Baby Boomers currently own 66 percent of all private businesses that have employees. Those Baby Boomers are now reaching retirement age at a rate of 10,000 per day. An estimated $10 trillion (that’s with a “t”) worth of businesses will change hands in the next 10 years. For Baby Boomer entrepreneurs with no inheritance option (Boomers had fewer children than their parents), succession and the associated liquidity needs require a solution.
Possible solutions include a sale of the business to a “strategic buyer,” a venture capital group or incumbent managers (a “leveraged buyout”). These transactions may make sense but they all have drawbacks. Many entrepreneurs hate to see their business legacy absorbed in a disruptive transaction that results in the liquidation of the business and the termination of its employees. An Employee Stock Ownership Plan offers an underutilized alternative – a solution that preserves the corporation as an on-going independent business and offers unmatched tax advantages.
What are Employee Stock Ownership Plans (ESOPs)? Think of them as ordinary profit sharing plans on steroids. ESOPs have two features that distinguish them from a typical profit sharing plan: (1) the ability to fund primarily with the sponsoring employer’s stock, and (2) the ability to borrow money. This allows the ESOP to borrow money to buy company stock (a “securities acquisition loan”) in a leveraged transaction. So, a business owner can sell his or her stock to the ESOP in a tax-advantaged transaction.
If the company is a private C corporation and you have owned your stock for at least three years, you can defer capital gains tax on the sale of your stock to the ESOP so long as you sell at least 30 percent of the outstanding shares and you invest the proceeds in “qualified replacement property.” No capital gains tax will be assessed until (and unless) you “dispose” of the qualified replacement property. Qualified replacement property is broadly defined to include stocks and bonds of any U.S. domestic operating company. That definition encompasses most of the publicly traded securities that are available to private investors – in other words, the same investments you probably already own in your personal portfolio. So, you can accelerate liquidity and diversify your investment without selling the company – or even giving up control.
Most ESOPs are sponsored by small and medium sized companies (there are over 500 ESOPs in Illinois). Do not be put off by the bad press associated with troubled ESOPs set up by United Airlines or the Tribune Company ESOP transaction engineered for Sam Zell’s takeover. And many ESOP sponsors find that, beyond the unique ESOP tax advantages, the most important ESOP advantage turns out to be improved employee morale and productivity.
Baby Boomer entrepreneurs are well advised to put ESOPs on their succession planning short list. ESOPs are flexible, require no negotiation or post transaction dealings with adversarial buyers, and they offer unique tax advantages that subsidize both the cost of borrowing and the selling shareholder’s net return. Do not let your banker (who doesn’t make ESOP loans) or a business broker (who wants his commission up front) distract you. Talk to someone who can answer your questions about ESOPs. That conversation could lead you to your ultimate succession solution.