United States: ESOPS Are An Excellent Business Succession

Imagine the scenario in which a business owner spends 30+ years developing and maturing a successful, privately held business. After a successful run, the owner, whose children have little interest in taking over the business, decides to cash out and sell the business. However, the owner, who is very proud of the business and the strong positive reputation associated with the company's name and branding, desires that the company keep its name and branding in place. In addition, the owner wants to make certain the company's loyal employees are not harmed by the sale. So before inking a deal with a private equity firm, the business owner negotiates certain protections to achieve these goals—a two-year employment agreement for the owner (the longest period of time the private equity firm would agree to) and an agreement that the company must remain in the same facility for at least three years following the sale. Finally, the business owner would like to reinvest the proceeds generated by the sale of the business in marketable securities in a tax-favorable manner.

Now fast forward to three years following the completion of the sale of the business. The private equity firm (now owning the company) has decided to consolidate the company's operations with another one of its portfolio companies. As a result of this restruc­turing, the company's products will now be marketed under a different name, and its operations will be moved to a location that is more than 300 miles away from the company's historical operating location. Due to the consolidation of operations and the related relocation, most of the company's employees will lose their jobs.

The former owner of the company is powerless to protect the company's former brand name and employ­ees because she was forced to retire more than a year earlier, at age 60, when the private equity firm elected not to extend her employment agreement. Even though the owner of the company was able to liquidate her investment in the company through the private equity sale transaction, she still had to pay capital gains tax on the sale proceeds. Moreover, two of her other primary objectives have not been achieved. Most of the compa­ny's employees are now unemployed, and the company's iconic brand name and identity have been gobbled up as part of a larger conglomerate.

There is an alternative sale strategy the owner could have pursued to both monetize her investment in the company in a tax favorable manner and achieve her other goals. Had this business owner sold her company stock to an employee stock ownership plan (an ESOP),1 the above unfavorable outcomes to both company branding/identity and employees would never have occurred. In addition, under certain circumstances the business owner could have deferred the imposition of capital gains tax on the sale proceeds.

A business owner can monetize his or her capital investment in the business by selling some or all of the company stock to an ESOP. Following such a sale, the business owner can still maintain an active role in the business he or she created, and make certain its image and brand continue to flourish. Moreover, through such ongoing involvement, the business owner can maintain and protect the job security of the company's employees, while also providing them with a supplemental retirement benefit. As a result of these factors, empirical data shows that ESOP-owned companies are more profitable and have lower turnover rates than non-ESOP companies.2

The best way to demonstrate how a leveraged ESOP transaction works is by example. Assume a busi­ness owner ( John) is looking to sell 40 percent of his company (a subchapter C corporation) to an ESOP for $5 million. Once the company, John and the ESOP negotiate the terms of the deal, the company will lend $5 million (the company obtains this money from either a commercial bank, company cash on hand, seller notes or a combination thereof) to an ESOP in exchange for a promissory note. The ESOP, in turn, uses the $5 million loan proceeds it just received from the company and purchases a 40 percent interest in the company's stock from John. John (under certain circumstances) may be able to avoid having to pay capital gains tax on the $5 million in sale proceeds. (The mechanics of this Section 1042 of the Internal Revenue Code of 1986, as amended tax deferral election will be discussed later in this article.) In addition to monetizing a portion of his capital investment in the company on a potentially tax-deferred basis, John still retains majority ownership of, and control over, the business—something a private equity firm would never permit.

Since this is not a private equity deal, and John retains control of the company, there is no risk the company will be relocated or consolidated into a larger business enterprise, and employee jobs are also protected. Moreover, the legacy of the company's name and branding will remain in place.

Under Code Section 404(a)(9), each year the company will make a tax-deductible contribution to the ESOP so the ESOP can pay its annual debt service requirement back to the company (remember the ESOP borrowed the $5 million from the company in exchange for a promis­sory note). The net cash flow from the company to the ESOP, and then from the ESOP back to the company, is cash neutral. In other words, the company is not out of pocket any dollars once the ESOP effectuates its debt service payment back to the company. However, this circular flow of funds generates a sizable tax deduction for the company, which means the company can now pay back outside bank financing (the company probably borrowed a portion of the $5 million from a bank) with pre-tax dollars. This results in tax-advantaged financing for the company. Private equity firms do not have the advantage of using pre-tax financing in their acquisitions.

As for the employees, as the $5 million note is paid off (assume it is a 10-year note), each employee/participant in the ESOP will receive an allocation of company stock in his or her account, pursuant to the requirements estab­lished under Treas. Reg. Section 54.4975-7(b)(8). Here, 10 percent of the company stock that was purchased by the ESOP is allocated each year to the participants (in the aggregate). After 10 years, all of the company stock that was purchased by the ESOP will be allocated to the participant accounts. Over the years, each participant's account balance will grow in size and, hopefully, will prove to be a significant supplemental retirement benefit for the participants. This ESOP benefit is entirely employ­er paid; there is no cost to the participant.

Unlike private equity sales, in which the $5 million in sale proceeds is subject to federal and state capital gains tax, John has the ability to defer capital gains tax by making a Code Section 1042 election. In order to have tax deferral treatment apply under Code Section 1042, the following criteria must be satisfied:

1. The company has to be a subchapter C corporation. As of now, current law does not permit sellers of S corporations to effectuate a tax deferral election.3

2. The ESOP must purchase qualified employer securities, which means the stock sold to the ESOP must possess the best dividend and voting rights of all classes of stock.4

3. The ESOP must own at least 30 percent of the company following the sale.

4. The stock sold by the owner to the ESOP cannot have been acquired through the exercise of stock options or under some other form of employee benefit plan.

5. The selling shareholder cannot participate in the ESOP.5

6. The selling shareholder must purchase qualified replacement property (QRP) within three months prior to the sale to the ESOP or within 12 months after the sale to the ESOP. QRP is essentially stocks, bonds, debentures or notes issued by domestic operating corporations. Investments in mutual funds or in foreign corporations will not qualify as QRP, thereby triggering capital gains tax.

There are about 10,000 ESOPs currently in place in the United States, covering over 10 million employees (which equates to about 10 percent of the private sector workforce).6 There are certain macro factors that support ESOPs in today's economy. Several of these factors include: 1) baby boomer business owners are approach­ing retirement age and need an exit strategy; 2) stock market multiples are at or near record highs; 3) borrow­ing rates on loans are low; and 4) banks' lending param­eters have generally loosened in the last few years.

In summary, an ESOP may be a superior business succession strategy as compared to selling to a private equity firm (or even certain other types of buyers). The only potential minor drawback to an ESOP transaction (as opposed to selling to a private equity firm or other strategic buyer), is that an ESOP, by law, is not permit­ted to pay in excess of fair market value for company stock that it acquires. In certain situations (in which a private equity firm or other strategic buyer thinks it can reap certain synergistic benefits by combining or consolidating target entities) certain buyers may be will­ing to pay a premium for a business owner's company or stock. However, many business owners may be willing to sacrifice a few extra dollars in sales proceeds in an ESOP transaction in order to protect the legacy of their company and to protect and reward their employees. In addition, the tax savings from a Code Section 1042 election may be sizeable enough to offset any premium offered up by a private equity firm or other strategic buyer for the business.

Footnotes

1. An ESOP is a qualified retirement plan.

2. ESOP Association, www.ESOPAssociation.org.

3. On July 19, 2017, the bill entitled the Promotion and Expansion of Private Employee Ownership Act (S. 1589) was introduced. This bill, in part, would extend the deferral of capital gains tax to qualified sellers of subchapter S corporation stock.

4. Under Code Section 409(l)(3), convertible preferred stock may be able to qualify as employer securities in certain circumstances.

5. Moreover and pursuant to Code Section 409(n), any individual who is related to the selling shareholder (within the meaning of Code Section 267(b)) cannot participate in the ESOP; and any other person who owns (after application of Code Section 318(a)) more than 25 percent of (a) any class of outstanding stock of the corporation or any member of the same controlled group, or (b) the total value of any class of outstanding stock of any such corporations, likewise cannot participate in the ESOP.

6. ESOP Association, www.ESOPAssociation.org.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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