ESOPs And Business Succession

Business owners who are used to making difficult decisions about running their companies, often become confused and frustrated by succession planning.

Business owners who are used to making difficult decisions about running their companies, often become confused and frustrated by succession planning. One reason is that business succession decisions are subjective and can’t always be measured by numbers. Another reason is that good succession planning forces owners to consider their values and how they will spend their time and money for the rest of their lives.

The following questions may be helpful to an owner of a private company who has considered involving their employees as part of a business succession plan.

1. How can I make wise decisions about ownership succession if I am not ready to give up control of my company?

Business owners are rarely ready to give up complete control of their companies and as a result, they procrastinate until it’s too late. The solution is to start early with a process of ownership succession that initially requires giving up only a small amount of ownership and no control. This approach sends the message to key stakeholders that you mean business and will follow through with your succession plan. A partial sale to an Employee Stock Ownership Plan (ESOP) allows an owner/seller to convert some stock to cash while retaining 100 percent control of the business and the right to remain working in the company if they choose.

2. How can I maintain family harmony through business succession if I already have conflicting goals within my family? 

If there is family conflict now, imagine the problems that may develop if an owner wasn’t around to mediate. With divorce rates in excess of 50 percent, it’s no surprise that most families in business struggle with conflict. Sixty-five percent of all planning failures are the result of lack of trust and communication, which can be improved through family wealth counseling and coaching through a values-based approach to business succession that includes all family members.

3. What are the tax and financial advantages to an owner who sells to an ESOP? 

The owner of a regular or "C" corporation may sell to an ESOP and elect to permanently defer capital gains taxation on 100 percent of the sales proceeds provided a few simple rules are followed. In addition to capital gains relief, the owner can take a business tax deduction for 100 percent of the cost of financing their own buy-out. For the owner of a sub-chapter "S" corporation, the tax advantages are slightly different. Instead of capital gains relief, the owner benefits from an unusual tax provision that allows the stock sold to the ESOP to become permanently tax exempt. If 50 percent the company is sold, then the company’s tax bill would be cut in half permanently.

4. If there were no tax advantages to an ESOP, would it still make sense to do one?

ESOPs allow an owner to sell all or part of their company and yet remain in control for as long as they want. The key is flexibility. An owner who makes a partial sale to an ESOP has many options including:

  • Keeping ownership at the same percentage.
  • Increasing ESOP ownership through a future sale.
  • Reducing the ESOP through stock redemptions as people leave the company.
  • Bringing family members into the business and giving them ownership or control.
  • Selling the entire company including the ESOP to a third party.

5. Is it true that ESOPs are expensive and very complicated?

ESOPs are no more complex or expensive when compared to other approaches to business succession. 401(k) plans governed by complex ERISA rules are well received by owners and employees alike. ESOPs are easy to understand with the help of professional advisors who specialize in them. The complexity and cost of finding the right outside buyer can be frustrating for an owner. While an ESOP transaction might cost between 3 to 5 percent of the total amount sold, a third party sale can easily run 20 to 25 percent when you factor in all transaction fees and taxes. The bottom line is that while ESOPs are complex, they eliminate many of the obstacles that keep owners from making wise business succession decisions. With proper guidance, ownership transition can be completed successfully and in a timely manner through ESOPs.

6. If I want the best price for my company, is an ESOP the right approach for me?

A sale to an ESOP usually results in the best after-tax price for the owner. There may be situations where a strategic buyer will be willing to pay a premium above what an ESOP can pay because of a special desire for your business. More often than not, however, the flexibility available through an ESOP sale outweighs the premium a strategic buyer may be willing to pay.

7. If ESOPs are so good, why aren’t more companies taking advantage of them?

Although employee ownership has been around for a long time, the tax incentives that created ESOPs as we know them today have only been around since 1984. ESOPs are not well understood by many owners and their professional advisors and as a result, are not recommended as often as other forms of business structure. While they initially may appear complex, anything worthwhile is worth the extra effort to understand. Ultimately, they appeal to business owners who care about their people. As more owners realize the value of protecting the human capital in their companies, more will turn to employee ownership as the preferred method of business operation and the ultimate tool of business succession.

Richard Tanner has written and lectured extensively on the topic of relationship solutions and ESOPs in the financial services industry. He can offer ways to avoid legal dispute in family trusts cases and is an expert in mapping out family wealth peaceably. Mr. Tanner can be reached at (216) 328-5538 or via e-mail at rtanner@ownershipadvi-sors.com.