Using ESOPs to Solve Succession Problems
Employee stock ownership plans benefit the seller, the buyer and the lender. There is no best way to transfer a closely held business, particularly when no traditional buyers--family members or other owners--are available. Since each owner's individual circumstances typically are unique, the first step is for CPAs to determine the owner's objectives. Although an outright sale to an unrelated party almost always is possible, such sales are rare because of the lack of ready buyers or the unwillingness of outsiders to pay a business's current value. As a result, most closely held businesses are sold or transferred to insiders. If family members or other owners are not interested in acquiring a business (or if there are none), the only insiders left are employees. Employee stock ownership plans (ESOPs) are an often overlooked way of transferring closely held businesses. Widely used by large corporations as employee benefit plans since they were created 20 years ago, ESOPs are tax-favored retirement plans, organized as trusts, that invest in an employer's own stock. Small companies' objectives in offering ESOPs probably are less benefit-oriented and more directed toward finding a means to transfer ownership. In a company organized as a C corporation, a closely held business owner can use an ESOP to dispose of the business while also expressing his or her appreciation to existing employees. (Proposals in Congress to extend ESOPs to S corporations are still under consideration.) An ESOP can not only meet the owner's financial goals but also enable him or her to fulfill nonfinancial objectives such as continuing the business as a going concern (as opposed to selling only the assets) and maintaining an ownership or employment role, something an outsider might not tolerate. ABCs OF ESOPs Although ESOPs formally were created in 1974, they actually date back much earlier. Complete details are covered in sections 409 and 4975 of the Internal Revenue Code. An ESOP is a qualified defined-contribution plan. Employer contributions to such plans are tax deductible. Benefits are tax deferred for employees. An ESOP must be invested primarily in securities issued by the employer (this is an exception to the pension plan rules outlined in the Employee Retirement Income Security Act of 1974). Securities are defined as common stock and noncallable convertible preferred stock. An ESOP can be either a stock bonus plan or a stock bonus plan plus a qualified money purchase pension plan. Surprisingly, ESOPs rarely are used to transfer ownership in closely held businesses. To date, there are only about 11,000 ESOPs nationwide, and perhaps 15% of them are in large publicly traded corporations. One problem may be that ESOPs are not simple entities; the rules for forming them are tricky. In addition, ESOPs are inherently risky for employees since their pension assets are invested primarily in employer securities. If the company goes out of business, employees not only lose their jobs but also their retirement funds. On the other hand, ESOPs can be motivational tools. When employees own the company, they are motivated to work harder, knowing any incremental profits accrue to their own retirement accounts. Given the apparent advantages of ESOPs, one would expect CPAs to recommend them to small business clients more often. If there is no obvious buyer for a closely held company, the majority shareholder can sell his or her stock to a leveraged ESOP (explained later). The transaction can take place all at once or over a period of months or years. The sale price must be the stock's fair market value, which requires valuation by an independent appraiser. The best part of the process is the seller can, under certain circumstances, defer taxes on any gain. IRC section 1042 allows deferral of any gain on the sale of securities to an ESOP (sometimes called a 1042 rollover) if at least 30% of all classes of stock are sold and the sale proceeds are reinvested in qualified replacement property, which is defined as stocks and bonds of U. …