Business Succession Planning

First Republic Investment Management
August 11, 2014

The Advantages to Using an Employee Stock Ownership Plan

When considering a succession plan for a family business, business owners are looking to minimize the financial burden on their children while also avoiding any unnecessary tax burden on themselves as they enter retirement. One nontraditional tool that can be used for this purpose is an employee stock ownership plan.

An employee stock ownership plan, or “ESOP,” is a qualified pension plan that permits a pension plan trustee to purchase shares of an employer’s stock. Shares of company stock are allocated to the accounts of each plan participant, or employee. At retirement the stock is sold back to the employer for cash (a “put” option on the stock). This redemption of stock is used to motivate employees to help make the company profitable because retirement benefits are directly based upon the future value of the company.

An ESOP enables the company to finance the buyout with pre-tax funds through employer contributions.

For certain business owners, however, ESOPs also can be used as a leveraged exit strategy to partially or totally sell a business to children. The employer has a ready buyer—his children—and can sell all or a portion of his stock in the company, at fair market value, when he is ready to retire and defer income taxes on the gain.

To better understand how an ESOP may be used as an exit strategy, consider the following situation: ABC Manufacturing Company was started 20 years ago by Mr. Smith. Mr. Smith is currently 60 years old and owns 70% of the company. His three children own the remaining 30% equally. The fair market value of the company is $10 million. The company is steadily growing and has 40 employees and two key executives in addition to the owners.

Like most business owners, Mr. Smith’s net worth is reflected in his company. Mr. Smith’s goal is to have control of the company stay within the family. In addition, he wants to convert his equity interest in the company into cash for retirement. Mr. Smith considered selling his 70% share of ABC to his three children but was concerned about burdening his children’s cash flows since they did not have enough liquidity to buy out their father’s interest and would have to buy him out through an installment note sale, which, in the end, would cost them more than what the business is worth. In addition, each installment payment made would reflect capital gain and interest that Mr. Smith would have to report as income on his federal income tax return. In addition, Mr. Smith’s children would have to use after-tax funds to pay for the stock.

A solution to Mr. Smith’s problems may be to have the company create an ESOP to purchase his stock. Here are the steps that would need to happen to establish an ESOP:

  1. ABC borrows cash (in this instance, $7 million for the 70% interest Mr. Smith owns) from a lending institution. Interest on the loan would be based on current interest rates and the financial stability of ABC.
  2. ABC, in turn, loans the $7 million to the ESOP established for this purpose.
  3. The ESOP uses the loan proceeds to purchase Mr. Smith’s stock from him.
  4. To assure an arms-length transaction, an independent appraiser values the company, and the ESOP hires an independent trustee.
  5. The bank loan is repaid by having ABC make income tax-deductible contributions to the ESOP. (Note that an ESOP is a defined contribution plan, and ABC will contribute the lesser of 100% of compensation, or $51,000 for each plan participant.)
  6. The ESOP trustee uses corporate contributions to repay the loan made by ABC, and ABC uses the same dollars to repay the bank.
  7. ABC’s stock is held in a locked account in the trust and is only allocated to plan participants as the loan is repaid.

Once Mr. Smith receives his $7 million, he can elect to purchase “qualified replacement securities” as defined by Section 1042 of the Internal Revenue Code (the section that covers ESOPs). If Mr. Smith holds the replacement securities until death, his heirs will realize a step-up in cost basis, and no income tax will ever be paid on the gain on these investments. If Mr. Smith wants to further diversify his portfolio, he can pledge his securities for a loan and use the loan proceeds to purchase other types of investments. Qualified replacement securities include common stock, convertible bonds, fixed rate bonds, corporate floating rate notes and other securities of U.S. operating companies. Government bonds, mutual funds and REITs are not considered qualified replacement securities.

After the transaction is completed, Mr. Smith’s children will have control over ABC. While a large portion of ABC stock (70%) is owned by the ESOP trust, Mr. Smith’s children have indirect control of the company because they can appoint the ESOP trustee. As plan participants retire and ABC purchases back their stock, Mr. Smith’s children’s equity interest in ABC will increase.

An ESOP makes financial sense for Mr. Smith’s children because it effectively reduces the cost of the buyout of Mr. Smith’s interest. In a traditional purchase, the company or Mr. Smith’s children would have to use after-tax funds to pay him for his interest. An ESOP enables the company to finance the buyout with pre-tax funds through employer contributions.

ESOPs are not for everyone considering a succession plan for his company. There are many rules regarding what types of businesses can establish ESOPs that are not discussed in this article. Working with skilled practi­tioners, however, can help you determine whether an ESOP is an option for your situation.

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