The Benefits of an Employee Stock Ownership Plan (ESOP) in the Sale of a Business

When it comes time to sell a business, owners usually consider many options such as selling to a third party or passing the company to their children. There is one option that is often overlooked that offers full market value, capital gains tax deferral and a tax deduction to the buyers. I am referring to an Employee Stock Ownership Plan (ESOP). Essentially, an ESOP is a trust through which shares of the company are bought in the name of employees and held by the trustee until employees retire or leave the company. But practically speaking, an ESOP is an exit strategy that enables the owner to retain control as the ESOP gradually buys them out.

Not every business will be a good candidate for an ESOP. It depends on the owner’s goals—are they looking to improve performance though equity incentives or share ownership as a way to incentivize employees to increase productivity—as well as the company’s profile. ESOPs work best when the company is at least five years old, has an eligible payroll of at least $1 million, has a solid EBITDA history, and has a current minimum market value of at least $3 million. It should also have C or S corporation IRS status.

Here are some benefits to choosing an ESOP as your exit strategy:

1. Taxes. By meeting certain requirements, the business owner can defer the capital gains tax on sale. The employees get a tax deduction on their contributions to the ESOP. In addition, S-corporation ESOPs are not taxed on income at the federal level on their percentage share of income, which increases cash flow significantly and can give your company a competitive edge.

2. Built-in buyer. One of the most difficult aspects of selling a business is finding the right buyer. An ESOP provides a ready-made buyer that you are already intimately familiar with: your own work force. Rather than waiting a year or more to identify a quality buyer, ESOPs can be established in a little as two or three months. An ESOP can be a win-win. You get to control your exit, while securing your company, and employees get to share in the company’s success.

3. Valuation. The owner is permitted to sell their business to an ESOP for full fair market value, which is determined by an independent appraiser. Yes, a strategic buyer might pay more, if such a buyer exists. Finding out could take a fair amount of time. Plus, third party buyers may want earn-outs, holdbacks, or a host of other stipulations. Selling to an ESOP is cleaner, eliminates price haggling and gamesmanship, and will consistently offer fair market value.

4. Loans. The ESOP can borrow money on a tax deductible basis for a variety of purposes: to refinance debt, to reinvest in the company, and to even acquire another business. Since ESOP loan payments are tax-deductible, it allows the business to borrow at a lower after-tax rate. Several studies suggest that ESOP companies have an advantage because they grow more quickly than non-ESOP rivals competitors.

5. Company sustainability. Congress passed the legislation allowing ESOP as a means for spurring productivity. If employees have a vested interest in a company’s success, they will generally work harder to ensure it continues to grow and prosper. That in turn will help the business and the owner’s legacy sustain for generations to come.

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