Over the past few years, there have been a growing number of business owners who have chosen to use an employee stock ownership plan‡ (ESOP) as a path to exit their business – a decision with many benefits, according to Forbes. Before you make a decision on ESOPs, consider the limitations of using an ESOP in an exit plan, and take time to discover the advantages and disadvantages of the strategy.

What is business exit?

Exiting your business can take years of planning. It means you transfer ownership to another person or the governing body. It should not be done lightly as there are different implications for the business owners and the employees. There are several different strategies you can use to exit your business with an ESOP being one avenue to explore.

ESOPs: A short history

ESOPs were created in the 1950s by Louis Kelso, an investment banker and attorney in San Francisco. His goal was to help employees share company ownership and increase their wealth as the company grew and succeeded. ESOPs were given statutory authority in 1974 under the Employee Retirement Income Security Act (ERISA) and they are governed under the same laws applicable to company retirement plans, like 401(k)s.

There is a very important distinction between an ESOP and traditional 401(k), notably around investment selection:

  • ESOPs are designed to specifically invest in the company’s stock.
  • A traditional 401(k) plan allows employees to diversify their investment among several options.

How does an ESOP work?

ESOPs have unique operating characteristics that make them appeal to business owners exiting their business. Congress applies a unique rule specific to ESOPs that allows the retirement plan to borrow money. This is important because it allows the ESOP to borrow money to purchase company stock. No other retirement plan is allowed to do this. The benefit for the company is that the loan can be repaid from tax deductible contributions from the company to the ESOP. The loan is not repaid from employee contributions.

Another significant benefit for the company is that it can exclude from income tax the ESOP’s percentage of ownership in an S-Corporation, which makes a 100% ESOP owned S-Corporation a non-taxable entity. For this plan to work, it is important that the company has sufficient capacity (collateral or cash flow) to support the funded debt.

A good candidate for ESOP consideration would be a company that has been in operation for several years, has a solid management team, 75 or more employees, and $3 million or more in earnings before interest, taxes, depreciation, and amortization (EBITDA).

What are the advantages of an ESOP?

Tax-related perks:

A significant advantage of the ESOP exit path is that if the company is a C-Corporation and the owners sell at least 30% of the stock to the ESOP, then the tax on the sale of the stock is tax deferred under Internal Revenue Code (IRC) Section 1042.

There are situations that can allow for the tax deferral to become permanent, and some or all the transactions to be non-taxable. But, to receive the tax deferrals afforded by IRC Sec. 1042, the shareholders must invest the proceeds in a “qualified replacement property.” This means they would need to invest in stocks and bonds of U.S. corporations that use 50% or more of their assets in an active trade or business, and the passive income of that entity is not to exceed 25% of its gross income.

Talent-retention perks:

ESOP companies have shown a trend toward faster growth with a higher degree of employee “buy-in” to the company mission. ESOP companies tend to be able to offer better pay and benefits to their employees and create a culture that enhances employee retention, according to the ESOP Association‡. The sale of the company from the owner to an ESOP can also be used to reward employees versus selling the business to a third party.

Ownership-control perk:

With an ESOP exit plan, the transaction can be structured to allow the owner to sell a partial interest in the company at full fair market value and still maintain total operating control of the company.

What are the downsides to an ESOP?

ESOPs can be more expensive to operate over the long term due to the nature of hiring a fiduciary trustee to guide the plan, annual valuations, additional retirement plan administration, and reporting costs. It is important to consider taxes a potential overall benefit of the plan.

The company launching an ESOP will require annual business valuations, and market conditions outside of the company’s control may impede business values. Since companies in these plans are leveraged with debt for the shareholder buyback program, it may lead to the lack of financial flexibility to grow the company and increased risk in market downturns. If the company does not perform, then its ability to repay the loan is at risk.

There have been instances of epic ESOP failures like Enron and United Airlines. An often-overlooked disadvantage is that if the owner is choosing the ESOP path to reward employees and preserve company culture, there is no guarantee that the new employee group will maintain that goal. In fact, the new employee owners may sell the company to a private equity firm after securing a controlling ownership interest. This does occur often and can be in direct contrast to the owners’ reasons for choosing the ESOP exit path.

ESOP governance and regulation

While ESOPs are beneficial programs to support employees, they are also held to tight governance policies. They are to be operated for the exclusive benefit of the employees on a nondiscriminatory basis. ESOP trustees and company management have a fiduciary duty under ERISA and are regulated by the Department of Labor (DOL).

Creative executive compensation programs will be lost as the ESOP standardizes the employee benefits across the entire employee base. ESOPs will broadly include most employees to be admitted to the plan, allocate benefits based on pay, and allow for employee vesting in the plan. Employees do not purchase the stock of the company; they are merely allocated shares of the company. The company must be aware of the share repurchase agreement when employees terminate or retire because this liability can strain cash flow if not properly planned and accounted for.

Overall, an ESOP can be an attractive tool depending on your business’s financial plan and your business exit plan. It is important to talk with a trusted financial team to ensure an ESOP is right for your business. Weigh the advantages and disadvantages of your financial team to see if an ESOP makes sense for your long-term personal and business goals.

Interested in learning more about Private Wealth Management Business Exit? With UMB, you have a guiding team that walks you from financial advising and investment portfolio management, to wealth-building strategies and retirement and legacy preservation plans.

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Disclosures

Financial planning services are offered by UMB Private Wealth Management, a division within UMB Bank, n.a. that manages active portfolios for individuals, fiduciary accounts, employee benefit plans, endowments and foundations. UMB Bank, n.a., is a subsidiary of UMB Financial Corporation.

This material is provided for informational purposes only and contains no investment advice or recommendations to buy or sell any specific securities or engage in any specific investment strategy. Statements in the presentation are based on the opinions of the author and are subject to change at any time without notice. You should not use this presentation as a substitute for your own judgment, and you should consult the appropriate financial professional before making any tax, legal, financial planning or investment decisions.

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