By Bernadette Starzee
The Daily Record Newswire
Not all family businesses have a next-generation member who is willing or able to take the company reins. For retiring owners, one option that is getting more attention lately is selling the business to the employees through an employee stock ownership plan.
An ESOP is a retirement plan in which employees have ownership shares in the company. While other retirement plans diversify their holdings by investing in a variety of assets, the ESOP invests primarily in stock of the company. It operates through a trust, under the direction of a trustee.
Though it may be more complicated than a traditional sale, going the ESOP route has certain tax advantages for the business owner. These became more appealing when the maximum capital gains tax rate rose from 15 to 20 percent in 2013, according to Dennis Klein, partner in charge of entrepreneurial services at Nussbaum Yates Berg Klein & Wolpow.
"When capital gains taxes were lower, there was less of an incentive to do an ESOP," said Klein, who noted an uptick in interest in ESOPs among company owners mulling their options.
The maximum capital gains tax was 28 percent until it was lowered to 20 percent in 1997 and 15 percent in 2003. ESOPs were more popular when capital gains taxes were higher; the number of plans has dropped since the start of the century but the number of participants has increased. Currently, there are about 7,000 ESOPs covering 13.5 million employees in the United States, according to the National Center for Employee Ownership. In 2002, there were 8,874 plans with 10.2 million participants.
An ESOP is "another arrow in the quiver for succession planning when businesses may not be able to find an outside buyer or if they want to sell to top managers within the company who may not have the money to purchase it," Klein said, noting either the seller or a bank may provide the financing to the ESOP for the transaction.
"The seller gets the benefit of deferring the tax on the sale of the company," Klein said, provided the seller reinvests the proceeds in qualified replacement property typically long-term bonds which he can borrow against.
"Say the owner sells the business to an ESOP for $1 million and buys $1 million in QRP bonds," Klein said. "He can then borrow against those bonds typically up to 90 percent of the value of the bonds and use that 90 percent to invest and diversify his portfolio." Diversification is important for many business owners, whose biggest asset is often the company.
"Often, all of their wealth is concentrated in the business," Klein said. "The ESOP provides a way for them to diversify their holdings."
An owner borrowing 90 percent against the QRP bonds has cash to invest elsewhere.
"As long as the interest income from bonds offsets the interest expense on the loan, it's a neutral transaction," Klein said. If the owner had sold the business traditionally, he would likely be on the hook for more than 30 percent in taxes on the sale of the business, and would only have 70 percent of the value to invest elsewhere instead of 90 percent.
Because an ESOP pays less taxes than a traditional business dividends, for instance, are not taxed within an ESOP the business valuation may be higher than it would be for a traditional sale and therefore, the "owner may be able to sell the business to the ESOP for a higher multiple of EBITDA" [earnings before interest and taxes plus depreciation and amortization, a calculation used in valuing businesses], said Mark Meinberg, partner-in-charge of EisnerAmper's Syosset office.
But ESOPs are not for everyone, mainly because of the costs involved.
"Generally, a business needs to be doing at least $10 million in annual revenue to make it worthwhile, because there are a lot of fees there are valuations involved, bank fees, banks' attorney fees, trustees' attorneys, trustees' fees, annual administrative costs," Klein said. "A lot of owners look at an ESOP and say, 'I could defer the tax on it, which is great,' but I could just pay the tax [on the sale of the business] and be done with it, and not have the administrative costs."
Further, if the seller is providing financing, there may be some concern whether the company would continue to prosper in order to pay the loan.
"There has to be good management in place who can carry on the business and continue to grow the business," Klein said. "An ESOP that doesn't have a strong management team is probably going to fail over time."
Klein set up an ESOP for a large distribution company, and for many years it was successful. However, "due to changing business conditions, the business deteriorated, and the remaining employees are getting virtually nothing," Klein said.
Because the fortunes of the plan are tied to the success of the company, "there have probably been as many successful ESOPs as there have been unsuccessful ESOPs," Klein said. "Employees can never count on that as their total retirement package it should be seen as a supplement to retirement."
Owners can transfer ownership to an ESOP all at once or over time (though, as Meinberg noted, there are additional costs involved when done in multiple transactions). At minimum, the owner can transfer 30 percent of ownership to an ESOP.
When Don Crotty, senior tax manager at Marcum, talks to clients about ESOPs, they often don't understand it the first time.
"We go through it a few times, and expel some myths," he said.
When considering selling part or all of the company to an ESOP, "some owners fear they will lose control that employees who don't necessarily know the inside and outside of the business will take control and run it into the ground," Crotty said. But the owner or appointed management team will be responsible for the running of the company which includes making decisions on firing employee-owners.
"It's not like a warehouse worker can go up to the president and say, 'You need to change this,'" Klein said.
But as part-owners, employees have a vested interest in the success of the company and their input on how to make the company more efficient or valuable is typically given through the independent trustee.
Published: Fri, Jul 24, 2015
