If you are a business owner considering your exit plan, you have probably considered selling to a small group of insiders (key employees and/or family members), financial buyers (private equity), or strategic buyers (competitors). Before evaluating these options alone, it would be wise to consider a fourth option: selling the business to your employees through an Employee Stock Ownership Plan (ESOP). Given some of its complexity, this lesser-known option is often left out of the consideration set. But before ruling it out, we recommend considering its distinct advantages:
- By selling to all qualified employees, the ESOP allows for a one-time and ongoing transfer of ownership to both rank-and-file employees and leaders, which can lead to an ownership culture primed to outperform the competition. The company’s identity and operations do not require as much change under this sales approach, and employees gain an opportunity to create more wealth than they typically could through a traditional 401(k) plan alone.
- Unlike any other ownership structure, most ESOPs pay little to no corporate tax. Future operating profits become ESOP contributions, and ESOP contributions are tax-deductible. The degree of tax minimization depends on whether the ESOP is an S Corp or C Corp; a 100% ESOP S Corp pays no federal income tax, and C Corps pay some.
- Strategic and financial sales usually require the seller to exit immediately (which is desirable to some sellers), whereas ESOPs offer the most flexibility and ability to stay involved. If any type of continued involvement is important to you, the ESOP route should be evaluated. The seller usually stays involved in the business for the duration of the payout or longer if the ESOP sale is structured as a partial ownership shift. ESOP payouts are often structured as an initial tranche payment in year one and a seller note, which is subsequently paid off over several years depending on business cash flow.
- Selling to an ESOP may allow sellers to eliminate capital gains taxes on their transaction. By electing a 1042 exchange and purchasing Qualified Replacement Property (stocks and bonds of certain U.S. companies) with your sales proceeds, you can defer capital gains taxes. Under the current tax code, if the Qualified Replacement Property is held until death, the estate can liquidate the Qualified Replacement Property after taking a step up in cost basis, thereby eliminating capital gains taxes on the original transaction.
- Lastly, ESOPs are complex; unlike many strategic and financial sales, ESOP sales can happen in as quickly as three to six months.
Despite these potential advantages, the upfront and ongoing complexity of an ESOP should not be taken lightly. However, if you have a strong management team in place with reliable business cash flow, then you should consider talking to your financial planner about how to approach a potential ESOP sale.
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