees via an Employee Stock Ownership Plan (ESOP).

An ESOP is a Trust that buys and holds the company's stock for the benefit of the employees. The Trustee of the ESOP Trust votes the shares of the ESOP.

The law allows, and GBH recommended that our client (now the Seller of his own company) be appointed as Trustee of the Trust, thus enabling him to maintain control of the company and continue to work as long as he desired.

Impact on the Owner

Our client sold the stock of his corporation to the ESOP Trust. Had the owner sold to a third party, the buyer would have insisted on an asset sale because of tax reasons. Although the agreed price for the assets may have been as much as $20 million, the seller would have received about $12.5 million after taxes.

The sale of stock to the ESOP qualified for the "1042 rollover" which allows certain sellers of shares of a C-Corporation to an ESOP can elect to defer taxes on the gain if the seller invests the proceeds in stocks or bonds of domestic corporations. In this case, our client made the election and did not pay tax on the gain.

Prior to the sale of the Company's stock to the ESOP, the land and buildings were removed from the corporation in a tax-free transaction. Our client then leased the property to his former company on a long-term basis at market value. This lease structure was anticipated in the valuation and the transaction price.

Post transaction, the company elected to be taxed as an S-Corporation. An S-Corporation pays not taxes on its income. Instead, its shareholders pay the taxes on their share of earnings. Post transaction, the company had one shareholder (the ESOP Trust), which is a non-taxable entity. As a result, the company, Trust, and Trust beneficiaries are not required to pay income tax.

The sale was financed by a combination of new bank debt and seller debt, a structure which is common in many sales of private companies. However, the seller believes that he will collect the entire note because 1) cash flow is better since there is not a tax cost and 2) The seller remains in control of the business.

Impact on Employees

The value of the company is being transferred to the employees as the ESOP debt is repaid. Upon retirement, participants will have a retirement benefit from the ESOP.