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The Tax Magic of ESOPs

Lawrence G. Silver, CPA
Lawrence G. Silver, CPA Director, Tax Strategies

5 hidden benefits of using an ESOP as an exit strategy

What if you were able to sell some or all of your company’s stock and:

  • Pay no federal and perhaps state income tax on the sale,
  • The purchaser could deduct the interest and the principal on the debt incurred,
  • The company could convert to an S corporation after the purchase and exempt future taxable profits of the new owner(s) from federal and most state income taxes, and
  • You could still manage the business?

All of these scenarios can potentially be realized when the purchaser of your business is an Employee Stock Ownership Plan (ESOP).

ESOPs were created as part of the Employment Retirement Income Security Act (ERISA) passed by Congress in 1974. The purpose of an ESOP is to assist employees to acquire a beneficial ownership in their company without using their own capital. The employees only have a beneficial ownership interest in an ESOP, rather than actual ownership, because the ESOP is actually a trust (known as an ESOT) that is a qualified retirement plan investing primarily in the employer’s stock.

If the employer is a C corporation, the owners can sell at least 30 percent of their stock to an ESOP. The gain on the sale of the stock can be tax deferred if the proceeds of the sale are invested in “qualified securities” within a certain timeframe. This deferral can become permanent if the qualified securities are not sold and the seller’s estate subsequently inherits them. However, keep in mind that this benefit is only available to C corporations.

After the sale of the stock to the ESOP, the C corporation can then elect to become an S corporation. As an S corporation, income is passed through to owners. If one of the owners is a tax exempt trust like an ESOT, the income allocated to the stock owned by the ESOT is also exempt from federal and most state income taxes.

Many ESOPs employ debt to finance the purchase of the stock from the selling shareholder. Most retirement plans cannot borrow money, but an ESOP is exempt from that prohibition.

An ESOP borrows funds to finance the stock purchase and it usually borrows from the selling company, which in turn borrows funds from a third party. This may be important if the company remains a C corporation, so that subsequent selling shareholders can utilize the gain deferral mechanism on the sale of their stock to the ESOP as mentioned above. The company’s annual deductible retirement plan contributions, which include interest and principal on this debt, may yield a most sizable tax deduction to minimize C corporation taxes.

There are other significant tax advantages, but the primary benefit of an ESOP is that it provides a very attractive exit strategy for business owners. It is an interesting option compared to most traditional methods of selling a business.

An ESOP allows the selling shareholders to create a market for all or part of their stock, stay in a management role, remain on the board, and/or become a trustee of the ESOP. It allows the business to remain independent and it creates an extremely loyal employee base, as the employees are now the “indirect” owners of the business (albeit with limited non-equity ownership rights). Perhaps best of all, numerous studies have shown that ESOP-owned companies are more productive than their non-ESOP-owned

So if you are thinking about selling your business to a strategic or a financial buyer, or even through a traditional leveraged buyout, you may want to consider an ESOP for its tremendous tax and non-tax advantages.

Lawrence G. Silver can be reached at Email or 215.441.4600.

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Contact the Author

Lawrence G. Silver, CPA

Lawrence G. Silver, CPA

Director, Tax Strategies

ESOPs Specialist, Business Tax Specialist, Individual Tax Specialist

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