Regardless of your political persuasion, most people agree that taxes for business owners are probably not heading anywhere other than up. This prophetic nugget, together with the fact that people tend to get older and not younger, suggests that entrepreneurs need to be more conscious about taxation as they evaluate ways to transition out of their businesses.
An ESOP - which provides tremendous tax incentives - is often overlooked as an ownership transition alternative to a third-party sale. There are pros and cons to ESOPs, but here are some things to think about:
- Shareholders may be able to sell their stock without any capital gains taxes due. At today's rates (which are probably as low as they may ever be), there could be as much as a 20-25% savings when considering federal and state taxes. A business owner who has a $10 million gain on the sale of his or her stock can actually keep the $2.0 – 2.5 million that they otherwise would need to pay Uncle Sam!The ESOP could be structured such that the company would be exempt from federal and (most) state corporate income taxes. Assuming marginal tax rates of 40%, a company producing $5 million of taxable income could save $2 million in taxes every year and use the savings to pay off the ESOP transaction debt.
- Private business owners can continue to operate the business without a new third-party owner breathing down their back. Many (certainly not all) entrepreneurs want to continue leading their company after selling it. This can be a source of major conflict in an out-right sale to a third party. However in an ESOP transaction, the business owner can sell his stock and continue operating the business without any cultural turmoil or micro-management hassle that might result from a third-party buyer.
- While employees receive economic value attributed to company stock, they do not own the shares directly. So, if a company has 100 employees and the business owner sells all of the stock to an ESOP, there is only one shareholder (not 100!) once the transaction is completed.
- Finally, under normal circumstances, employees are not entitled to the same information (i.e. financial statements, payroll information, etc.) that a normal shareholder might be entitled to.
The devil is in the details and there are many issues to consider, however an ESOP might be an excellent alternative. A problem we often encounter is many business owners and their advisors don't even realize that an ESOP might be a viable solution. So I encourage folks to give us a call or send us an email to learn more about what can and cannot be done using an ESOP.