ESOPs: A Compassionate Business Succession Opportunity

At some point in time, every company must either be sold or liquidated. There is no alternative.

Most business owners will agree that a properly structured and planned business transfer is preferable to liquidation. Most employees happily agree!

Let’s take a closer look at ESOPs, their role in business succession, and how the tax-efficiencies of life insurance make it an ideal ESOP funding tool.

Options for Business Succession

In some settings, owners of family businesses find it desirable to transfer their ownership interest to the next generation. While this is a common goal, studies show that only approximately one third of companies survive the second generation, and just over 10 percent make past the third.

Some owners decide to sell their company to a competitor. While such a transaction may optimize profits to the former owner, the consequences for employees and on company morale can be devastating. No matter how good the intentions, many such mergers lead to significant job reductions as employees in overlapping departments are cut. It can also be extremely difficult to integrate the corporate cultures of two former fierce competitors.

There is kinder, gentler solution that avoids many of the pitfalls that come with intra-family transfers or sales to a competitor: Employee Stock Ownership Plans (ESOPs).

ESOPs are unique business succession vehicles in that they benefit company owners, employees, and the communities in which they reside. Because of the favorable social aspects of such business transitions, ESOP companies gain access to unique qualified tax benefits not available to other forms of ownership succession.

ESOPs – A Defining Act of Greatness for Business Owners

Good prospects for discussions about ESOPs are benevolent business owners who approach retirement age. An ESOP enables them to transfer their ownership to the individuals who helped build the company, their employees. In exchange, they receive fair market value for their firm, gain access to unique tax benefits, and are able to finance a secure retirement.

Let’s take a closer look at how ESOPs benefit owners and their employees.

Benefits to Company Owners

ESOPs have several unique features that immediately benefit company owners.

For one, ESOPs establish a fair market value for privately held company stock. The owner sells some or all of the stock to a special tax-exempt trust, creating an immediate personal fund for retirement. The sale of company stock to the trust is financed with pretax profits the company will earn in the future. This tax benefit is unique to ESOPs and is designed to reward company owners for electing a socially beneficial business transfer.

There are many ways to structure an ESOP. Owners who are not ready to retire can retain full control and continue to participate in company management, grooming future leadership to take over at an appropriate time.

Many owners take great comfort in knowing employees will eventually be empowered to make decisions about the future direction of the company, continuing to build on the foundation they have laid through decades of passionate labor. They know that future employee-owners will think and act like they did when they founded the company, always looking for ways to improve the company.

In stark contrast, there is no such guarantee when an owner sells to a non-employee successor owner, to a competitor, or even to family. While those new owners may promise to retain the existing corporate culture, short-term profit motives often interfere with those lofty goals.

An ESOP leaves company control with those who helped build it, enabling employees to focus on long-term growth rather than extracting short-term profits. In doing so, they will continue to build on the legacy left by their company’s founder.

Beyond the emotional reward of transferring their company to its employees, business owners may also be able to defer or even avoid capital gains taxes on the sale of their stock.

Benefits to Employees

ESOP companies provide many emotional and financial benefits to their owner-employees.

On the financial end, employees often gain access to retirement savings not available to employees of non-ESOP companies.

Employees also benefit from the improved performance by their colleagues. Being a company owner has a powerful way of changing attitudes. Company owners work harder and smarter than non-owner employees, accelerating company growth, increasing profits, and leading to an increase in the value of the shares they own!

Based on the social benefit provided by ESOP companies, government provides unique tax incentives that provide low-cost resources not available to other companies, bolstering profits.

On the financing end, borrowing costs are often reduced for ESOP companies, facilitating investments, or enabling acquisitions that accelerate company growth.

ESOP companies are also well-positioned to acquire the industry’s top talent. Employee-owned companies usually allocate stock distributions based on employee performance. As a result, ESOP companies are well positioned to attract, retain, and reward top talent, leading to growth other companies can only dream of.

There is also an emotional lift that comes from working for a company in which one is part-owner. This additional motivation often leads to accelerated company growth, higher profitability, lower employee turnover, and therefore higher incomes and better benefits.

Retirement savings for employees of ESOP companies typically exceed those available at other companies. When a plan participant terminates, becomes disabled, reaches a certain age, retires, or dies, the ESOP sells the stock allocated to the employee’s account back to the company and distributes the proceeds to the employee in cash.

There are also several non-financial benefits to employees of ESOP companies. Economic stability is a key benefit. Employee owned companies tend to make decisions that benefit employees! This usually means it is highly unlikely that a company will require everyone to move to another state to take advantage of temporary tax incentives. Employees gain peace of mind, knowing they can reside in their community for the long term.

During economically difficult times, ESOP companies tend to be more protective of jobs relative to other companies. Job security is key to the emotional well-being of all employees.

Finally, ESOP companies are also less likely to go bankrupt relative to companies with other forms of ownership, creating additional appeal to both current and future employees.

ESOP Considerations & Implementation Steps

By now it should be obvious that an ESOP based business succession strategy provides countless emotional and financial benefits for company owners and their employees. Thousands of ESOPs exist benefitting approximately 10% of the private workforce.

Assuming the benefits of an ESOP are at least of some appeal, under what circumstances does such a transfer of ownership make sense?

A lot of that depends on company size, structure, and financial stability and where the owner sees him or herself relative to retirement goals. Also, who does the owner feel will be most capable to make good decisions for the company when he or she either wants to retire or is otherwise unable to continue due to poor health or worse?

If answers to those questions point toward an ESOP, the following tasks become relevant:

• Preliminary company analysis to determine if an ESOP makes sense; if so:
• Company facilitates the formation of a tax-exempt ESOP trust
• The trust is funded by the company or via loans from the seller or a bank
• The trust purchases some or all of the stock from the retiring owner(s) at FMV
• The trust allocates company shares to employee retirement accounts
• When an employee leaves, becomes disabled, reaches a certain age, retires, or dies, the company purchases the stock allocated to the employee from the ESOP for cash; the ESOP then distributes the cash to the employee.

One highly effective tool that provides for liquidity exactly when needed to fulfill the obligations under the last bullet, usually referred to as the ESOP’s repurchase liability obligation, is tax-favored, optimally structured, cash value life insurance.

ESOPs Supported by Life Insurance

A new life insurance product has been developed for ESOPs in order to overcome some of the hurdles associated with traditional cash value life insurance. In traditional policies, it takes between 5 and 10 policy years before the cash value equals premiums paid, having an adverse impact on the corporate balance sheet for that time.

The new product has done away with all surrender charges and credits earnings immediately. The CFO does not record an insurance expense; instead he/she books an immediate increase on the balance sheet.

Policy earnings are competitive with similar liquid conservative asset classes – but can be accessed tax free, immediately. These unique policy features allow a business to acquire significant life insurance policies without expense; the corporate balance sheet will simply list an “other asset” that immediately reflects increased value.

Ideal ESOP participants on whom life insurance will be most relevant include:

• Executives pre-retirement, up to age 69
• Management employees with incomes > $75,000 (including bonuses, profit sharing)
• Groups of 10 or more participants may qualify for guaranteed issue coverage

Life Insurance Benefits for Established ESOPs

Repurchase obligations for newer ESOPs are often relatively minor. Many companies plan to fund early obligations out of cash-flow. However, as the ESOP – and its participating executives – mature, repurchase liability obligations steadily increase. Life insurance becomes an increasingly effective tool to meet these recurring predictable funding needs. Thus, many existing ESOPs also acquire life insurance.

For existing ESOP companies, answers to the following questions are helpful in developing life insurance models to provide the liquidity needed to meet repurchase obligations:

• When was the ESOP established?
• Was a repurchase obligation study completed when the ESOP at that time?
• Date of the most current repurchase liability study?
• How is the company paying for retirements (stock repurchases) from the ESOP?
• Working capital/cash flow?
• Asset/sinking fund “earmarked” to pay for these retirements?
• Company-owned life insurance (COLI)
• To provide cash to assist with retirements (stock repurchases)?
• Or – as a cost recovery vehicle to help the company be reimbursed for payments out of cash flow?
• Was/is any portion of the ESOP transaction backed by bank financing?
• If so, does the bank require life insurance coverage on any the key executive and/or the prior owner(s) of the company?
• Does the company currently own life insurance on owners or key executives?
• Are there key executives, technical employees, sales personnel the company would want to provide incentives to in order to encourage them to stay with the company long term?
• What special programs does the company current use to attract, retain, and reward key executives?
• What is the tax structure of the company?

Exploring ESOP Opportunities

Every business must eventually be transferred or liquidated. Most business owners – and their employees - will agree that a properly structured, orderly, and properly funded transfer of ownership is preferable to liquidation.

For some privately held companies, ESOPs represent an ideal business succession vehicle. While such transfers are extremely beneficial to company owners and their employees, they are also complex. ERISA, IRS rulings, and DOL requirements must be followed to ensure plan integrity for the benefit of the company and fair treatment of its employees. While these regulations are beneficial, they do require ongoing work with a competent team of ESOP specialists.

We work with a number of experienced ESOP teams around the country. If you are interested in learning more about ESOPs, or are interested in assessing whether an ESOP could become your vehicle of choice for business succession, connect with me and let's explore appropriate options.