When an owner of a privately held business is planning to retire, there are many ownership transition options to choose from. You can go the route of a management buyout, transfer to the next generation, a sale to a third-party buyer, an IPO, or even liquidation. Each of these options has pros and cons which should be evaluated based your unique situation.
One option that business owners tend to be less familiar with is an employee stock option plan, or an ESOP. Using an ESOP as an exit strategy can be an effective way to meet many of your transition goals and provide for the long-term success of the organization you worked so hard to build.
Here are five benefits of transitioning your business to an ESOP.
1. Preserve your legacy
Owners of privately held or family-owned business are often looking for much more than a large payday when they exit their companies. They want to know that their employees and their customers will be taken care of, and that the legacy they worked so hard to build will live on.
When selling to a third-party buyer, owners often can’t be sure what will happen once they walk out the door. An ESOP can help reduce that uncertainty.
In some situations, family-owned businesses are passed down from generation to generation, but eventually reach a point when the next generation is not willing or able to take over the reins. An ESOP not only maintains the legacy of the departing owner and the family, but it also rewards the employees who helped build the business.
2. Lower your stress
Some business owners agonize over the thought of selling their business and putting it on the market. The process is not only stressful for the owner, but it can also be a distraction to the entire company.
On the other hand, an ESOP is often referred to as a “friendly buyer.” Unlike going out to the market and negotiating with a buyer, an ESOP transaction involves using a third-party valuation specialist who will help determine the fairness of the proposed transaction
If the value is acceptable to the owner, then the lawyers will prepare all the required documentation and the transaction will proceed smoothly to closing. The process is more controlled and much less disruptive to the company.
3. Transition the business at your pace
Many owners grapple with the idea of handing over the keys to their company in one shot, and welcome the opportunity to gradually transition ownership to their employees. An ESOP can provide a succession strategy that allows the owner to move tranches of equity to the ESOP over time while they transition their role from CEO to board member, and eventually to full retirement.
4. Gain tax benefits for yourself
ESOPs offer various tax advantages that can be beneficial to the selling owner. If the business is organized as a C corporation at the time of the sale transaction, an election can be made on the selling shareholder’s personal tax return to defer the taxable gain related to the transaction. This is known as a 1042 election, and it requires certain conditions to be met with regard to the percentage of equity transferred and the use of the proceeds.
Under the right circumstances, the unrecognized gain can be held until it reaches the owner’s estate – and it may potentially never be subject to income tax.
5. Realize tax benefits for your business
Your business can also receive beneficial tax treatments. The most prominent advantage is the ability to be essentially tax free.
If the company is structured as an S Corporation, the portion of the company owned by the ESOP will not be subject to federal income taxation, and in most states, will also not pay state income taxes.
Not having to pay corporate income taxes on all – or even a portion – of earnings is a substantial advantage that ESOP-structured companies can use to their benefit. Not only will it allow the business to retain more capital for reinvestment or to compensate key employees, it will also provide additional cash flow to help finance the ESOP transaction with the owner.
ESOP transactions are typically financed using the business’s future cash flows. By reducing the corporate tax burden, the company will be able to more easily meet the debt service, which originated from the shareholder redemption.
When starting to plan for an ownership transition, it is wise to consider the pros and cons of each option and the potential impact to both the business and the exiting owner. An ESOP can provide unique advantages that may not be available through other exit channels. In some cases, the intangible factors associated with ESOPs can outweigh the benefits of other exit paths.