ESOPs as a Succession Plan

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Davis Wright Tremaine LLP

Succession planning, the art of ensuring that a family business successfully outlasts its founding generation, is a perpetual issue for family business owners. Employee stock ownership plans (ESOPs) can be a valuable, but often overlooked, succession strategy.

What Is an ESOP?

As the name indicates, an ESOP is a vehicle through which a company can give its employees stock in the company. To implement an ESOP, a company must set up a tax-qualified plan and trust (like a 401(k) plan)—with a key difference being that an ESOP is designed to be primarily invested in employer stock. (Note that ESOPs require corporate stock, and so employers that are partnerships or LLCs taxed as partnerships cannot implement an ESOP without first adding a corporate entity to the mix.)

The company can then deposit one of two things into the trust: (1) newly issued stock, or (2) cash with which to buy previously existing stock. Family businesses using an ESOP as a succession tool will typically implement that second option. Once the cash is in the trust, it is used to buy shares from the company's founders, resulting in the shares being held in the trust and owned by the ESOP for the benefit of employees participating in the ESOP.

ESOP shares are typically allocated in proportion to a participating employee's compensation (for example, all participating employees might receive an ESOP allocation for the year equal to X percent of their annual compensation). In some instances, ESOP stock is allocated as a matching contribution, based on employees' elective contributions to a 401(k) plan.

Upon a termination of employment, the ESOP participants have the right to request that their ESOP account be distributed in the form of company stock, but there are exceptions to that general rule. For example, if the company's bylaws restrict stock ownership to only active employees and the ESOP, then departing employees will receive cash, not stock, as an ESOP distribution.

In addition, participants in the ESOP of a privately held company also have the right to "put" their ESOP shares back to the company for repurchase at fair market value. This ensures that participants in an ESOP of a closely-held company have access to liquidity for their otherwise illiquid ESOP stock. And because there is no public market, the ESOP of a privately-held company must obtain an annual valuation of the company's stock by an independent appraiser.

In short, an ESOP can be a tool to enable the owners of a family business to cash out and remove themselves from the business, in whole or in part, while rewarding their employees with full or partial ownership of the business—and keep the company independent.

Advantages to Using an ESOP as a Succession Strategy

Taxes

ESOPs provide significant tax advantages. First, if certain conditions are met, owners who sell their shares to an ESOP have access to unique succession planning strategies. According to I.R.C. 1042, if the owners of a C-corporation sell at least 30 percent of their company to an ESOP, the owners will defer tax on any amount from the sale that they reinvest in "qualified replacement property." Qualified replacement property is defined as certain securities issued by domestically operating companies.

Essentially, family business owners who have held their shares for a long time and realized massive gains on those shares can delay paying taxes on those gains if they sell to an ESOP rather than a third party. (Taxation will eventually occur when the individuals ultimately sell the qualified replacement property.)

Second, cash or stock contributions made by the company to the ESOP are tax deductible, just like other contributions to a qualified retirement plan. This means that when a company puts money in the trust to purchase shares from the owners, it is reducing its tax burden.

Culture

Selling to an ESOP rather than a third party comes with at least two distinct cultural advantages for the company. First, the friction that inevitably comes when combining two businesses is avoided—the company is able to run the same way it always has.

Second, employees with an ownership stake in the company are more invested in its success as they will directly receive benefits from an improved bottom line. This can invigorate a workplace and encourage employees to reach new heights.

Conclusion

ESOPs are complicated (very complicated), and cost more to implement and operate than other types of qualified retirement plans. This summary does not intend to address the many factors that should be considered before adopting an ESOP.

However, successfully navigating an ESOP's intricacies can be extremely worthwhile, and can prove to be an excellent succession strategy for the owners of family businesses.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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