ESOP Succession Planning
Establishing a succession plan beneficial to you and your employees is vital. You may be aware of more traditional methods of transferring ownership, such as selling to a third party; however, selling to an employee stock ownership plan (ESOP) may be the right solution for your company. An ESOP allows you to retain control of the business and protects the employment of valued workers, creating a win-win situation for your company and your employees.
What is an ESOP?
An ESOP allows you to sell all or a portion of your investment in the company while retaining business continuity and control of business decisions and operations. An ESOP is a qualified retirement plan allowing eligible employees to receive an annual allocation of stock. Stock acquired by an ESOP is legally held in an ESOP trust, and employees are simply beneficial owners in the value of the stock. Employees do not legally own the stock and they may only vote in a few major events, such as the sale of company assets, mergers, etc. An ESOP does not change the operations or management of the company.
ESOP Tax Benefits
Because of certain tax benefits, the ESOP purchase essentially is funded with pre-tax dollars. One advantage with leveraged ESOPs (those with debt) is principal payments made on the acquisition debt are tax deductible. Further, S corporation earnings attributable to an ESOP are exempt from federal and state income taxes (except in states that do not recognize S-corp status). A company that is 100 percent ESOP-owned and taxed as an S corp is exempt from federal and most state income tax, regardless of profitability. An ESOP provides a market to sell your stock at fair value, which generally results in greater tax advantages than you would receive by selling company assets. Further, if certain requirements are met, the sale of your stock may be tax-deferred or possibly tax-free. (You must reinvest in a qualified replacement property within 12 months of the sale date.)
Existing ESOP Companies
Existing ESOP companies face unique opportunities and challenges. Many mature ESOPs have benefited from acquisitions, realizing higher returns than non-ESOP companies through enhanced tax savings on future profits. These companies also can provide the sellers unique tax advantages, providing additional leverage during the negotiation process.
As ESOP companies mature, it is important to continuously monitor the structure of the ESOP and adapt to legislative changes, repurchase liability issues and employee benefit issues. Mature ESOPs also need to evaluate available executive compensation plans so they can retain and attract top talent, an element critical to the company’s success.
CCA understands privately owned businesses and the unique succession issues they face. During the past decade, CCA’s ESOP advisory group has acted as the principal coordinator in closing more than $2.7 billion in leveraged ESOP transactions. We work with some of the largest 100% ESOP-owned S corps in the country, providing accounting, tax and advisory services ranging from acquisition assistance to executive compensation design. CCA also stays abreast of legislative changes that could affect ESOPs, advising companies about the potential impact to their organization.
ESOP solutions include:
- Performing ESOP feasibility and structure analysis
- Coordinating ESOP transactions
- Communicating ESOP benefits to employees
- Helping design executive compensation plans
- Evaluating and restructuring existing ESOPs
- Analyzing potential acquisition opportunities
- Analyzing repurchase liability
- Providing ESOP recordkeeping and compliance services
Example Engagement: Professional Services Employee Stock Ownership Program
The shareholders of a professional services firm wished to transition from the business but the organization did not have a succession team with the financial wherewithal to fund a buyout. The shareholders wished to maintain the independence of the organization, so a sale of the firm was ruled out.
We asked the shareholders if they had considered an ESOP (Employee Stock Ownership Program). An ESOP creates a ready market for closely held shares and provides an avenue for the transition of the business.
The shareholders decided to implement an ESOP to transition the business. Since the stock was privately held, an independent valuation was required to determine the value of the shares. The ESOP created a trust fund that borrowed funds to purchase the existing shares, and the owners were paid from their shares at that time. Shares in the trust fund were allocated to employees based on an equitable formula, and a vesting plan was defined.
Under the ESOP plan, the company will make an annual contribution to the ESOP to fund the repayment of the loan. Within certain limits, these contributions will be tax deductible to the organization.
The ESOP has been a tremendous success for the company and the employees. The original shareholders were able to receive cash up front for their shares and maintain the independence of the company, two of their major goals. Employees have assumed an ownership mentality and understand the contributions they make to the success of the company, and are incentivized to remain with the company and help the company succeed.
CCA has provided clients with the know-how to implement ESOP solutions in these circumstances, providing cash out exit strategies for ownership while maintaining jobs for current employees. ESOPs are qualified retirement plans permitting indirect ownership of a company by its workforce. Tax law makes such buy-outs attractive to ownership and workforces alike. CCA has assisted several clients with the implementation of ESOPs including coordination of the required legal and financial
professionals as well as the involvement of financial institutions.