Selling to an ESOP: Shared Benefits for Business Owners and Employees

When planning their exit strategy, business owners must weigh numerous worthwhile alternatives. One option worth exploring is an employee stock ownership plan (ESOP). An ESOP is a qualified retirement plan that allows employees to own shares of the company they work for. ESOPs offer a number of advantages for the owner and employees alike, such as tax benefits, increased productivity, and a shared ownership culture. Here, Dan Markowitz, CPA, Boulay’s ESOP advisory leader, explains the benefits of selling your business to an ESOP.

What’s an ESOP?

An ESOP works by creating a trust that purchases some or all of the owner’s shares and allocates the shares to the employees over time within the trust. Depending on their liquidity needs and preferences, the owner can sell their shares gradually or in one lump sum. The owner can also choose to stay involved in the business by continuing to be the CEO or a member of the Board of Directors after the sale. Some of the potential benefits of an ESOP include:

1.  Tax Benefits

• • • • C-Corporations: The owner can defer or avoid capital gains taxes on the sale of their shares if they reinvest the proceeds in qualified replacement property (QRP) under IRS Section 1042, such as stocks or bonds of U.S. companies. The company can deduct the interest payments on the loan used to finance the ESOP purchase, reducing its taxable income. The company can also make tax-deductible contributions to the ESOP trust to repay the loan principal. The employees pay no taxes on their shares until they receive distributions from the ESOP, usually upon retirement or termination of employment. The downside of a C-Corporation ESOP is the entity is still subject to income taxes post-transaction.
      • S-Corporations: A company may be eligible for certain tax advantages depending on its designation as an S-Corporation. If the company is an S-Corporation, the income allocated to the ESOP trust is tax-exempt under the IRS Code. Therefore, a 100% S-Corporation ESOP will be exempt from federal and most state income taxes post transactions. 

2.  Shared Ownership Culture: An ESOP can create a sense of pride and ownership among the employees; they will view themselves as co-owners rather than just employees. An ESOP aligns the interests of the owner and the employees, creating mutual trust and respect. It helps preserve the company’s legacy and values, as the employees are more likely to carry on the founder’s vision and mission. According to National Center for Employee Ownership (NCEO) research, ESOP companies tend to grow faster, retain employees longer, and be more profitable than companies without ESOPs. ¹

Is an ESOP Right for Your Business?

While an ESOP can offer many benefits, it is not a one-size-fits-all solution for every business owner. An ESOP involves complex legal, financial, and operational issues that require careful planning and professional guidance. Some of the factors to consider before pursuing an ESOP include:

• • Size and Value of the Company: An ESOP typically requires a minimum of 25 employees and an EBITDA of $1M. Smaller or less profitable companies may be unable to afford the costs and fees associated with setting up and maintaining an ESOP. Additionally, the owner must be willing to accept a fair market value for their shares, which allows the seller to receive a fair price for their company.  For companies that do not meet the criteria above, an owner could consider selling to an existing ESOP company.
  • Financing and Cash Flow: An ESOP purchase is usually financed by a combination of seller financing, bank loans and company cash flow. The owner must be willing to provide some seller financing, meaning they will not receive the full payment upfront and bear some risk if the company defaults on the loan. The company must also have sufficient and stable cash flow to service the debt and make contributions to the ESOP trust. An ESOP advisory team can perform a feasibility study to ensure you have the most up-to-date information.
  • Sellers’ Investment: Selling to an ESOP allows the owner to separate their exit from the liquidity event of the sale. This allows for a flexible exit compared to that of a sale to a financial buyer.
  • Employee Participation and Education: An ESOP requires a high level of education to be successful. The employees must understand how the ESOP works, how it affects their compensation and benefits and how they can influence the company’s performance. The company must provide regular and transparent communication and education to the employees to keep them informed and engaged. 

Helping You Get There…

An ESOP can offer many benefits to a business’s owner and employees. By selling your business to an ESOP, you can enjoy tax advantages, preserve your legacy and reward the workforce. You can also retain some control and involvement in the business if you wish. ESOPs promote a sense of ownership and alignment among employees, positively impacting the company’s culture, productivity and profitability.

If you are a business owner thinking about your exit strategy and what comes next, Boulay is committed to helping you get there. To determine if an ESOP is right for your business, connect with Dan to learn more about your exit strategy options.