New Hampshire Business Review (NH) December 3, 2018
Owners often wait
until it's too late to consider various options, at which time the only answer
might be selling the business to a third party, perhaps a .competitor or a
private equity group.
For some
businesses, that last-minute strategy ends with success, but for many owners,
that is not an acceptable or desired solution to their ownership succession.
There are a limited
number of options for business succession. The standard list of options for
most businesses includes sale to a third party, management buyout or transfer
to family members, but have you heard about ESOPs?
Employee stock
ownership plans (ESOPs) have been around since 1974, yet only approximately
7,000 businesses nationally are currently utilizing them for their ownership
succession needs.
ESOPs are a great
alternative for business owners who are not interested in turning the keys to
the business over to a stranger and do not have any family in the business
ready to write a check for the owners' equity.
As a qualified
retirement plan, ESOPs serve both as a mechanism for employees to receive the
value of company stock as an additional retirement benefit and as a buyer of an
owner's company stock.
An ESOP's purchase
of company stock from the owners allows a business to continue to operate
without changes to management or operations (i.e. former owners can continue to
serve in the same role), and employees do not have to worry that a third party
will move the operations elsewhere.
Additionally, ESOPs
can be implemented in a way that allows business owners to sell their company
stock over many years instead of all at once. In addition to the operational
aspects of ESOPs, there are also tax advantages that can be obtained with ESOPs
that are not available in any other type of sale (except ih a co-op).
ESOPs offer tax
deductions to companies that can result in a pre-tax purchase of company stock
from a shareholder. Instead of using after tax dollars to buy back company
stock, which is how many professional services firms approach ownership
succession, the ESOP purchases the company stock with the company's pre-tax
dollars.
What about the
selling shareholder? Internal Revenue Code Section 1042 allows an individual
who sells company stock to an ESOP to elect the deferral of their capital gains
tax on the proceeds of the sale potentially forever.
That means that a
selling shareholder can avoid sending to the IRS a rather significant tax
payment on the sale of shares, provided that he or she is willing to meet the
requirements of Code Section 1042, which also requires the reinvestment of the
proceeds from the stock sold to the ESOP.
However, if the
selling shareholder does meet the Section 1042 reinvestment requirements and
they don't liquidate the investments, at the time of the selling shareholder's
death those investments will have a stepped-up basis and no one will ever pay
the original capital gains tax from the sale of the shares.
Essentially, the
owner has deferred the capital gains tax forever! Although not every selling
shareholder finds the Section 1042 strategy desirable for their situation, it
should be considered.
All those tax
advantages of ESOPs might sound appealing, but the really powerful tax
advantage of ESOP ownership of company stock is: found with the combination öf
ESOPs and stock of S corporations.
Corporations are
taxable either as G corporations, in which case the company: pays the annual
incothe tax'; orasScorporaw : tions, in which case the shareholders pay the
annual income tax of the business.
As qualified
retirement plans, ESOPs are exempt from paying income tax. Therefore, if a
company's stock is owned by its ESOP, that portion of the company's taxable
income will avoid taxation.
So if the ESOP owns
100 percent of a company's stock from a purchase of that stock from the
previous owners, the company no longer pays any federal income tax (and in some
states, does not pay state income tax). Can you imagine having that extra cash
available for other purposes, such as acquisitions or desired capital
expenditures?
In conclusion,
although ESOPs are not the right ownership succession strategy for every
business, every business owner should at least consider whether an ESOP might
be their best strategy.
It is worth a
conversation with an ESOP attorney and a little research to confirm whether or
not an ESOP is appropriate before an owner makes one of the biggest decisions
in the lifecycle of a business.
Tabitha Croscut is
a shareholder and chair of the ESOP Team at Devine Millimet & Branch, with
a national practice focused on Employee Stock Ownership Plans (ESOPs) as an
ownership succession and employee compensation strategy for privately held
businesses.
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