While business succession planning poses a challenge to any retiring small business owner, the challenge is magnified in the small business context where the owner may not have the funds to implement a traditional succession plan.
These small business clients need creative solutions in order to successfully transition the business to key employees who have been selected to take over following the owner’s retirement.
The concept of an employee stock ownership plan (ESOP) strategy may be appealing to the small business owner, but in a very small business the plan may simply be too expensive to adopt and administer. On the other hand, an ESOP alternative that uses a modified defined benefit plan structure may provide a more viable option for an existing small business owner who is both trying to transition the company and minimize current tax liability.
An ESOP is essentially a trust created by a small business owner. An owner who wishes to exit the business sells his or her business interests to the ESOP, which may finance the purchase through a traditional financial institution or funds provided by the small business owner. An ESOP must meet certain employee coverage, nondiscrimination, and vesting requirements in order to qualify for favorable tax treatment.
The business owner is entitled to defer taxation on the sale if the owner subsequently invests the proceeds in qualified replacement property—meaning the securities of a third-party company (or companies) that does not receive more than 25% of income from passive activities—within 12 months after the sale. The ESOP must then hold the business interests for at least three years following the purchase or pay a 10% penalty tax. That means, of course, that as a succession strategy advance planning will be required.
It is particularly important that a business establishing an ESOP be profitable, as the business will have to generate sufficient revenues to repay the business owner or lender that financed the transaction. While each client’s situation is unique, as a general rule business owners with less than $1 million in annual profits will not usually be good candidates for an ESOP strategy.
If the owner is willing to transfer the shares to a key employee for little to no consideration, the share transfer will likely be treated as compensation, so that it will become subject to income and employment taxes at its fair market value—making the traditional ESOP strategy unappealing for some clients.