Selling your business to those who helped you build it

How an employee stock ownership plan offers a tax-advantaged path to succession

When owners of closely held businesses think about succession, two paths usually come to mind: hand the company down to family or sell it to an outside buyer. But there's a third option worth considering. An employee stock ownership plan, or ESOP, lets you sell your stake to a trust that holds the company stock on behalf of your employees. The mechanics take some unpacking, but the approach holds many advantages.

How the transaction works

An ESOP begins with establishing an employee stock ownership trust. The company then borrows money – from a bank, or from you – and lends those funds to the ESOP trust, which uses them to purchase your shares at their appraised fair market value. Over time, the company makes regular contributions to the trust out of its operating earnings, and the trust uses that money to pay down the initial loan.

It is important to note that the ongoing contributions to the plan are returned to the company immediately to repay the load provided by the company. Because the IRS treats company contributions to the trust as stock-based employee compensation, which is fully deductible, the company repays its original loan with money it has already deducted. As the loan is repaid, shares are released from the trust and credited to individual employee accounts. Over time, each employee accumulates a meaningful stake in the company – one whose value rises and falls with the business itself. When employees retire or leave, the company buys back their shares – often over time rather than in a single payment.

Tax advantages for all involved

The tax case for an ESOP is what makes it stand out from a conventional sale. If your business is structured as a C corporation, Section 1042 of the tax code allows you to defer capital gains on the sale, provided that you have sold at least 30% of the common stock and reinvest the proceeds in qualified replacement property (QRP) within 12 months. Typically, a QRP involves stocks or bonds of other US operating businesses, and you can build a diversified portfolio rather than concentrating in a single holding. Only the gain portion of the sale needs to go into QRP – the rest of the proceeds comes out free of any reinvestment requirement. Done well, a Section 1042 rollover combines meaningful liquidity for the owner at closing and lifetime capital gains deferral.

After the owner sells the company to the ESOP, the new owner – the ESOP trust – often elects S corporation status because the company’s income then passes through to the trust tax-free, since the trust itself is a tax-exempt retirement plan. A 100% ESOP-owned S corporation can therefore operate without paying federal income tax on its earnings. The sequencing matters: most owners sell as a C corporation to capture the Section 1042 rollover, and the company then elects S-corporation status to layer in the entity-level tax exemption.

Factors to consider

ESOPs aren't a fit for every company. Setting one up carries certain upfront costs with valuation, legal and trustee fees, though these costs are typically offset by the tax savings achieved in a transaction. And because the trustee has independent fiduciary duties to the employees under the Employee Retirement Income Security Act of 1974, the trustee will negotiate appropriate valuation and terms for the transaction that the trustee believes are in the best interests of the employees.

The company also needs durable cash flow to fund trust contributions year after year, especially while the loan is being paid off. As such, ESOPs tend to work best for profitable, established companies with thirty or more employees and a management team capable of running the business after you step back. A startup or a small partnership generally won't have the structure or scale to make an ESOP viable.

A reward for your employees

In addition to all the financial advantages of selling your company to a trust that holds it for the benefit of the employees, an ESOP is a powerful way for owners to share their company’s success with the employees that contribute to it.

Although an ESOP doesn’t confer upon your employees any day-to-day operational control over the company, it gives them financial benefits. Conferring these financial rewards and giving your employees an ownership stake through the ESOP trust is a great way to say thank you.