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Owners of small and mid-sized businesses are often looking for a way to sell all, or a part, of their business for the highest price possible and pay the least amount of taxes.
If the business is a corporation, the owners should consider a sale of their business to an Employee Stock Ownership Plan, or ESOP.
An ESOP is a special kind of qualified employee benefit plan designed to give employees an ownership stake in their company by investing primarily in the stock of the company. An ESOP structure can be very flexible and is extremely effective when used in conjunction with business succession planning. It is also very effective for a company desiring to purchase the stock of a retiring shareholder and for business owners seeking alternatives to selling their business to a third party buyer.
Often the value of the stock of a family business will comprise a significant part of an owner’s net worth. The sale of all, or a portion, of the owner’s stock to an ESOP may provide the owner with funds to diversify their investments or implement lifestyle changes. For example, such a sale may provide an owner with liquidity to facilitate their desire to equalize inheritances, thereby permitting family members not participating in the business to share in the wealth created by the business.
For those owners who are concerned about the future of their long-term employees, the sale of stock to an ESOP, rather than a third-party buyer, may help ensure the preservation of the employees’ jobs.
A sale to an ESOP is the only strategy available whereby the stock of a selling shareholder can be acquired by the selling shareholder’s corporation utilizing pretax dollars, rather than after-tax earnings. The corporation makes tax-deductible contributions to an ESOP and the ESOP uses the contributions to acquire stock from the selling shareholder. The use of pretax earnings to acquire the stock may provide a very significant cash flow benefit to the corporation.
Certain tax benefits that are available to the corporation and its shareholders are a function of whether the company is a C corporation or an S corporation. For example, it may be possible for a C corporation shareholder to defer, or in some cases avoid, income taxes on any gain on the sale of stock to an ESOP. S corporation shareholders may benefit because an S corporation owned by an ESOP (a tax-exempt trust) pays no income taxes on the company’s income that is allocated to the ESOP.
Maximum tax savings are sometimes achieved when a C corporation establishes an ESOP, the ESOP purchases the stock of one or more shareholders, and the corporation then elects S status. In this situation, the selling shareholders pay no tax on the sale of their stock because their gain is deferred and the ESOP pays no taxes on its share of future earnings of the corporation because the corporation has elected S status.
Most ESOPs are leveraged ESOPs which means the ESOP uses borrowed funds to purchase company stock. Many banks are eager to finance ESOP transactions. Usually, the bank makes a loan to the company and the company then loans the funds received from the bank to the ESOP. In most cases, the bank will not loan the full amount of the selling price of the stock, so the selling shareholders will “seller finance” a part of the transaction.
An ESOP provides business owners with a unique estate and succession planning tool. The ability of the corporation to deduct principal payments for stock purchases, the resources available for obtaining outside financing, and the flexibility in designing innovative exit strategies for selling shareholders, make sales of stock to an ESOP a preferred solution for many exit-planning situations.
• David O’Leary is a partner at Schaumburg-based Lavelle Law. O’Leary focuses his work on matters of business, taxation and estate planning, and is highly experienced in all facets of ESOPs. He holds a degree in finance for the University of Illinois, a J.D. from Loyola School of Law in Chicago, and is a CPA and Real Estate Managing Broker.
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