ESOPs — Sell Your Business to the Next Owner
and Pay No Taxes on Your Gain
It’s called an “Employee Stock Ownership Plan” (ESOP) — often well-known as a widely sought after benefit by employees working for successful public companies.
Yet, if you are a departing or retiring owner, major-shareholder, and/or founder of a closely held company, it can provide for the means of business continuity. If the ESOP holds 30% or more of the company’s stock, and certain other requirements are met, the owners can defer tax on the gain they have made from sale to an ESOP. In addition to the tax deferment, the purchase can also be more attractive to the purchasing corporation, because the corporation can purchase the stock using pre-tax corporate dollars.
Between use as an employee benefit and being used to buy the stock of a retiring company, as mentioned in the previous paragraph, these two uses probably account for over two-thirds of all ESOPs. Since you are most likely interested in this as a business owner, we’ll briefly discuss here the latter use — that of buying out a retiring owner.
The fact is, many closely held companies have no plans, or incomplete plans, for business continuity after the departure or retirement of the founder or major shareholder. If this is you, or you hope for it to be you one day, you may want to pay close attention!
As a retiring owner, you may think that business continuity is not a possibility, and that when you retire, the jobs of your loyal, hard-working employees will disappear. But several unique options exist that benefit not only you, but your employees as well. Under the right conditions, when you retire, you can sell your stock to an ESOP and incur no taxable gain. This is done to encourage you as an owner of a closely-held company to create new owners through the ESOP purchase.
ESOPs can purchase the ownership shares through one of two ways: either through a leveraged ESOP, or through a non-leveraged ESOP.
While the details of how the ownership shares are actually purchased are beyond this short article, it’s useful to look at how each of these types of ESOPs is created.
First, let’s look at a non-leveraged ESOP. In a non-leveraged ESOP, an employer sponsor funds it by contributing cash or stock. These corporate contributions become “newly issued shares.” By doing so, the corporation gains a tax-deduction for the appraised fair market value at the date of contribution. Since the company gains tax deductions, it helps to improve the cash flow that can then promote the growth of the company.
A leveraged ESOP occurs when the company borrows money to create the ESOP. It seems crazy that a company would do this simply to enable their employees to acquire stock. But two tax incentives make borrowing through an ESOP extremely attractive to companies.
Since the ESOP contributions are tax deductible, a corporation which repays an ESOP loan, in effect, gets to deduct principal in addition to deducting the interest from taxes. Needless to say, this can cut the company’s cost of financing significantly, by as much as a 34% reduction in the number of pre-tax dollars needed to repay the principal.
Another option, if your company would not want to take out a loan to finance the ESOP, would be to ask you, as the retiring owner, to finance the sale. As the owner of the company, instead of being paid with borrowed money (see leveraged ESOPs), you would take a note payable from the ESOP as payment for the purchased stock.
Are you an owner of a company and haven’t considered your “exit” strategy? Remember, under the right conditions, you could end up selling your stock to an ESOP and have no taxable gain. Talk with us about how structuring your company and ESOPs can create considerable tax advantages for both you and your company.
Why not call us today at 970.744.4626? Or sign up for a free consultation where you can write in your questions, and we’ll get back to you with answers right away.
