Business owners often have a sense of gratitude towards their employees—they understand that they couldn’t have built their business without those employees and want to see them have the opportunity to run the business and enjoy the fruits of ownership. Over 50% of my clients express an initial desire to sell to employees if the key employee group (KEG) can obtain financing for the purchase.
There are generally 2 avenues that can be taken here—a sale of the company directly to the KEG or a sale to an Employee Stock Ownership Plan (ESOP). An ESOP is an IRS/Department of Labor qualified retirement plan with a unique feature—it is the only retirement plan that is allowed to own shares of the sponsoring company’s stock. The net effect is that each employee winds up owning stock in their retirement plan account. Ownership is distributed via annual contributions that the company makes to the ESOP/retirement plan, with those contributions allocated based on compensation. In an earlier article (ESOP versus M&A, May 2016), we considered a sale to an ESOP versus a sale to a third-party. Here we will consider the sale to an ESOP versus a sale to a key employee group.
An ESOP involves significant regulatory oversight from both the IRS and the Department of Labor; in order to consider an ESOP the firm must be large enough and the benefits great enough to absorb fixed administrative/regulatory costs. We think a company must have a minimum of $1 million in EBITDA (cash flow) and $1 million in payroll before an ESOP can be considered a viable option.
Let’s see how an ESOP stacks up against a sale to a KEG in the following areas:
1) Tax benefits. This is the key advantage of an ESOP. If the company is a C corporation and at least 30% of the shares are sold to an ESOP, the tax on the sale can be deferred if the seller invests the proceeds in publicly traded U.S. securities (individual stocks and bonds but not mutual funds). The full capital gains will be realized when the acquired securities are sold. If the company is an S corporation, the ESOP’s share of income is not subject to income tax because an ESOP is a tax-exempt organization. An S corporation that is 100% ESOP owned pays no income tax.
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