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Exit Planning Strategies with ESOP'S

Jul 18, 2011

You may be thinking of selling your business in the traditional way but have you considered an ESOP (Employee Stock Ownership Plan) as an alternative vehicle to exit your closely held business?  If not, this article may get you thinking.

 

ESOP’s have been around since the early 80’s but not well known as a selling strategy for business owners of a closely held business until recently. The very name ESOP suggests confusion not only with the business Community but also with many Accountants as well. Some demystification is required.

 

An ESOP (Employee Stock Ownership Plan) is a defined contribution employee benefit plan that allows employees to become owners of stock in the company they work for. It is equity based deferred compensation plan. Under the ESOP plan, companies provide their employees the opportunity to acquire the company's shares at a reduced price over a period of time. Employee ownership can mean many things, ranging from a few executives owning stock in their companies to the ownership of a company by most or all of its employees.

 

So what does an ESOP have to do with selling your business? Let’s examine the benefits of selling your business through an ESOP compared to an outright sale to a third party. If you sell your business to a third party you will receive cash, stock or perhaps notes as payment for the purchase price. Without proper tax and estate planning strategy the taxes paid on the gain from this type of transaction may take up to 50% of your proceeds. Of course, there are some sophisticated tax concepts that can be utilized to shelter some of this tax but for the most part the tax bit will be big. When you do an ESOP, seller shareholders are given special tax favored treatment under IRS Section 1042 election that allows deferral of the gain if certain Tax Laws, Department of Labor and ERISA rules and guidelines are followed. How does this work? There are several steps in the process but let’s assume you have arrived at a valuation for your business and you are ready to sell it to your employees.  By the way, you do not have to sell all of your shares or lose control either. In fact, you can still work in the company every day if that’s a preference of yours.

 

To make it a simple example, let’s say the sales price is $5,000,000 for 30% of the stock. (I used 30% because this is the minimum percent to qualify for special tax favored treatment mentioned above)

 

The ESOP Trust, an entity formed to hold the shares for the employees the seller shareholder sells will pay you $5,000,000 for 30% of the company’s stock. There are several ways for the ESOP to raise the funds to pay you but we will not get into this in this article. I’ll save these details for further articles. Let’s assume they have the funds. Now comes the important part! You must invest (within 18 months) the $5,000,000 you receive in Qualified Replacement Property (QRP) (stocks etc.) and make an election under the IRS Code Section 1042 in order to get the qualified tax favored deferral of the gain. The gain is postponed indefinitely until the sale of the QRP and if you hold it in your estate it’s never taxed.  The transfer to your heirs will be on a stepped-up basis. Not a bad deal! Also there are significant tax deductions and savings at the company level with an ESOP transaction that generates positive cash flow.

 

But you are wondering how do I get any money if it’s all invested and I can’t sell shares without being taxed? You can borrow against these funds and pull out a significant amount of the $5,000,000. The end result of the transaction? You diversified your wealth into a liquid portfolio and you have no tax bill unless you sell the QRP.

 

An ESOP is a great Estate Planning mechanism and one that is worthy of a hard look when you are thinking about your EXIT Strategy.

 

In further articles I will elaborate more on the process involved in preparing for an ESOP and how they work and the benefits to shareholders and ESOP companies.

 

More from Tom Azzarelli…

About the Author

Tom has 35 years of diversified experience working with private companies providing strategic advice on critical business decisions across a broad range of domestic and international disciplines. He has a strong background in financial planning, profit improvement, operations management, acquisitions and divestitures, consolidations and technology.He has served in a variety of industries including; manufacturing, distribution, consumer goods, specialty chemicals, food processing, tobacco processing and products, transportation, construction products, commercial steel fabrication, semi-conductor and clean-room operations, software development products, automobile dealerships, equipment leasing and intermediate pharmaceutical industries ranging in size from start-up to $1 billion.Tom's concentrated areas of expertise includes maximizing cash flow, bank and lending relationships, budgeting and cost control, risk management, software selection and implementation. He has negotiated revolving credit loans in excess of $85 million and worked with lenders in restructuring debt of distressed businesses. His other areas of experience include: Implementing "Best Practices" accounting and reporting/IT systems to deliver on-time, accurate financial statements Start-ups, turnarounds and reorganization programs Employee Stock Ownership Plans and business exit strategies Equipment lease financing programs Presentations(Road Shows)to private equity firms and investment banks to obtain mezzanine financing for business expansions, divestitures of businesses and IPO's Coaching and mentoring accounting and management staff members to excel in performance Tom is a seasoned financial advisor that creates value for your company. He will carefully analyze your business and then offer solutions for improvements in a clear and concise manner. He is a trusted advisor with the highest degree of integrity and ethics that partners with CEO's to accomplish organizational goals together. With his diversified experience he is uniquely capable of providing business owners with financial clarity to increase cash, profits and company value.Tom earned his Bachelor of Science Degree at the University of Scranton, Pennsylvania. He is a licensed New Jersey and Arizona Certified Public Accountant and a Certified Management Accountant. Tom worked in the Metro NYC market for over 20 years and recently relocated to Arizona. He resides with his wife Kathy in Chandler. Tom is also a 4th degree Black Belt in Tang Soo Do Korean style of Karate.

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