Succession planning is complicated but essential for any closely held business. A business needs to consider the next generation of leadership to ensure that the business remains viable, retains its value and fulfills its obligations to employees, customers and clients. Options for business transition include a transfer of ownership to the next generation of leadership (whether family members or employees), selling the company to a third party, or liquidating the business. For a company interested in longevity and maintaining a legacy, another option is an Employee Stock Ownership Plan, or ESOP.

An ESOP is a form of a federally regulated retirement plan. A business owner sells some or all of his or her shares to an Employee Stock Ownership Trust in exchange for payment equal to the fair market value of the shares, as determined by an independent valuation. An independent trustee holds the shares in trust, and employees are allocated interest in the shares over time. The employees do not own the shares outright, and they do not have the right to vote the shares.

ESOPs have certain tax benefits. If an S corporation is 100% owned by an ESOP, the corporation will not have to pay any federal income taxes. If the entity is a C corporation, the business owner has the option to make a 1042 election and defer gains on the sale of shares. Limited liability companies would need to convert to a corporation in order to sell to an ESOP, and upon such conversion, the tax benefits would also be available to the newly converted corporation.

What are the benefits of an ESOP?

With an ESOP, employees have another retirement planning option while allowing the owner to achieve liquidity from selling the business. Unlike a traditional business sale, the ESOP generally means that the same management team remains intact, and the company’s culture and values remain the same. As a result, the legacy of the business will endure, while the owner has an exit event and can receive the value he or she has grown through the years.

For certain industries in particular, such as construction or personal services, an ESOP could mean even greater value than a third party sale. If a business is highly dependent on its people for its value, rather than hard assets or production, the business may be most valuable by continuing to operate in its current form. A third party sale might mean the exit of key people, and a buyer won’t pay top dollar for assets that can leave freely.

The ESOP can serve as a retention tool for employees because employees now have a stake in the future of the company. Employees become more educated about the ways to drive financial performance, and this can improve the company’s results. The ESOP structure also means that the business will continue to operate in its current form, rather than being subject to new management that may focus solely on financial results with less regard for the long-standing culture of the business.

What are the downsides of an ESOP?

ESOPs carry a certain administrative burden. An ESOP is subject to extensive federal laws and regulations, and compliance is essential. After the ESOP closes, the business will need to engage a third party administrator to administer the ESOP, similar to the process with a 401(k) plan. In addition, the sale to the ESOP itself is more expensive than a traditional sale to a buyer because the selling company is responsible for its own professional fees, as well as the fees of an ESOP Trustee, and the Trustee’s valuation team and legal counsel.

An ESOP structure is best suited for a business with steady performance and predictable cash flow. The ESOP transaction often involves additional financing, so companies with lower debt may be in better position to implement the ESOP. Employee education is also essential, so that employees understand the new benefit and can feel a sense of ownership to the business.

Finally, for certain types of businesses, an ESOP sale will not be able to match the offer of a third party buyer willing to pay a premium for the acquisition. By law, the ESOP Trustee cannot pay more than fair market value for the business. For some owners, a payout above fair market value is more important than ensuring that the business continues to run in its current form.

How Can I Learn More?

At Hinckley Allen, we view ESOPs as one of several possible ways to accomplish a business transition. For the right business, an ESOP can offer sufficient liquidity to a selling owner without disrupting the nature of the business itself. Our cross-disciplinary team of corporate, tax, ERISA, financing and employment attorneys works together to make sure that an ESOP transaction is the right fit for our clients. Please contact Jen Doran or Libbie Howley O’Keeffe to learn more.

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