Employee Stock Ownership Plans Deserve a Close Look for Business Transition: Part Four
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by Corey Rosen, Founder, National Center for Employee Ownership
In previous articles
, I have discussed using an Employee Stock Ownership Plan (ESOP) for business transition. These plans have exceptionally strong tax benefits, but they are not right for every company. Some employers will want instead to sell to a few select employees. There are no tax advantaged ways to do this, and it can be a financial stretch for employees, but many successful transitions have been done this way.
There are several ways to sell to employees:
- Direct sale for the entire value: Here the employees would buy the company outright out of their own assets, which usually would mean substantial personal borrowing. These kinds of sales are unusual because of the considerable cost and risk involved. The employee money is after tax and is treated as a capital gain to the owner.
- Gradual sales: Here the employees buy the shares year by year, either out of their own after-tax dollars or foregone bonuses. The tax treatment would be the same as in a direct sale.
- Installment sales: The seller takes a note that is repaid by the employees with interest over time. If cash flow from the business is used to reply the note, principal is not tax-deductible to the company. The interest may or may not be deductible. If the employees pay the note, it is out of the after-tax dollars. The sale can be structured so that the seller takes capital gains tax treatment. There are a number of issues in installment sales, such as the interest rate determination, the structure of the promissory note, contingencies on their use of corporate cash, the role of the seller going forward, and security for the note.
A variation of this cancels the remaining value of note if the owner dies. The purpose here is to remove the asset from estate taxes, albeit many small businesses will be under the state tax exclusion anyway.
- Intentional Grantor Trust: Here the owner sets up a trust that buys the business, usually with an installment sale. The seller pays no capital gains taxes because the assets are considered held by the trust, but income from the trust is taxable as ordinary income. The main benefit of an intentional grantor trust is that the value of the asset is removed from the seller’s estate.
- Private Annuity: In this case the buyer gets a proposal for an annuity for the rest of the seller’s life. The value is not included in the seller's estate. A present value for the annuity is calculated at sale, and the buyers would pay for it out of after-tax dollars.
Regardless of how the sale is financed, there is the issue of to what extent the sale can be structured as a lease of assets (tangible or intangible) so that the company can repay the loan for this amount in deductible dollars (in which case the seller pays ordinary income taxes) versus a sale of the assets, which can qualify as a capital gain for the seller buy must be financed by the company or the employees in after-tax dollars. Another alternative is for part of the sale to be some combination of employment agreement, non-compete agreement, and/or payment for services in the board. The sale may also include some kind earn-out or similar provision as part of the sale price so that what the owner ultimately gets depends on how the company performs.
As with any business transaction, it is critical to get highly qualified advice from an expert in exit planning.
About Corey Rosen:
Corey Rosen is the founder of the National Center for Employee Ownership, a nonprofit information, membership, and research organization. Details on all forms of employee ownership can be found at www.nceo.org
Employee Stock Ownership Plans Series
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