An employee stock ownership plan – better known as an ESOP - can be an attractive and tax-efficient alternative for owners of private companies seeking liquidity but don't want to sell to a third-party buyer. An ESOP is a qualified retirement plan that provides the business's current and future employees beneficial ownership in the company over time. In addition to providing retirement benefits for employees, selling a company to an ESOP can be used as an exit or liquidity vehicle for the selling owner as well as provide tax benefits for both the owner and the company.
Why sell to an ESOP?
An ESOP transaction can provide tax and other advantages for the company. An ESOP can boost recruitment and employee retention and drive business growth by providing incentives to the company’s management team in the form of future equity or pseudo equity participation. ESOP transactions also offer certain advantages for the selling owner, including:
- Flexibility in deciding how much of the business to sell and when;
- A fair market value price for the business;
- The preservation of founder legacy and company culture;
- The ability to exit the company gradually over time to provide a period of transition for the next generation of leaders;
- Continued operational control over the company, since the company’s board of directors and management team will continue to run the company even when the ESOP owns a majority of the stock;
- The possibility of receiving warrants in the transaction in lieu of cash pay interest on seller notes. Warrants would allow the selling owner to benefit from a future increase in the company’s value and are taxed at capital gains rates upon exercise; and
- The potential to participate in the ESOP.
Tax benefits of an ESOP
ESOP transactions offer valuable tax benefits that can increase the after-tax proceeds to the selling owner and the after-tax income of the company. These benefits include the following:
- Capital gain on the sale of shares of a C corporation to an ESOP may be deferred by the selling owner as long as, among other requirements, the ESOP owns 30% or more of the corporation’s shares after the transaction and the selling owner invests the sale proceeds in qualified replacement property.
- The percentage of profits of an S corporation owned by an ESOP are not subject to Federal (and possibly state) income tax, because ESOPs are income tax exempt. It is important to note that converting a C corporation to an S corporation to take advantage of this benefit requires careful upfront planning, as a conversion could trigger unintended tax consequences, including an entity-level tax on built-in gains triggered during the first five years following conversion.
- Contributions by the company to the ESOP (including contributions used by the ESOP to pay principal and interest on a loan) are considered contributions to a tax qualified employee benefit plan and are tax deductible within certain limits.
- Dividends paid on stock held by the ESOP are tax deductible to a C corporation (but not an S corporation) if they are distributed to ESOP participants or are used to pay principal and interest on a loan.
- There are estate as well as charitable gifting planning opportunities for the selling owner.
Other Considerations
- Some of the many other tax and non-tax considerations when planning a sale to an ESOP include:
- The future tax benefits of net operating losses and other tax attributes of corporations sold to an ESOP may be limited if there is a “Section 382 ownership change.”
- Certain industries might have licensing or bonding requirements.
- Owners of a partnership that wish to sell their business to an ESOP may be able to incorporate the partnership and sell the resulting corporation’s shares; however, careful planning is necessary to avoid unwanted tax consequences.
Although ESOPs provide advantages and compelling tax benefits, the process of selling a business to an ESOP must be carefully planned and both the advantages and disadvantages considered to determine whether selling to an ESOP is right for a particular business and business owner.