Owners often wait until it’s too late to consider various options, at which time the only answer might be selling the business to a third party, perhaps a .competitor or a private equity group.
For some businesses, that last-minute strategy ends with success, but for many owners, that is not an acceptable or desired solution to their ownership succession.
There are a limited number of options for business succession. The standard list of options for most businesses includes sale to a third party, management buyout or transfer to family members, but have you heard about ESOPs?
Employee stock ownership plans (ESOPs) have been around since 1974, yet only approximately 7,000 businesses nationally are currently utilizing them for their ownership succession needs.
ESOPs are a great alternative for business owners who are not interested in turning the keys to the business over to a stranger and do not have any family in the business ready to write a check for the owners’ equity.
As a qualified retirement plan, ESOPs serve both as a mechanism for employees to receive the value of company stock as an additional retirement benefit and as a buyer of an owner’s company stock.
An ESOP’s purchase of company stock from the owners allows a business to continue to operate without changes to management or operations (i.e. former owners can continue to serve in the same role), and employees do not have to worry that a third party will move the operations elsewhere.
Additionally, ESOPs can be implemented in a way that allows business owners to sell their company stock over many years instead of all at once. In addition to the operational aspects of ESOPs, there are also tax advantages that can be obtained with ESOPs that are not available in any other type of sale (except ih a co-op).
ESOPs offer tax deductions to companies that can result in a pre-tax purchase of company stock from a shareholder. Instead of using after tax dollars to buy back company stock, which is how many professional services firms approach ownership succession, the ESOP purchases the company stock with the company’s pre-tax dollars.
What about the selling shareholder? Internal Revenue Code Section 1042 allows an individual who sells company stock to an ESOP to elect the deferral of their capital gains tax on the proceeds of the sale potentially forever.
That means that a selling shareholder can avoid sending to the IRS a rather significant tax payment on the sale of shares, provided that he or she is willing to meet the requirements of Code Section 1042, which also requires the reinvestment of the proceeds from the stock sold to the ESOP.
However, if the selling shareholder does meet the Section 1042 reinvestment requirements and they don’t liquidate the investments, at the time of the selling shareholder’s death those investments will have a stepped-up basis and no one will ever pay the original capital gains tax from the sale of the shares.
Essentially, the owner has deferred the capital gains tax forever! Although not every selling shareholder finds the Section 1042 strategy desirable for their situation, it should be considered.
All those tax advantages of ESOPs might sound appealing, but the really powerful tax advantage of ESOP ownership of company stock is: found with the combination öf ESOPs and stock of S corporations.