The following article was published in the Fall 2019 Edition of the Pennsylvania Bar Association Business Law Section Bulletin.
The Business Succession Planning Conundrum
A recent survey of family businesses suggests that many business owners are putting their wealth and legacy at significant risk. The survey, conducted by PwC, found that a shocking number of respondents do not have a formalized plan for business continuity: only 18 percent of the family businesses surveyed stated that they had a documented succession plan. This lack of formal business succession planning for a closely-held corporation or family business can lead to significant business continuity issues and loss of income and opportunity for management and employees alike in the event of the death or disability of a business owner.
So why don’t more owners have a formal succession plan in place? First, succession planning requires time, a resource that many owners feel they cannot spare given the demands of managing business development and operations. Second, business succession planning, done the right way, requires the consideration of sensitive, difficult questions that many may want to avoid: Who can and will replace me when I leave the company? What does the business need for continued success and growth now and after I retire? What happens to the business and my employees if I sell the business to a third party? Do my kids want to run the business after I retire? What kind of legacy do I want to leave behind?
In the course of considering these and other essential questions, an owner is presented with the difficult task of determining how to sell or transition his or her business — especially if an owner wants to maintain his or her family’s legacy in the business while extracting liquidity from it. In that case, a management buyout or a third party sale may not be ideal solutions. A management buyout would allow a closely-held business to maintain the culture and approach that made the company successful but may be impractical if the business has appreciated significantly. Conversely, a sale to a third party may give an owner an exit from his or her business, but risks limiting the family’s influence over the operation and success of the business and the preservation of its legacy if a controlling interest in the business is sold. Lastly, the transition of a business to an owner’s children may not be an option if they do not have the desire or the ability to run the business successfully.
The ESOP Solution
An employee stock ownership plan (ESOP), unlike the options noted above, is a succession planning tool that allows an owner to determine his or her desired mix of liquidity and control and preserves and enhances an owner and his or her family’s legacy while providing a potentially life-changing benefit to employees. An ESOP involves the sale of a business to a retirement trust established for the benefit of the business’s employees. Federal law provides incentives for sales to ESOPs that allow for the tax-efficient sale of a company in which an owner receives fair market value for the interest in the business that he or she sells.
What is an ESOP?
An ESOP is a defined contribution plan, akin to a profit-sharing plan or 401(k) plan, established under the Employee Retirement Income Security Act of 1974 (“ERISA”). Like a participant in a profit-sharing plan or 401(k) plan, each ESOP participant has an account that is subject to vesting and other requirements under ERISA. Unlike 401(k) and profit-sharing plans, which require diversified investment of plan assets, an ESOP is invested primarily in employer securities.
How is a sale to an ESOP structured?
An ESOP acquires employer securities through contributions or by purchasing shares of company stock using debt financing, and it is the latter form of acquisition that is used to provide liquidity to selling business owners.i A sale of stock to an ESOP is typically structured as a leveraged buyout in which the company sponsoring an ESOP takes on debt to finance the acquisition of shares from the selling shareholder(s). This debt is used to fund either a redemption of a shareholder’s shares by the company, with a subsequent sale of newly-issued shares to the ESOP or a direct purchase of shares from the business owner by the ESOP. The exact structure typically depends on the tax benefits that a selling shareholder desires to leverage in an ESOP sale.
What are some of the tax benefits that incentivize sales to an ESOP?
Several tax benefits are used to incentivize the sale of a business to an ESOP. For instance, a selling shareholder can defer paying federal income tax on capital gains from the sale of his or her shares of stock to an ESOP if the sale proceeds are reinvested in certain securities of U.S. operating companies under Section 1042 of the Internal Revenue Code. This same benefit applies in most states, but not Pennsylvania. For an owner to take advantage of the tax deferral, the company must be a corporation taxed as a C-corporation, and the sale of shares must be made directly to the ESOP.
If an owner wants to sell all of his or her business to an ESOP, another tax advantage presents itself. If the company is an S-Corporation when the company becomes 100 percent ESOP-owned, the corporation is owned by a tax-exempt trust that does not have to pay federal or state income taxes. As such, the corporation does not need to make tax distributions. This “tax-exempt” status is especially important to selling business owners because they typically take back seller debt to finance the transaction, which can be structured to give the selling owner equity-like returns on a portion of the seller financing through warrants. Without the need to make tax distributions, a corporation can pay down the debt used for the ESOP transaction more quickly and can use the tax-free cash flow to make investments in the business. Such actions, in-turn, enhance the value of the warrants held by the selling business owner.
What are the other benefits of using an ESOP for succession planning?
In addition to the tax advantages provided by ESOPs, there are several other benefits to utilizing an ESOP for succession planning:
- Legacy: As opposed to a company acquired by an unrelated third party, it is more likely that a company purchased by an ESOP will keep the company name and remain locally owned.
- Time/Efficiency: A third-party sale process typically takes more than a year and may not result in an offer that appeals to a closely-held or family business owner. In contrast, a feasibility study for an ESOP transaction takes just 60 to 75 days, and an ESOP transaction can be negotiated and closed three to four months after that.
- Flexibility: Utilizing an ESOP allows an owner to sell all or a portion of his or her business. This flexibility allows a business owner to pass on control of the company to some children while getting liquidity that enables the owner to provide for other children who are not involved in the business.
- Employee “Benefits”: In addition to receiving a share in the ownership of the company, employees in ESOP companies are more likely to retain jobs during a recession than employees in companies that are not ESOP-owned.
Conclusion — Is my business or my client’s company an ideal ESOP candidate? If so, what are the next steps?
If you are advising a closely-held or family business that is, will be or should be going through a succession planning process, an ESOP should be considered as a potential business transition and liquidity tool. When evaluating whether an ESOP is right for a particular business, it is important to keep in mind the following core attributes of an ideal ESOP candidate: a profitable business with a trusting environment and at least 20-25 employees. If your company or your client’s business fits these general parameters, the next step is to reach out to an experienced ESOP advisor to conduct a feasibility study and to assist in designing a transaction that will be sustainable for the business and in line with the guidelines, rules and regulations stipulated by the U.S. Department of Labor and the Internal Revenue Service under ERISA.
i. Note: A business organized as limited liability company can use an ESOP as a succession planning strategy with careful tax analysis and planning.↩