Exit Planning Strategies: Is an ESOP Right for You and Your Employees?

Tuesday, January 12, 2016

When planning your business exit strategy, one of the first things to do is decide who will succeed you. For example, you can sell the business to an outside buyer, pass it on to family members, or sell it to existing employees.

If you decide to sell to employees, consider looking into the benefits of doing so via an Employee Stock Ownership Plan (ESOP). An ESOP is one of the most common ways for owners of closely held businesses to transition ownership of their company to their workforce.

About ESOPs
According to the National Center for Employee Ownership, there are currently about 7,000 ESOPs in the U.S. that cover about 13.5 million employees. Most ESOPs are in private companies — fewer than three percent of all ESOPs are in public companies. A few well-known major corporations that are majority employee-owned are Publix Supermarkets, Lifetouch and W.L. Gore and Associates.

An ESOP may offer a number of benefits to both you as an exiting owner and your employees, including these:

• It gives you the most control over the timing of your exit from the business.
• You may be able to realize significant tax benefits.
• It can generate a steady stream of retirement income for you and your spouse.
• It can serve as a key motivational and retention tool for your employees, especially your key executives.

How ESOPs Work
Your company contributes ownership shares or cash to a tax-exempt trust created for this purpose. Tax-deductible (for the company) cash contributions are then used to purchase company stock for employees, who don’t have to pay income tax on the money until distributions from the ESOP start later.

With an ESOP, you can exit your business gradually over a number of years if you prefer, while still retaining controlling ownership. Your employees would purchase a minority ownership interest over time while you remain active in the day-to-day operations of the company, including making key business decisions.

From a tax standpoint, you essentially can move ownership by selling shares to the ESOP and any gain would be taxed at the long-term capital gains rate, which is currently 20 percent; however, profits distributed from the company to you are taxed as ordinary income tax with rates as high as 39.6 percent. And, using special provisions available only to “C” corporations, you can even permanently avoid paying personal income taxes on gains from selling your business to an ESOP if you don’t need to tap into the monies.

From an income standpoint, you have a lot of flexibility in how you structure the payout from the business’ sale. For example, you can create a stream of income to meet your living expenses in retirement or use the proceeds from the sale to buy another business if you’re not yet ready to retire.

Ownership control and tax benefits aside, many owners who have successfully used ESOPs say that their biggest advantages stem from the positive impact ESOPs have on employees. Many workers who are participating in ESOPs adopt an employee-owner mindset, which often leads to higher productivity and loyalty, lower turnover and absenteeism, and improved morale. These factors, in turn, can increase your company’s profitability, valuation and selling price.

Start Preparing Early
One of the best ways to help ensure a successful ESOP is to start your preparation and planning early. At least two or three years before the ESOP process begins, you should answer such questions as:

• What are your goals for the business transition, from both a business and personal perspective?
• How much income will you need to realize from the sale of the business to meet your personal goals?
• When would you like for the business transition process to begin and end?
• How much is your business worth today?
• Are your key managers and executives ready to assume leadership roles in the company, and are you prepared to mentor and help prepare them for these roles?
• Is an ESOP a feasible economic strategy for your business succession?

Note that there are both upfront and ongoing expenses involved in ESOPs that can make them cost-prohibitive for smaller companies. And ESOPs can be complicated, requiring expert assistance from professionals. So be sure to consult with BMF, along with your banker and attorney for more detailed guidance on your situation.

Contact us for assistance in examining the pros and cons of an ESOP for your business.