Business owners who transfer ownership of their companies to employees receive big tax benefits.
Our April issue of Oregon Business magazine featured a column by Bob Moore, the founder and president of Bob’s Red Mill Natural Foods. Moore wrote about his decision to “give” ownership of his company to employees through an employee stock ownership plan, or ESOP.
The column provoked readers to take Moore to task for describing his decision to give ownership of the company to staff, because it implies that he selflessly gave his business away for free.
Business owners can in fact reap large financial rewards for selling to employees rather than to a strategic buyer. These financial incentives take the form of tax breaks, which are often large enough to offset the higher price that a strategic buyer may offer.
Yet many in the business community do not understand how ESOPs work.
“Unfortunately, when business owners go to advisors, very few advisors know what an ESOP is,” says Corey Rosen, founder of the National Center for Employee Ownership (NCEO). He adds that business brokers steer away from ESOPs because they don’t receive a portion of the sale proceeds.
“It is not something the business press writes a lot about,” he says.
To clear up any misconceptions about ESOPs, here is a brief rundown of how they work:
When a business owner transfers ownership of the company to employees, he or she sells shares in the business to a trust, which holds the shares for the employees. The ESOP trust buys the stock at fair market value, which is determined by an independent appraiser.
In selling shares to an ESOP trust, the owner can defer paying capital-gains tax until death by investing the proceeds of the sale in stocks and bonds. Although a strategic buyer pays fair market value up front, owners who sold to an ESOP often find their after-tax payback is higher, according to the NCEO.
To pay for the shares, the ESOP trust borrows money, usually from a bank. The seller can also lend money to the trust and earn interest on the loan.
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Employees typically do not pay anything for the company stock. ESOP rules usually require, at a minimum, full-time employees with a year or more at the company be part of the plan and receive allocations of stock based on pay or other formula.
The owner has the flexibility to stay on at the company, which is often not the case when he or she sells to a strategic buyer. The owner can sell part of the stock, a portion of the shares at the beginning and transfer more later, or sell all the shares to the trust.
Companies that are 100% owned by employees pay no corporate tax. Cash that would otherwise be paid in tax can be reinvested in the company. The money could be used, for example, to pay off debt or acquire other companies.
Although there are legal and advisory costs of setting up an ESOP, as well as the costs of administrating the retirement plan, these costs “are more than offset by tax benefits,” says Olivia Pieschel, senior associate at Chartwell Financial Advisory.
The benefits of selling to employees are compelling. Employee-owned companies have a much lower default rate on their loans at two per 1,000 a year, according to an NCEO study. They also tend to have better profitability and lower staff turnover, says Rosen.
Yet ESOPs still remain a small portion of the business sector; there are 7,000 employee-owned companies nationally and 14 million participants.
Rosen says he sees more interest from business owners in creating ESOPs as the baby boomer wave of retirees picks up.
For owners who have trouble finding a strategic buyer, ESOPs may increasingly turn out to be the best route to go.
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