Considering ESOPs as a Business Succession Strategy

PUBLISHED MARCH 2024

Most business owners eventually face the need to plan for succession of ownership of the business. Planning for that deserves time and effort, and often the chosen path takes time to implement. The basic alternatives are: sell to a third party (including management), transfer to your family, or sell to an “employee stock ownership plan,” commonly known as an ESOP. This article focuses on the ESOP strategy:  Why and how it might work for you.

An ESOP provides a seller with an opportunity to keep the profits of the business in the community and benefit the workers who helped build its value. By transferring ownership to employees, those employees will earn the value of the stock over time and be motivated to make the business successful.

ESOPs can pay fair market value for the company’s stock, pursuant to negotiation with a trustee for the ESOP (who should be independent from the seller). Typically, the ESOP’s expenses related to the ESOP transaction do not reduce value, so they are not borne by the seller. Also, no business brokerage fees are typically paid. 

The biggest financial benefit of the ESOP alternative is tax advantages for both the company and the seller. ESOP companies can, and typically are, set up so that they pay no federal income tax and little or no state income tax. 

Varying Tax Impacts

If the corporation is or becomes an S corporation, to the extent the income of the corporation is allocable to the ESOP, no income taxes would be owed by either the corporation or the ESOP on that income; therefore, if the ESOP were to own 100 percent of the corporation, no federal income taxes would be paid (and most states provide the same treatment). Additionally, ESOP companies may deduct (within certain limits) both the principal and interest payments on ESOP debt used to fund the ESOP’s stock purchase, which in certain cases could substantially reduce the taxable income of the corporation.

An ESOP transaction is structured as a sale of stock. For sellers, this results in one level of tax, as opposed to the two levels of tax that often apply to the sale of private businesses in asset-sale transactions, and even this one level of tax can be deferred in some situations. For instance, normally, sellers must pay tax on any gain on sale of their stock; however, if they sell to an ESOP—and if the proceeds are invested in qualified replacement securities and if certain technical requirements are met—they may defer the tax until they sell the replacement securities, or in the event of the death of the stockholder, taxes can be avoided altogether.

A common misconception is that an ESOP means that the company will become a democracy run by the employees. That is not the case. The company will continue to be run by its board of directors and management team, and the seller can remain on the board and as an executive of the company if desired.

Another factor that merits consideration is the ability of owners to sell part of their business by using an ESOP. This helps resolve the quandary that some owners experience when they desire to monetize part of their stakes but also want to retain some of the business’s future upside potential. It can be very difficult to find a buyer for anything less than 100 percent of a private company; the ESOP structure is well suited to handle situations where less than all current owners want to sell or where one or more current owners want to diversify without selling all of their stock. 

Finally, many ESOP deals involve the seller receiving both cash and company notes for the stock sale to the ESOP. As part of the transaction, sellers often receive an option or “warrant” to acquire a set number of shares of its stock at a set price equal to the price, which gives the seller an ability to experience continued upside in the stock value.

ESOPs can be complex transactions. That is why a well-qualified team of financial and legal professionals should be engaged to assess options. 

With attention to detail and excellent planning, ESOPs can accommodate a wide range of goals.