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Employee Stock Ownership Plan: Understanding the Business Succession and Financial Planning Benefits

Brittany Taylor, CFP®


On February 24, HBKS Wealth Advisors presented a webinar offering insights on the advantages to employers and employees of an employee stock ownership plan (ESOP). The panel of experts discussed the challenges many business owners face with succession planning and personal financial planning, and the solution an ESOP can provide.

Ashleigh and Drew Walters purchased Onex, a 50-year old, Erie, Pa.-based custom furnace manufacturer, from Drew’s father in 2018 after leading a turnaround beginning in 2013 that included resolving operations issues and improving financial performance. They began planning their own succession soon after purchasing the business in order to ensure business continuity for their clients and employees should they be unavailable to manage the business.

Moderator. Why should a business owner plan early for succession?
Taylor. I work with families on their financial future and ultimately it’s planning that sets you up for success. You need to plan to meet your goals, and the earlier you start, the better chance you have of reaching those goals. Business owners are often so focused on their businesses that they fail to address their personal situations. If they don’t plan ahead, they can wind up unprepared for retirement and having to put aside an exorbitant amount of money as they near retirement or work a lot longer than they had planned.

We’d love for all businesses to be successful, but that’s not always the case. Unforeseen circumstances can present themselves; many businesses were lost to the pandemic. You have to think outside of your business. What if things don’t go as planned? What do your retirement and future look like? We help business owners determine what their resources are and what we can do with those resources to help them secure their future.

Zugell. Starting early gives you options. It doesn’t mean that you’re walking away from your business early. Ashleigh and Drew aren’t going anywhere soon, but they have acted to control their own destiny, not letting circumstances control what they do.

Walters. We didn’t want to have to rely on someone to make a hasty decision if something should happen to Drew and me.

DiGirolamo. At HBK we work with many owners of family businesses. With proper planning, you can avoid issues like liquidity problems should an event require a sale or transfer of ownership. It’s a conversation we like to have with all business owners no matter the stage of their business.

Moderator. What is an ESOP and how does it work?
Zugell. First, it’s important to mention that it is different from employee stock options. An ESOP is a qualified retirement plan, like a 401(k), and covered by the same regulations. But while the 401(k) takes employee dollars and invests them in mutual funds, an ESOP’s primary investment is the stock of the sponsoring company. The ESOP is designed to provide liquidity to selling shareholders and to benefit employees who don’t have to make out-of-pocket contributions. There are extensive tax incentives for businesses to sell at full market value to the ESOP retirement plan and those tax benefits offset whatever financing or loans are required by the employees to buy the company stock from the shareholders.

How it works: The ESOP borrows money from a bank to buy stock from the selling shareholders. The company makes a contribution to the ESOP retirement plan every year, and the ESOP uses that money to pay off the loan. The tax benefits allow the company to make those contributions without stressing its cash flow needs.

Walters. We were on a path to understand our options for selling the company when the time came and considering what the company needed to look like in the future to make that transition. For us as a family, there were succession planning options that had some tax advantages, but ultimately the ESOP was the most comfortable for us.

Moderator. Why not sell to an outside third party?
Taylor. It may be difficult for a buyer to come up with the financing needed to buy a company. So the seller has to agree to a deal for getting some money now and the rest over time. But if the business doesn’t do well after the owners’ departure, the buyers can find themselves in bankruptcy and the original owners don’t get their full value. That is a risk.

Walters. For us, it just didn’t feel good. We heard so many horror stories of private equity coming in, stripping out the cash, then selling it again. An ESOP allowed us to keep our business here in Erie with the same management team and employees. It also ensured that our family-centric culture remained intact. For every 1 manufacturing job, there are 4 support jobs created in the local community. This is why manufacturing is so important to our towns and the local economy.

Zugell. ESOP companies keep jobs and the businesses in their communities. You have to feel good about that. It’s an admirable position.

Moderator. Did you consider moving the business along to the next generation?
Walters. Studies show that only 13 percent of third generation ownership is successful. I would encourage anyone considering keeping the business in the family to ask the children if they love the business. You don’t want it to be something they fall back on or feel obligated to do.

Taylor. Sometimes parents will have to take it over again if the kids aren’t engaged. The parents often stay working a lot longer than they wanted to just to keep the business going.

Walters. Our boys are just 9 and 11. We don’t know what they want to be when they grow up. But we did talk to them and ask them how they felt about it. They didn’t know how to feel about it, but we had a family conversation and they supported it—and they attended the party announcing the ESOP.

Moderator. What role does the family play in an ESOP? Do the employees now run the company?
Walters. We simply expanded the definition of family. We’re keeping the family name and legacy intact. In practice, the family still runs the company. In the ESOP world you can sell as much of the company as you want and still run it and protect proprietary information. We share information with employees about growth and show how performance affects the value they have in the company. Information and communication are important.

Culture for us was a guiding principle. In any merger or acquisition culture is an important piece.

Moderator. What are the tax considerations and benefits of an ESOP?
DiGirolamo. You need to consider the tax ramifications of any business sale. With ESOPs, there are some significant tax benefits to buyer and seller. It starts with structuring the company for tax purposes pre-sale. Many businesses we serve are taxed as S corporations, where income flows to the owners who pay the taxes. In a C-corp, the corporation itself is the taxpayer. There are benefits to both to sell to an ESOP.

When the business is an S-corp, the ESOP as a qualified retirement plan is not subject to tax on the business income. That income can be helpful to the seller because the seller is receiving a revenue stream from the sale of the stock and it helps the business to be able to meet that obligation to pay the seller. When a C-corp is sold to an ESOP, the C-corp is still the payer of tax on the income, but the seller can roll the cash from the sale to other stock investments and defer the gains on the sale. The seller can roll the proceeds over to a diversified portfolio and defer paying taxes as long as they hold the stock they have reinvested their proceeds in.

Zugell. The tax advantages provide the cash flow for the sale. The company no longer has to give owners money to cover their tax obligations since the ESOP, as the new owner, is exempt from federal and state income tax on profits. The company can use the money to pay off the loans on the debt that was incurred to buy up to 100 percent of the company. Most ESOPs are 100 percent sales because they can use what otherwise would be tax dollars to pay off the loans. For employees, the ESOP buys the stock and when you retire you can cash out your stake and roll the money into a tax-deferred IRA.

Taylor. These are additional dollars provided to employees they wouldn’t otherwise have. They can participate in the upward mobility of the business and benefit from that continued growth.

Moderator. Is this all too good to be true? Could government do something to take away the tax benefits?
Zugell. Both the federal and state governments like ESOPs. There’s no talk about getting rid of the tax benefits, only of adding benefits. Employees are getting something they deserve. Governments like that people are being taken care of, that there will be fewer people they need to take care of later on. The tax revenues they‘re giving up are compensated for by employees paying taxes on their bigger paychecks.

Moderator: Who are the best candidates for ESOPs?
Zugell. There are expenses associated with setting up an ESOP and keeping it going, so you have to make sure the company can absorb that. The business should be about $5 million or more in value with 20 to 25 or more employees and at least a million-dollar payroll. There are contribution limits in terms of percentage of payroll. You need a critical mass and positive cash flow. With that being said, tax-free profits go a long way in supporting cash flow.

Moderator. What’s the best time to sell to an ESOP?
Zugell. When you’re thinking about taking some chips off the table. It will take five to ten years to get all your money from the sale. This does not mean that the sellers cannot reduce involvement as desired.

Taylor. That stresses the importance of planning early.

Moderator. Are there other keys to a successful ESOP?
Walters. Honest, transparent communication. Our leadership team knew that Drew and I were considering an ESOP. We didn’t want false rumors circulating. We pulled our leaders in and assured them we were not selling outside. We had Kevin McPhillips from the PA CEO come in and explain and answer questions just prior to the pandemic and shutdown. Drew and I continued with the ESOP transition even during the pandemic because it still made good business sense.

Zugell. Culture, caring about your employee, cash flow, and communication are the keys.

Moderator who actually benefits from the sale to an ESOP?
Walters. As owners we had the opportunity to transition the business but not in a traditional way. Statistics show that employees with an ESOP will have two and a half times more retirement money than through their 401(k). And our business will remain here in Erie for generations to come.

Zugell. It’s important to the community to keep those jobs that often go away in a third party sale. That’s fewer people requiring a government safety net. And you can still do things like supporting local charities that a third party might not do. We got legislation passed in Pennsylvania to increase the tax benefits because they recognized it was good for the community.

DiGirolamo. ESOP owners and participants get the benefits of acquiring an entity with after tax dollars and getting 100 percent of the profits from the business.

Moderator. Is there any benefit to consider an ESOP now?
DiGirolamo. There are tax reasons for considering a sale in 2021. We’ve had relatively low tax rates for years, but rates might be increased to cover the costs of the COVID-19 relief responses. In sales of businesses, capital gains are a key consideration. There is talk in Washington of limiting capital gains on sales over a certain threshold. We could see changes in 2022 or after, so 2021 seems to be a good year to sell and get the benefit of current low tax rates.

Zugell. As of now, if you’re selling to an outside party, you have 10 months to find a buyer, make the deal and close the sale. An ESOP’s a lot faster. You can get it done effectively by the end of this year.

Moderator: Any other advice to owners thinking about their succession plan?
Walters. Start early; don’t wait till you’re ready to retire. Plus, you need a good team of knowledgeable professionals behind you; you can’t do all this on your own. Also, understand that this is an emotional process, so do it early when you can control the process and the emotion.


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