One of the critical mistakes most business owners make is the lack of a succession plan. That is, there only plan is to die in their chair. The sad truth is that many business owners leave a lot of value on the proverbial table by not planning for the EVENTUALITY that they will someday die. Traditional options for business succession are generally grouped into three categories:
- Sale to outsider (third party)
- Sale to insider
- Transfer to successors (children, grandchildren, etc.)
Each has its advantages and disadvantages, but one alternative that is often overlooked is a variant of number 2, sale to insider, known as the Employee Stock Ownership Plan (ESOP).
I’m assuming most people are not familiar with ESOP’s, so I’ll start at the beginning. ESOP’s became an option under the Employee Retirement Income Security Act of 1974 (ERISA), and historically have been used by larger corporations. Following legislative changes in 1996 that allowed S-corporations to adopt ESOP plans, there has been tremendous growth in small and medium sized businesses adopting this option. According to the The National Center for Employee Ownership (www.nceo.org), the total number of ESOP plans exceeded 11,000 in 2009 with almost 14,000,000 participants.
Let’s say you have a company that is owned by only one shareholder who is contemplating their retirement. Deciding an ESOP is his best choice, he sets up a plan. Because he has several years until retirement, and because he wants to maintain control of the company, he decides to fund the ESOP with ongoing contributions. Each year, he can make tax deductible contributions to the ESOP, which in turn purchases the shares from him. Not a lot complicated here, but if he was in a hurry, he could go to the bank and borrow the money to facilitate the ESOP purchasing all of this share now.
Of course there are a lot of options, and moving parts, but in its most basic form, that is what an ESOP does. Now for the beautiful part, the tax savings. As said before, the corporation receives a deduction for contributions to the ESOP, so even though the company is paying for the share, it is doing so in pre-tax dollars, which can be a significant percentage. Second, the ESOP pays no taxes on the income of S-corporation shares that it owns. Lastly, if the selling shareholder structures the transaction correctly, they can defer the gain on the sale (maybe permanently). That’s a conversation for another day, but suffice it to say that the ESOP has some very powerful tax deductions built into it.
The downside is that there are a lot of rules, and compliance isn’t cheap. Generally ESOP’s work best for companies that have strong performance history, and stable cash flows. Management is also key, especially if the company is borrowing money to facilitate the transaction. Lastly, because of how the contribution amounts are calculated, it is ideal to have a company with a significant amount of payroll.