Taxation is a key planning element when selling a business. And while crowing to your golfing pals about the great price you got feels good, keeping more of what you get feels even better. Whether you sell via an IPO, merger, or third-party transaction, read on if keeping more of what you make is of interest.
We don't have to tell you about increased capital gains rates, the ACA surcharge and growing state income tax rates. This environment has prompted more and more business owners to look for tax advantaged sale structures. For those with transition goals that include more than just price, there is no transaction more efficient than selling internally using an employee stock ownership plan, or ESOP. ESOPs allow: 1) sellers to indefinitely defer their capital gains tax, 2) employees to receive a deferred retirement benefit and 3) companies to eliminate federal and (most) state corporate income taxes. While tax efficiency isn’t the only criteria for a sale, it’s a strong motivator.
Consider the following example of a company generating cash flow of $3MM. Assume the valuation is 6X cash flow and the company has no debt. This yields an enterprise and equity value of $18MM. The business is a C corporation, has asset basis of $4MM and the owner has a stock basis of $3MM. We’ll further assume an offer has been presented from a third-party and the owner is comparing a sale of assets or stock to the third-party and an ESOP.
The following table summarizes the after-tax proceeds from different transaction types.
Your CPA reports back that after paying corporate and personal taxes you’ll take home $9.5MM in an asset sale and $13.7MM selling stock. They also report a sale to an ESOP incurs no corporate or personal taxes and thus yields $18MM on an $18MM sale price. Lots of owners using the ESOP say they’d likely get a better return by sharing with their employees than the state and federal taxing authorities.
To look at this example differently, let’s calculate the sale price needed to net the same $18MM. Using the same assumptions as before, you can see an asset sale to the third-party would require an 83% premium to the ESOP sale and a 33% premium to the stock sale.
This analysis focuses solely on the owners’ proceeds, but let’s also consider corporate taxation. For more than 10 years, an ESOP has been an eligible shareholder of an S corporation. We all know the S-corporation is a flow through entity and is taxed at the shareholder level. But did you know the ESOP doesn’t pay taxes? Imagine a 100% ESOP owned S-corporation. Can you say ‘tax free company.” In 2000, only 5% of ESOPs in the US owned 100% of their companies. Today that number is over 45% and you can see why.
Eliminating corporate taxes frees up cash flow to repay debt faster. On average, we see a comparative difference of 2-3 years. Once the buyout debt has been repaid, the tax holiday doesn’t go away (as it does when a financial buyer purchases the business). Imagine again competing without the burden of corporate taxes.
Keep in mind that the government isn’t giving away the store. Despite all the current tax savings, it will ultimately realize its income when employees are cashed out of their ESOP accounts and pay income taxes. Done correctly, everyone wins!
While this blog has focused on the extraordinary tax benefits afforded ESOPs, we know there are other equally important criteria as well. If you are considering how to transition the ownership of your business and would like our perspective on whether or not a sale to an ESOP, makes sense for you, give us a call.