Gerry Spitzer is the Founding Partner at Questar Capital Partners.
Everyone has met that person who believes they will live forever. In my experience, owners of privately held companies have a zest for life that translates into their business. These visionaries continue making plans to take their operations far in the future. But while companies may be expected to carry on indefinitely, business leaders are mortal.
Death may force the succession of leadership, but so might incapacitation due to injury or illness, a desire to pursue other interests or even a spouse insisting on a move to a warmer climate. An exit plan must be put in place. An employee stock ownership plan (ESOP) is a tax-advantaged strategy allowing business owners to reward workers with stock ownership while retaining operational control.
Selling Ownership While Still Holding The Reins
Some company owners who have spent a lifetime building a business may be torn between fully enjoying the fruits of their labor and handing over control. An ESOP is a way for owners of a C-corp or S-corp to liquidate equity in their business while retaining governance over the operation. Although such a plan is often viewed as a way for company owners to ease into retirement, typically more than one goal is at play. Purposes might include raising funds for a new project, diversifying one’s investment portfolio, using money for philanthropy, setting up a strategic estate plan or all the above.
A foremost desire of an owner or owners may be to reward employees with a piece of the business. Providing the workforce with annual stock allocation increases creates an inclusive culture since employees have a financial stake in the operation. A residual benefit is the resulting incentivization; employees have more reason to be at their most productive.
ESOPs certainly provide a shared economic dimension but also include an equally important legacy dynamic. Owners not only get to keep the company name in the window but are positioned to prevent outsiders from disrupting the good existing inside the business. People are the building blocks of a successful operation. Companies entrenched within a surrounding community may see their dedicated workers as part of an extended family.
Selling to a competitor or private equity firm could spell layoffs or even relocation. Since ESOPs allow for control to remain constant, the operation and its employees enjoy protection from the drastic changes an outright sale may bring. The legacy component of these plans provides advantages for ownership and employees as well as the company itself.
How ESOPs Are Structured
A privately held company deciding to create an ESOP first sets up a trust with an appointed trustee. Company stocks are purchased either with company funds or by a loan from the owner or institution. The company stock is transferred directly into the trust to be allocated to employees based on established rules outlined in the plan, usually relating to salary and tenure. It is the trustee’s responsibility to ensure fair stock valuation and to represent the employees by collectively voting for them on company matters. Employees’ allocations in the stock plan increase each year through the adherence to a vesting plan. Participants normally receive a distribution at retirement, termination, disability or death.
Company boards appoint officers, who then hire managers. This structure remains after establishing an ESOP. Trustees handle the plan’s fiduciary duties, track performance with officers and vote ESOP shares. They report annual account valuations to participants. Employees don’t have access to financial data, as with other private companies.
C-Corp Tax Shields Of ESOPs
For a C-corp establishing an ESOP, the most attractive aspect is often the resulting tax deductions. C-corps are allowed to deduct contributions (stock or cash) up to 25% of the covered payroll amount. ESOP loan interest is not subject to the limitation and is 100% deductible. Dividends distributed to the ESOP enjoy the same tax advantage, bound by some limits. In these respects, an ESOP operates as a tax-free trust.
1042 Open Architecture For Owners Of C-Corps
Many are familiar with Section 1031 of the Internal Revenue Code, which allows taxpayers to defer capital gains on the sale of business-use or investment-use property by reinvesting it in like-kind property. Section 1042 of the Internal Revenue Code works similarly as it relates to ESOPs. When selling, shareholders of closely held C-corps that are at least 30% owned by an ESOP are allowed to defer capital gains taxes by purchasing stocks or securities in qualified replacement property. The capital gains deferment remains in place until the business owner sells.
This section of the IRS code has a striking advantage for those seeking an estate-planning strategy. While a sale of the replacement securities by the owner triggers a capital gains event, their heirs experience something very different. If the deferment is still in place when the owner dies, the value in the securities at the time of death becomes the new stepped-up basis. Thus, the capital gains from the original sale of the securities are deferred or eliminated. This advantage in the tax code involves C-corps only and not S-corps.
The Tortoise And The Hare
Anyone familiar with the famous Aesop fable knows that the tortoise uses smarts and diligence to beat the hare. Owners of privately held companies who build successful businesses the same way deserve to be richly rewarded. ESOPs offer advantages not only to owners but also to the employees contributing to a company’s growth and achievements. The company itself also benefits, as the plan provides the potential for a more engaged workforce, greater retention and smoother succession.
ESOPs are not all rainbows and unicorns. These trusts are complex entities that come with a cost to administer. They are certainly not for any do-it-yourselfer. Setting up an ESOP requires the expertise of a professional who is well-versed in these plans and understands the exit planning space. For a company owner who sees the finish line, consulting with a qualified financial advisor to discuss implementing an exit strategy is evidence of a race well run.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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