A Business Owner's ESOP Checklist

A Business Owner's ESOP Checklist by Kevin Long an ESOP Advisor.

by Kevin G. Long, Esq.

Most business owners assume that when they are ready to retire/sell/move on, that all-cash buyers or buyers that let them just walk away will be there. In the real world, however, there are not many buyers that will meet a seller's initial expectations, even if the owner looks for one. Fortunately, like the prince, if the business owner is properly advised and searches far and wide, he may just find the perfect buyer — in the form of an ESOP. This may bring him, his employees and the company magnificent tax advantages and a resolution of the selling shareholder's succession problem.

There is a catch. The business owner has to look hard and be dedicated to the search for a business-succession solution. Finding Cinderella may require trying a "glass slipper" on a number of alternatives. Most will not fit. Hopefully, one will. It is this author's opinion that in many circumstances the business planning slipper will fit the ESOP, and everyone can live happily ever after, tax benefits and all.

Let's take a look at some of the obstacles the business owner has to overcome to find the right solution or determine if an ESOP will be a part of his Cinderella fairy tale.

Assemble And Review The Alternatives

As the story goes, the prince/owner must throw a "ball" and invite all the fair maidens/business-planning alternatives and look them over. They may include family limited partnerships, sales to third parties, a non-ESOP sale to management, or simply the liquidation of the company. The business owner should be advised of the tax, control and estate planning concerns and economics of each alternative for himself and his family and how they affect the company and its employees.

As in the fairy tale, it is often pure chance or serendipity that the ESOP even makes it to the ball. In most situations, the business-planning advisers are only somewhat familiar (if not entirely unfamiliar) with ESOPs as an alternative. For many business owners, a trusted business adviser may turn out to be the "fairy godmother" that sees to it that the ESOP is presented for what it truly is. Alternatively, the close adviser may be a "jealous stepsister" who keeps the prince from meeting his Cinderella. After all, an ESOP is a highly complex, yet extraordinarily versatile, planning vehicle. Many business advisers will not consider or assist the owner in evaluating an ESOP because it seems to compete with other traditional estate- or business-planning objectives that they are more comfortable and familiar with. It is important when assembling all the alternatives to ensure that the ESOP is included and seen for what it is and what it can do.

It is, therefore, the job of business advisers to any company or the shareholder planning a long-term business or succession strategy to ensure that an ESOP is considered. Furthermore, if the business owner's advisers do not know how to dress up and present an ESOP to their client, then perhaps they should contact an Employee Retirement Income Security Act fairy godmother, who may be a specialized ERISA attorney or specialized ESOP consulting firm, to present the alternative in all its tax-advantaged glory. The business owner's regular advisers should not fear the inclusion of the ESOP in the planning process. After all, all they are concerned with is making sure that the prince/owner is happy.

How To Spot The ESOP At The Ball

For the ESOP to stand out in the parade of business-planning options, it is important to understand how the ESOP can fit in. An ESOP can take many forms and be used in many ways. Let's take a look at some of the ways an ESOP can be a part of the business and succession-planning process. It can:

·         Lower the costs and facilitate cash flow in a management-led purchase of the company.

·         Provide the selling shareholder with the capability to reinvest the proceeds of the sale of his stock without immediately paying federal capital gains tax.

·         Provide a market for stock where otherwise no market existed.

·         Be used to acquire shares with pretax cash flow.

·         Be used to retire or buy out a dissident or unhappy shareholder.

·         Help provide estate liquidity for heirs that wish to continue in the family business.

·         Be used to help establish minority discounts on family-held stock for estate planning purposes.

·         Help attract financing at about 85 percent of the cost of conventional financing.

·         Be a minority purchaser of stock, providing asset diversification, or a 100 percent purchaser of the company.

·         Permit the seller to remain involved while the purchase is being completed, thus lowering the seller's risk.

·         Help attract minority-subordinated equity investors in a management-led buyout.

Often, more than one of these ESOP advantages can apply to a business owner's needs. For example, a sale of shares to an ESOP can provide the selling shareholder with capital gains deferral, finance the purchase with pre-tax dollars, and permit the company to borrow in order to finance the purchase with a loan at an interest rate lower than they could have normally obtained.

For a more detailed look at the capital gains deferral mechanism and the corresponding reasons employees would be interested in using an ESOP, see the article, It's No Fairy Tale: ESOPs Benefit Both Buyers And Sellers.

Does The Slipper Fit?

So, the business owner has caught a glimpse of the fair ESOP beauty at the ball and learns that she comes with magnificent tax advantages. Is an ESOP really right for the situation? Unfortunately, there is no way for the shareholder to get around trying the business-planning slipper on several alternatives on a one-on-one basis before deciding what fits. After the initial glimpse, the shareholder needs to carefully evaluate the suitability of the business planning alternatives.

There are some basic questions you can ask about the company and the shareholder owners to determine whether an ESOP is worth considering:

·         Is the company a corporation taxed in the normal manner and not a Sub Chapter S corporation?

·         Is the company closely held or publicly traded with significant ownership in a few hands?

·         Does the company have sales and payroll adequate to support an ESOP, meaning total current and projected payroll as a percentage of sales is perhaps 20 percent or greater?

·         Does the company have a strong earnings or cash flow record over the previous five years?

·         Does the company expect to pay substantial federal income tax over the next few years?

·         Do at least some stockholders have a reason why they might be interested in selling some stock (e.g., planning for retirement, liquidating an estate, entering a new business venture, children not involved in the business, etc.)?

·         Will one or more principal executives be departing in connection with the sale, and is there strong management available to take their places?

·         Does the company customarily make payments to a profit sharing or other employee benefit plan that could in the interim be used, or in part, to fund an ESOP?

·         Are the owners psychologically willing to share ownership with their employees, assuming that an attractive deal can be arranged?

Characteristically, the last of these questions is often times the most difficult question for the business owner to answer. The cash flow and financial questions are objective, quantitative and easy to measure. However, the notion of selling ownership to an employee group or to the employees generally is often something the owner shareholder has a hard time envisioning, unless he has a good reason.

In addition to the tax incentives discussed in It's No Fairy Tale: ESOPs Benefit Both Buyers And Sellers, an owner of a business has to dwell, as mentioned above, on the reality that there are not that many buyers available to acquire his company. The all-cash buyer is a classic myth of the closely held corporation. More often than not, sale to a third party involves a certain amount of cash up-front, with the remainder of it financed over a period of time. It is sometimes possible for a buyer to obtain cash financing through a bank or other lender, but typically this is not for 100 percent of the purchase price. Sometimes, alternative sale approaches are "earn-outs" or other payments depending upon future profitability of the company that is being sold. Finally, there is also the possibility that a merger could occur with a publicly traded corporation in which the owner of the closely held company receives shares from the publicly held company. In that situation, the seller does not receive cash, but in theory the shares he receives in payment are more liquid and more easily disposed of in the market, although this is often times subject to substantial restrictions after the sale.

So what does a selling shareholder do? It is important to get objective and expert information and a comparison of the sale alternatives to determine whether the trade-off in the last question above, can inspire him to consider an ESOP. After all, that is precisely what the Congress intended when they passed all of the tax incentives for ESOPs. They wanted them to become attractive enough for the shareholder owners to consider their employees as not just an attractive alternative, but arguably one of the best alternatives available for selling a closely held business.

Important ESOP Suitability Questions

Whether an ESOP is suitable for the owner and the company also depends upon a number of factors. While the tax advantages apply to nearly all (assuming a company is profitable, is paying taxes, and can use the tax benefits), other less quantifiable issues have to be weighed. For example, the following should be considered:

·         Is the company in an industry that is labor- or people-intensive and can take advantage of the ESOP's promise of productivity enhancement?

·         Is the company in a highly cyclical industry with extreme ups and downs in stock value?

·         Is the company in an industry that has a high risk of obsolescence? That is, could a change in technology put it out of business at any time for reasons beyond its control?

·         Does the company have such thin margins and poor cash flow that it can't afford a financed buyout?

·         Does the shareholder have family members he wants to take over the business and control it in a legal and absolute sense?

·         Does the company have a second level of management that is ready, willing and able to take over the operation and growth of the company after the buyout?

·         Does the company have enough employees and eligible payroll to permit an ESOP to reasonably spread the stock ownership and support the contributions to the plan?

·         Would the ESOP be the only retirement plan the company offers, or would a 401(k) or other plan also be available?

·         Does the business owner want to sell the company but maintain complete control?

·         Do the owner and future management want to use the ESOP strictly as a tax boondoggle, or are they really interested in sharing ownership with other employees?

There may be a few answers to these questions that indicate an ESOP may not be suitable for a company.  However, there are few obstacles that may be identified in this list that are intrinsic to ESOPs. That is, most of the reasons an ESOP is not suitable are company-specific, owner-specific, or economic and financial. In most situations, it is not the ESOP itself that is unsuitable for a given company.

In the course of analyzing the trade-offs and advantages of an ESOP, certain common myths and misconceptions will rise to the surface. That is why we have written Common Misconceptions About ESOPs. Take a look at some of the points we raise. Do any of these sound familiar to you if you are a business adviser or business owner? Have you heard these before? While complete and exhaustive answers to those misconceptions are beyond the scope of this issue, hopefully we have begun to address them.

What To Do?

If you are a company owner (a real prince) or are a business adviser to the kingdom, it is important to be sure that all business planning alternatives are invited to the ball. Do not make the mistake of making the ESOP stay at home. It may turn out to be exactly what the kingdom needs. Before you choose an ESOP, though, be sure to have a qualified ERISA attorney or consultant evaluate all the positives and negatives that will determine whether an ESOP can bring a happily-ever-after conclusion to your business planning needs.


Editor's Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government's rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or email us at