Is an ESOP a Better Option Than an Outright Sale of Your Business?

As a small business owner, there comes a time when you will want move on to the next phase of life and need the equity from the business for personal living. However, after spending years building the business, it’s likely you don’t want to leave current employees feeling left behind or clients feeling underserved.

So, what are your options?

Of course, you could outright sell the business to an outsider, but an outside buyer may have a different personality or existing business with its own way of doing things. Poor cultural fits are a leading cause of the failure of buyouts and mergers. It can be a painful experience for both employees and customers. Also, it is not uncommon for outside buyers to issue layoffs of long-time loyal employees.

Selling to current employees may mitigate some of this fear, but employees often do not have the financial resources to make an outright purchase of the business. However, an Employee Stock Ownership Plan (ESOP) might be just the solution.

An ESOP enables employees to buy all or part of a company without having to produce all of the finances themselves. Unlike an outright sale or merger, the ESOP enables the seller to sell any portion of his or her stock, and do so over a period of time rather than all at once — so the earlier you start the better.

Selling portions of stock in this manner can also serve as an effective retention and motivation tool in the interim. And, it allows the owner to maintain control until he is ready to exit and pass control over to key employees.

As with all such transactions, there are some logistics to work through.

An ESOP is set up as a tax-exempt trust/entity for tax purposes. This allows the Company to make cash and/or Company stock contributions to the Trust, which are then used to acquire stock in the Company for its employees. This mechanism allows employees who, on their own, may not be able to get financing to acquire part of the company.

Without an ESOP, the employees receiving ownership would be taxed as it is received (if it is issued to them as direct compensation). With the ESOP, they are able to acquire this stock without paying a current income tax on the stock. Furthermore, even if some employees could obtain financing, such arrangements almost always result in the ability to acquire larger percentages of the company.

An advantage to the Company is that the ESOP makes pre-tax dollars available to finance Company growth and/or to create ownership liquidity at the time of retirement. If the ESOP acquires more than 30% of the outstanding stock of a privately held company, any capital gains tax on the transaction is deferred indefinitely, provided that the seller reinvests the proceeds in “qualified replacement property” within 12 months of the date of sale.

The ESOP also enables the company to repay principal with tax-deductible dollars. Dividends paid on stock held by an ESOP are fully tax-deductible, provided that such dividends are either passed on to participants or are used to make principal or interest payments on an ESOP loan. In the case of an S corporation, the ESOP’s share of S corporation earnings is not subject to federal or state corporate taxation or to taxation as “unrelated business income tax,” unless the ESOP runs afoul of certain “anti-abuse” provisions. Thus, in the case of an S Corporation that is 100% owned by its ESOP, the company’s earnings will be entirely tax-exempt.

So while it may be a little bit more complicated than an outright sale, an ESOP is something that should be explored by any owner wanting to make the best decision for the company and its employees.