One of the biggest issues for business-owning clients is how to get out of that business some of the sweat equity they’ve put into it. The problem arises when a business-owner client works for years to develop wealth by building up his business. Then when he is ready to get out of the business, he can discover that his wealth is locked up in an illiquid–albeit valuable–asset: his business. How is he going to cash in on that value? One way is to set up an employee stock ownership plan, or ESOP. Used correctly, an ESOP can provide substantial advantages over other business succession alternatives. Here’s how ESOPs work, and when they are appropriate.
There are currently about 11,000 ESOPs and similar plans covering over 8.5 million employees in both publicly traded and closely held companies of every size in the U.S. An ESOP is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the employer company. ESOPs are qualified in that, in return for meeting certain rules designed to protect the interests of plan participants, ESOP sponsors can make tax-deductible contributions to fund the participants’ retirement. ESOPs are defined contribution plans in that the employer makes yearly contributions that accumulate to produce a benefit that is not defined in advance. Rather, what the plan participant receives is based on the growth of the assets in the plan: for the ESOP, it’s the value of the employer’s stock.
ESOPs and the Closely Held Business
The ESOP is often used as a way to monetize all or part of an owner’s interest in a closely held company. The owner may sell in whole, in part, or in stages over a period of years so he can gradually ease out of the company–a particularly important consideration for sellers with management responsibilities. With a C corporation, the selling owner may defer taxation on the gain on the sale by using a Section 1042 rollover.
The ESOP is very valuable in an exit-planning situation for an owner in helping access his wealth for the following reasons:
1. It creates a ready market for the closely held business;
2. It provides the ability to diversify the closely held business or concentrated business interest on a tax-incentive basis;
3. It provides liquidity during the owner’s life and liquidity at his death;
4. If used appropriately by knowledgeable people, it can enhance the effectiveness of other wealth-planning techniques.
By investing primarily in the employees’ own company shares rather than in the securities of other companies, the ESOP also gives employees a vested interest in the business: the better the company does, the greater the rewards for the employees participating in the plan. Moreover, the other interest the ESOP serves is the remaining, or what’s called “leave-behind,” ownership. It gives these employees the ability to buy the company over time with company profits.
With all this going for it, the ESOP is almost like the tonic that the traveling salesman used to hawk as a miracle cure–it was good for iron-poor blood, for the gout, for depression, for everything. But the magic elixir was snake oil. In the same way, the ESOP approach should always be analyzed in light of other ways that the owner can satisfy his departure objectives. Initial public offerings, leveraged recapitalizations, a sale to a strategic buyer (i.e., an outside buyer), or a transfer to insiders (possibly key employees or family members) must all be considered as well.
While going public, i.e., the IPO route, may sound impressive, it can be costly and the owner is going to have to jump through many regulatory and financial hoops. How about leveraged recapitalization? If the company is doing well and has built substantial equity, it can borrow money, but then has to find a way to get the borrowed money to the owner without triggering an additional tax burden. And a transfer to insiders may not yield properly timed cash flow to facilitate the owner’s desired exit.
While these other approaches may be more suitable in some cases, the departing owner is likely to find that the ESOP is a very attractive alternative. In certain circumstances, an owner with a concentrated equity position in his business can sell his position, buy a broadly diversified portfolio of securities with the proceeds, and still not pay any capital gains tax.
The ESOP as Exit Strategy
While three types of ESOPs can be used in exit planning–the conventional, the leveraged, and the seller-financed ESOP–the most appealing strategy is the leveraged ESOP.
In a conventional ESOP, the owner is bought out over time. Each year the employer makes tax-deductible contributions to the ESOP based on the overall payroll of the participating employees. These yearly contributions are then used to purchase shares from the departing owner in bits and pieces based upon the contributions that are made in that year. Once they purchase these shares, the shares are allocated to the participants’ accounts. The successor ownership then buys out the participants as they retire.
Although this is done on a tax incentive basis, the departing owner almost always would prefer to get his money up front. “I worked hard for 20 or 30 years,” the thinking goes, “I’m ready to go and I want my money now.” But “leave-behind” owners (typically family or key employees) who buy the business often don’t have that kind of money up front and would prefer to buy it over time.
If a leveraged ESOP is used, the ESOP borrows the money to acquire the exiting shareholder’s stock in a lump sum up front. These shares are then put into a suspense account in the ESOP as the security for the loan. Each year as tax-deductible contributions are made to the ESOP based on the payroll of participating employees, these contributions can then be used to pay off the loan. As the loan is paid down, the securities that were purchased from the exiting shareholder are now freed up and put into each employee’s account. In addition, there is potential for gain deferral under IRC Section 1042. To do so, however, the departing owner must meet various criteria, including the purchase of “qualified replacement property” within a 15-month period extending three months before the sale to the ESOP until 12 months after the sale. Qualified replacement property includes stocks, bonds, and debentures of domestic operating companies (i.e., publicly traded securities). The owner typically buys the property with the money from the sale. Gain on the sale of his company stock is delayed until the qualified replacement property is disposed of.
The seller-financed ESOP is a little more esoteric because it’s not as easy to get the deferral of the gain on the sale of the shares by the departing or exiting shareholder. In the seller-financed ESOP, the seller, in essence, lends the money to purchase his shares, letting the ESOP buy him out over time. There are two reasons he would do this: one, the seller gets paid the interest rather than the bank; and two, there are lower transaction costs when it’s a seller-financed ESOP. The annual tax-deductible contributions made to the ESOP are used to extinguish the loan.
If done the right way, the seller can still qualify for a gain deferral under IRC Section 1042. The most problematic of the IRC Section 1042 criteria that must be met is the purchase of qualified replacement property within the time period required. So if the seller lets the employees buy him out over time, where is he going to get the money to buy the replacement securities?
He can get it from one of two places. There’s nothing in Section 1042 that requires that the money from the sale of the shares must be the money used to buy replacement securities, so if he has some other money squirreled away, he can use that to purchase the securities (though that’s not usually the case). Otherwise, the seller can buy a long-term (30-year) floating rate debenture–sometimes known as an ESOP bond. Financial institutions will lend up to 90% of the cash needed to buy replacement securities on the ESOP bonds. The owner can use this leverage to purchase the requisite amount of replacement securities, paying off the margin debt as he receives his payments from the ESOP.
Is Section 1042 a Silver Bullet?
At about this point, you’re probably wondering what the catch is. When anyone looks at an ESOP and the benefits of IRC Section 1042, it seems like a no-brainer. As is usually the case, let the buyer beware. First, the qualified replacement securities take the cost basis and tack on the holding period of the old securities.