My client asked me about an ESOP; what do I need to know?
By Hillary Hughes
August 31, 2021
As a trusted adviser to business owners, you may be asked about employee stock ownership plans (ESOPs) and are looking for answers on how to discuss them with your clients. While ESOPs have been around since 1974, many myths and misconceptions still exist around selecting an ESOP as a way for a business owner to exit the business partially or completely.
What is an ESOP and what are its benefits?
To be prepared when a client asks you whether an ESOP may be right for their company, here are some important facts about ESOPS:
- ESOPs are a retirement plan. An ESOP is a retirement plan governed by ERISA (the Employee Retirement Income and Security Act of 1974), a federal statute that regulates private retirement plans. Notably, employees do not pay tax on the contributions made to the ESOP on their behalf, and the value within an ESOP participant’s account grows tax deferred; taxes are only paid upon distribution of the individual’s account. When an employee leaves the company, the company repurchases the ESOP stock allocated to that individual at fair market value.
- ESOPs are a liquidity strategy. For owners who are looking to gain liquidity by selling their company, or even just a fraction of the company, a sale to an ESOP is typically a more controlled and friendly process than a third-party sale. A sale to an ESOP also allows for the continuity of the company’s culture and provides a legacy for the owner, both of which are often attractive benefits to owners of privately held businesses.
- ESOPS allow for tax efficiency. If the ESOP needs to use either third-party debt or seller financing to facilitate an ESOP transaction, the debt is repaid with pretax dollars. The ESOP is a tax-exempt retirement trust. For S Corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level — and oftentimes at the state level as well. In addition, under certain circumstances, C Corporation owners who sell their stock to an ESOP can defer capital gains on the sale under Section 1042 of the Internal Revenue Code.
Who makes a good ESOP candidate?
An owner may feel an ESOP makes sense for their company because selling to an ESOP usually allows the selling shareholder to stay with the company for a period of time, which is rarely possible with a third-party buyer. It also gives the owner pride to sell the company to the employees who, in turn, will carry on the company’s legacy. Keeping ownership in the hands of the employees will avoid the potential loss of jobs that may occur if the business is sold to an outside buyer. These plus points may tip the scales toward the implementation of an ESOP as opposed to selling to an outside buyer — even if selling to a third-party may net the owner a higher selling price.
My company has found that strong candidates for ESOP ownership are companies that are profitable and growing, have a strong management team and a solid operating model, wish to retain their independence, have the capacity to take on debt and repay the selling shareholder over time, and have an owner or owners that are looking for a tax-favored exit.
In terms of size, ESOPs have proved successful in small local businesses with as few as 15 employees to large multinational corporations with billions in value. The key to success is making sure the transaction structure is aligned with company needs for ongoing operations, seller expectations and a sustainable retirement benefit level.
Do ESOPs last?
The resilience demonstrated by ESOP firms is leading to increased interest in ESOPs. A recent study conducted by Rutgers University and market research firm SSRS found that workers whose companies provide ESOPs fared better overall during the COVID-19 pandemic in the areas of job retention, pay, benefits and workplace health and safety than companies without them. The study also found that, during an economic downturn, companies with ESOPs are nearly six times more likely to anticipate their business will return to its precrisis level of performance than are non-ESOP companies.
Why should you care about ESOPs?
Being part of the team that works on the sale of a business to an ESOP offers CPAs numerous opportunities:
- Client continuity. Through the partial or complete sale to an ESOP, many of the trusted advisers to the company continue on after the ownership transition, which is rarely the case in a third-party sale. Additionally, many trustees and lenders to an ESOP will require an increased level of financial reporting — typically an audit or review.
- Better able to serve your clients. Being knowledgeable about ESOPs and being involved in ESOP transactions gives you the opportunity to differentiate yourself from other CPAs; it shows your expertise regarding a tax-advantaged ownership transition structure that is an alternative to a third-party sale.
- Fee opportunities. Fee opportunities involved with both ESOP transactions and existing ESOP-owned companies include tax planning (S Corps versus C Corps, built-in gains tax, tax issues of the selling shareholders, structure of seller debt and warrants from a tax standpoint, gifting by the selling shareholders pre- and/or post-transaction, etc.), feasibility and general consulting.
- Develop your network. ESOP transactions involve many players, which gives you the opportunity to network and make referrals to attorneys, financial advisers, lenders, trustees, wealth managers and third-party administrators, among others.
For these reasons, we encourage you to learn more about the numerous benefits offered by ESOPs to both selling shareholders and their CPA firms. Since employee ownership is one area in which Prairie focuses for its clients, we have advised more than 500 companies on various issues that arise in running an ESOP company. Our website offers numerous resources that can help you gain further knowledge on the topic. In addition, should you wish to further discuss opportunities related to ESOPs, please feel free to contact us directly.
Hillary Hughes is a director at Prairie Capital Advisors, assisting business owners and their advisers with long-term ownership transition goals, including ESOPs, mergers and acquisitions and other business interests. You may reach her at hhughes@prairiecap.com or 319-366-3045.
The Minnesota Center for Employee Ownership serves as a free, unbiased source for education and resources around all forms of employee ownership. With 52,000 business owners over the age of 55 in Minnesota exiting their business in the next 3-5 years, there is a crisis looming. What will happen to their legacy, employees, community? Business owners will look to their advisers on how best to exit. Contact us for more information on how we can be a resource for you (www.mnceo.org) or Sue Crockett, executive director, at scrockett@mnceo.org.
