Employee Stock Ownership Plans (ESOPs): Sell to Your Team and Save on Taxes

One of the most common items I hear from small business owners preparing to sell their business is a concern for their team. They’ve helped you build your business, and you want to make sure they’re taken care of after you sell.

Whether it’s a fear of the new owner letting the team go, concern for a key employee, or something else; it’s natural to take them into account as you consider your next steps.

If this sounds like you, there's a strategy that might be perfect: an Employee Stock Ownership Plan (ESOP). An ESOP lets you sell to your team while potentially saving on taxes by deferring your entire capital gain from the sale.

What is an ESOP?

An Employee Stock Ownership Plan or ESOP is a qualified retirement trust that is set up for the benefit of your employees. The trust purchases your business, owns it, and operates it on their behalf. In essence, you are creating a business that is owned and operated by a retirement plan setup for your employees. The trust will then appoint a board of directors, and your existing executive team will manage/operate the business.

How does an ESOP Work?

As a qualified retirement trust, an ESOP trust is tax deferred. If the business is an S-Corp, the business and trust will pay no income taxes on the business income. If the business is a C-Corp, the business will pay corporate income taxes, but the dividends received by the trust will be tax-free. As we will see in a later section, there are other reasons for being structured as a C-Corp.

How do Employees Benefit from an ESOP?

Each year eligible employees will receive additional shares in the trust that are calculated based on their compensation and years of service.  Over time, the value of their shares will increase due to the value of the company increasing and the distributions that the trust receives from the business.

ESOPs also typically contain a vesting schedule similar to a 401(k) so that employees who leave the firm early won’t qualify to take their shares with them. Once a fully vested employee retires or leaves the firm, the ESOP will have to purchase their shares back from them. Once they do, those shares go back into the pool to be distributed amongst the remaining employees.

How does an ESOP buy the business?

An ESOP is set up to facilitate the exit of the current owners. Once the trust is set up, the trust typically pursues bank financing to purchase the business. Banks won’t usually finance 100% of the purchase price and the ESOP will then purchase the business using the bank loan + an installment note to make up the difference.

Once this is done, the ESOP begins owning and operating the business for the employees’ benefit and the seller works for a few years as an employee to assist the transition. For ESOPs that own S-Corps, the tax savings can be used to pay down these notes much faster than the average business would be able to.

To summarize, an ESOP:

• Is a qualified retirement trust
• Doesn’t pay taxes on business income if structured as an S-Corp, although the business will still pay taxes if structured as a C-Corp
• Is owned by the employees
• Employees receive shares yearly based on compensation and years of service
• Allows for employees who couldn’t otherwise purchase the business to benefit from the business

Section 1042 Rollover: How ESOPs Can Help you Defer Capital Gains

Now that we have brief understanding of what an ESOP is, where do the tax benefits for the seller appear?

ESOPs that own S-Corps don’t pay income taxes, but ESOPs that own C-Corps do. As with most tax decisions, there is a tradeoff here. The benefits to a seller are the opposite of that setup. A business owner who owns an S-Corp doesn’t receive any tax benefits for selling to an ESOP. However, a C-Corp owner can receive benefits for selling to an ESOP.

As the owner of a C-Corp selling to an ESOP, you can elect what is called a Section 1042 rollover. When you elect a Section 1042 rollover, you must reinvest your sales proceeds into Qualified Replacement Property to defer your gains. There are a few requirements to do this:

1. You must sell at least 30% of your company to qualify
2. Hold your shares for at least 3 years to qualify
3. You must reinvest your funds within 3 months prior to the sale or 12 months after the sale
4. You must reinvest in Qualified Replacement Property or QRP. Here’s what qualifies as QRP:
   
   1. Common stock, preferred stock, bonds, and convertible bonds of operating companies within the US
   2. 50% of company’s assets used in active trade or business
   3. No more than 25% of gross receipts from passive sources
   4. Does not include securities issued by US government agencies, non-US entities, US subsidiaries of foreign companies, FDIC insured deposits, mutual funds or securities issued by the corporation that issued the stock sold to ESOP or its control group members
   5. Typically, QRP takes the form of public stocks or floating rate bonds issued by corporations.

To put it simply, as the owner of a C-Corp, you can sell your business tax free if you sell at least 30% of the business to an ESOP and then reinvest your proceeds into QRP within 12 months.

One thing to keep in mind is the timing of your cash flow when it comes to QRP.

When you sell your business to an ESOP, the ESOP may only have 40-60% of the purchase price upfront, but the 1042 Rollover rules require that the ENTIRE amount that you’d like to defer is rolled into QRP. That may leave you 40-60% short on cash to defer your taxes.

To solve this problem, there are creative financing groups that can structure your reinvestment portfolio in such a way that you can take a margin loan out with minimal risk to have the full amount available to you. Then, as the installment note pays you, you take your payments and pay down your margin loan. At the end of the payment period, you wind up with an investment portfolio free and clear of any loans with no taxes paid on the transaction.

These portfolios are typically made up of Floating Rate Notes (FRNs) or public stock and I would highly recommend that you speak with and engage a professional manager to structure this.

If you pull this off, the QRP inherits your business’s tax basis, and the tax deferral lasts indefinitely or until the QRP is sold.

What is the ESOP Setup Timeline?

Although every sale is different, an ESOP typically takes slightly more leg work to complete than the average sale. There are several steps and parties involved in an ESOP transaction. The main parties are ESOP advisors, ESOP trustees, and your legal team.

The first step in an ESOP process is a feasibility study. This study is performed by the ESOP advisor and reviews whether your business is a good candidate for an ESOP. Once complete and assuming your business is approved, you can move along in the process.

The next step in an ESOP is the valuation. Because the business is being sold to what amounts to an internal buyer, there must be a 3^rd party valuation. This assures the trustee that they aren’t overpaying for the business and are looking out for the employees’ best interests. An interesting quirk of ESOPs is that the trustee legally can’t pay more than the 3^rd party valuation states that the business is worth even if there is a bidding war, so keep that in mind.

Once you have the valuation done, you can move into finalizing the plan design, implementation, and purchase. At that point you have a transaction ready to go. For most ESOPs, it takes 6-12 months to execute a transaction.

Can I convert my S-Corp to C-Corp to receive Section 1042 Treatment?

On the personal side of things, there are also a few additional timelines to consider to reduce your taxes on a sale to an ESOP.

As mentioned earlier, you need to hold your shares for 3 years to qualify for a Section 1042 Rollover. If you’re already a C-Corp, that’s not an issue. However, if you’re an S-Corp, you need at least a 3-year runway to convert to a C-Corp and qualify for a 1042 rollover.

Additionally, your company can’t switch back to an S-Corp for 5 years after making the change to a C-Corp. That means that to qualify for the tax deferral, you can change now, sell your business in 3 years, and then your business can switch back to an S-Corp 2 years later. In this scenario, the ESOP owned business would only pay taxes for 2 years, you would receive your tax-free proceeds, and the business would become tax free in year 3 of the ESOP.

ESOP Example: The Tax Savings for Daniels Engineering

To view how an ESOP would benefit you as a seller, let’s walkthrough an example with Daniels Engineering. Daniels Engineering is a 40-person firm worth $10,000,000. They have a great group of managers who they’d like to take over the business and turn their engineering firm into a multigenerational firm that benefits every employee. Because of that, an ESOP works great.

Following the requirements of a 1042 Rollover, the Daniels execute their transaction, and it results in ~$2.7m in tax savings. While the tax savings initially look similar to a QSBS transaction, it’s important to note that these gains are only deferred, not excluded, and the Daniels will be taxed when they sell their QRP in the future.

To eliminate taxes, the Daniels could combine their ESOP with other capital gains saving strategies like Tax Loss Harvesting. If they pulled that off, they could sell their business tax-free and then slowly sellout of their QRP portfolio without realizing any capital gains.

What are the drawbacks of an ESOP?

While ESOPs provide significant benefits to both employees and seller, there are a few drawbacks to consider:

• Administrative Fees: specific laws related to an employee trust owning the firm cause annual administrative fees to be incurred.
• Annual Valuation: one of those fees is the requirement that the firm be valued annually.
• Valuation: Sometimes, the trustee will not be able to pay the same valuation that an open market buyer could pay.

Does an ESOP Work for You and Your Business?

We’ve spent a lot of time talking about ESOPs, how they work, and their tax benefits today, but we haven’t discussed the single most important piece in detail – you and your employees.

Wanting to leave your business to your employees and trusting that they can manage the business are the single most important pieces to a successful ESOP transaction. Interestingly, but not surprisingly, many studies have shown that ESOP owned firms tend to grow faster and have better employee happiness.

To make this happen, early, open coordination with your trusted managers is key. And if you don’t have a strong team who can pick up the slack when you’re gone, an ESOP may not be the right fit.

How to Set up and ESOP?

• Review all available strategies
• Model out financial scenarios
• Locate an ESOP Specialist Advisor
• Complete Feasibility Study
• Complete Valuation
• Engage Trustee
• Sell Business to ESOP

How Ironclad Guides Your ESOP Journey

Determining if an ESOP is right for your business requires analyzing your financials, team capabilities, and personal goals. At Ironclad Wealth Management, we start with a comprehensive review of all exit strategies before recommending any single approach.

If an ESOP is the right strategy for you, we will assist with financial modeling, coordinate with your ESOP advisor and trustee, and assist with the investment management of your QRP. By integrating all of these steps, we can make the process as smooth as possible. If at any point it becomes apparent that an ESOP isn’t right for you, we can course correct and pivot to another strategy.  

Schedule a tax deferral consultation with Ironclad Wealth Management to see if a ESOP Transaction or another strategy is right for your transition.

Want to Keep Reading more about saving capital gains on your business sale? Check out our blogs on Asset vs. Stock Deals, Installment Sales, Structured Installment Sales, Qualified Opportunity Zone Funds, Tax Loss Harvesting, Charitable Remainder Trusts, and Qualified Small Business Stock Exclusions (QSBS).

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