Selling a Business to Employees with an ESOP

Using an Employee Stock Ownership Plan for Business Continuity

Corey Rosen
Executive Director
National Center for Employee Ownership

Introduction
One of the most difficult problems for small business owners is finding a way to turn their equity in a business into cash. Owners may want to sell the entire business or, and this is even more difficult, just part of it. Equally challenging is finding a buyer for a minority owner of the company when other owners don’t want to sell.
Fortunately, the tax laws provide an alternative that a great many business owners will find very attractive: selling to the employees through an Employee Stock Ownership Plan (ESOP). For the owner, proceeds on the gain made from the sale to an ESOP can be tax-deferred by reinvesting in the securities of other domes¬tic companies. The company buys the shares in tax-deductible dollars, either from company contributions or plan borrowings. The sale can be all at once or gradually, for as little or as much of the stock as desired. For the employees, no contributions are required to purchase the owner's shares. The owner can stay with the business in almost whatever capacity desired, and control of the company can be arranged however management wants, with a few limitations. Key employees can acquire stock outside the plan as well, although as in any employee purchase, they will have to do so with after-tax dollars.
HOW AN ESOP WORKS
An ESOP is a type of employee benefit plan, and it automatically must include at least all full-time employees with one year or more of service. To establish an ESOP, a firm sets up a trust and makes tax-deductible contributions to it. The ESOP can be funded through tax-deductible corporate contributions to the ESOP or by having the ESOP borrow money, with the company repaying the loan by making tax-deductible contributions to the plan. Stock acquired by the ESOP is allocated to accounts for indi¬vidual employees based on relative pay or some more equal formula. Accounts vest over time, and when employees leave the company, they receive their vested ESOP shares, which the company or the ESOP buys back at an appraised fair market value.
ESOP participants must be allowed to vote their allocated shares at least on major issues, such as closing or selling the company, but are not required to be able to vote on other issues, such as choosing the board. Instead, the plans are governed by a trustee, appointed by the board, who votes the shares for all major corporate issues except these very limited required matters, which rarely, if ever come up.
Once 30% of the company's stock has been trans¬ferred to the ESOP, if the company is a C company, the seller can reinvest the gains in the securities of other companies (other than real estate trusts, mutual funds, and other passive investments) within 12 months after or three months before the sale. No taxes are due until these replacement securities are sold. If the securities go into an estate, no capital gains taxes are due. S corporation owners either need to convert to a C or pay capital gains taxes on the sale. However, in an S corporation, while owners have to pay capital gains tax, any profits attributable to the ESOP’s ownership are not taxable. A 30% ESOP pays no tax on 30% of its profits; a 100% ESOP pays no taxes.
Compare this method to other common approaches to selling an owner's shares: redemption or sale to another buyer. Under a redemption, the company gradually repurchases the shares of an owner. Corporate funds used to do this are not deductible. In a cash sale to a buyer, taxes would be due that tax year. If the sale is for an exchange of stock, taxes can be deferred until the new stock is sold, but 80% of the company must be sold all at once and the owner ends up with an undiversified invest¬ment for retirement. The price the ESOP will pay for your shares, as well as any other purchases, must be determined at least annually by an outside, independent appraiser.
All this may sound appealing, but it is not for every firm. According to Corey Rosen, executive director of the National Center for Employee Ownership in Oakland, CA, Several factors must, at a minimum, be present:
1. The company is making enough money to buy out an owner.
2. Your payroll must be adequate to cover the purchase. You can only deduct up to 25% of the payroll of the plan participants to cover the annual principal payments on the ESOP loan. Payroll includes only those people in the ESOP. If you are rolling over your gains from the sale of stock, certain family members or key employees may be excluded from receiving stock allocations from the ESOP, and their sal¬aries would not be counted as a result.
3. If you are borrowing to buy the shares, your existing debt must not prevent you from taking out an adequate loan. Similar¬ly, you must not have bonding covenants or other agreements that prohibit you from taking on additional debt.

ESOPs will cost about $40,000 to $60,00 to set up for typical “plain vanilla” transactions, much less than what it usually costs to sell a business, where brokers charge 5% to 10% of the transaction and lawyers, accountants, and others add additional costs. ESOPs are no right for every company, but they deserve a serious look if there are ownership interests to be sold.

For more information on ESOPs,go to our web site at Using an Employee Stock Ownership Plan for Business Continuity

Corey Rosen
Executive Director
National Center for Employee Ownership

Introduction
One of the most difficult problems for small business owners is finding a way to turn their equity in a business into cash. Owners may want to sell the entire business or, and this is even more difficult, just part of it. Equally challenging is finding a buyer for a minority owner of the company when other owners don’t want to sell.
Fortunately, the tax laws provide an alternative that a great many business owners will find very attractive: selling to the employees through an Employee Stock Ownership Plan (ESOP). For the owner, proceeds on the gain made from the sale to an ESOP can be tax-deferred by reinvesting in the securities of other domes¬tic companies. The company buys the shares in tax-deductible dollars, either from company contributions or plan borrowings. The sale can be all at once or gradually, for as little or as much of the stock as desired. For the employees, no contributions are required to purchase the owner's shares. The owner can stay with the business in almost whatever capacity desired, and control of the company can be arranged however management wants, with a few limitations. Key employees can acquire stock outside the plan as well, although as in any employee purchase, they will have to do so with after-tax dollars.
HOW AN ESOP WORKS
An ESOP is a type of employee benefit plan, and it automatically must include at least all full-time employees with one year or more of service. To establish an ESOP, a firm sets up a trust and makes tax-deductible contributions to it. The ESOP can be funded through tax-deductible corporate contributions to the ESOP or by having the ESOP borrow money, with the company repaying the loan by making tax-deductible contributions to the plan. Stock acquired by the ESOP is allocated to accounts for indi¬vidual employees based on relative pay or some more equal formula. Accounts vest over time, and when employees leave the company, they receive their vested ESOP shares, which the company or the ESOP buys back at an appraised fair market value.
ESOP participants must be allowed to vote their allocated shares at least on major issues, such as closing or selling the company, but are not required to be able to vote on other issues, such as choosing the board. Instead, the plans are governed by a trustee, appointed by the board, who votes the shares for all major corporate issues except these very limited required matters, which rarely, if ever come up.
Once 30% of the company's stock has been trans¬ferred to the ESOP, if the company is a C company, the seller can reinvest the gains in the securities of other companies (other than real estate trusts, mutual funds, and other passive investments) within 12 months after or three months before the sale. No taxes are due until these replacement securities are sold. If the securities go into an estate, no capital gains taxes are due. S corporation owners either need to convert to a C or pay capital gains taxes on the sale. However, in an S corporation, while owners have to pay capital gains tax, any profits attributable to the ESOP’s ownership are not taxable. A 30% ESOP pays no tax on 30% of its profits; a 100% ESOP pays no taxes.
Compare this method to other common approaches to selling an owner's shares: redemption or sale to another buyer. Under a redemption, the company gradually repurchases the shares of an owner. Corporate funds used to do this are not deductible. In a cash sale to a buyer, taxes would be due that tax year. If the sale is for an exchange of stock, taxes can be deferred until the new stock is sold, but 80% of the company must be sold all at once and the owner ends up with an undiversified invest¬ment for retirement. The price the ESOP will pay for your shares, as well as any other purchases, must be determined at least annually by an outside, independent appraiser.
All this may sound appealing, but it is not for every firm. According to Corey Rosen, executive director of the National Center for Employee Ownership in Oakland, CA, Several factors must, at a minimum, be present:
1. The company is making enough money to buy out an owner.
2. Your payroll must be adequate to cover the purchase. You can only deduct up to 25% of the payroll of the plan participants to cover the annual principal payments on the ESOP loan. Payroll includes only those people in the ESOP. If you are rolling over your gains from the sale of stock, certain family members or key employees may be excluded from receiving stock allocations from the ESOP, and their sal¬aries would not be counted as a result.
3. If you are borrowing to buy the shares, your existing debt must not prevent you from taking out an adequate loan. Similar¬ly, you must not have bonding covenants or other agreements that prohibit you from taking on additional debt.

ESOPs will cost about $40,000 to $60,00 to set up for typical “plain vanilla” transactions, much less than what it usually costs to sell a business, where brokers charge 5% to 10% of the transaction and lawyers, accountants, and others add additional costs. ESOPs are no right for every company, but they deserve a serious look if there are ownership interests to be sold.

The National Center for Employee Ownership is, a nonprofit organization (www.nceo.org).

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