Employee Stock Ownership Plans May Offer Family Owned Businesses Transition Opportunities


David Whaley, Esq., Dinsmore & Shohl

Employee Stock Ownership Plans are business transition vehicles that, in certain instances, can address many of the ownership transition issues existing in family owned companies. When designed correctly an Employee Stock Ownership Plan (also referred to as an “ESOP”) can create liquidity to resolve potentially contentious family business issues related to estate planning or generational transfers. While there are other transition vehicles that can offer potential solutions to address these family owned business challenges, none can do such with the desirable tax advantages available to the owners who sell to an ESOP and to the companies that have an ESOP as a shareholder while still permitting (and often requiring) the continued operation of the company by the same management team. The end result allows for a sale of the company to its employees in a tax advantaged means while offering the selling family and existing management the opportunity to continue to operate the company for the benefit of the employees.

At its base, an ESOP is a defined contribution retirement plan (an account based retirement plan like a profit sharing or 401(k) plan) which invests primarily in a company's stock. The stock is held in a trust and held for the benefit of the employees who participate in the ESOP. To facilitate the ESOP in acquiring the company’s stock, the ESOP trust is allowed to obtain a loan to purchase the company’s stock from the family owners. Then the loan is repaid as the company makes deductible retirement plan contributions to the ESOP on an annual basis.

During employment, employees are not taxed on their share of the ESOP assets, nor on their share of appreciation of the ESOP stock. Upon an employee's departure from the company, the stock in the employee's account is purchased by the company from the employee at fair market value and those proceeds can be rolled into either an IRA or another qualified plan – allowing the employee to utilize the proceeds for retirement savings.

An ESOP offers the potential for significant tax advantages to a selling shareholder as well as to the operating company following the sale to the ESOP. For the selling shareholder, subject to certain requirements, federal law permits the seller to incur no taxable gain on the sale of the company’s stock to the ESOP. Then, the replacement property purchased with the proceeds of the sale to the ESOP will receive a carry-over basis, thereby deferring tax until its later sale. Furthermore, if the replacement property is held until death, there is the potential to eliminate the tax entirely through a step-up in basis.

In addition, the taxable income of the company can often be eliminated or greatly reduced through a deduction of retirement plan contributions at the maximum amount permitted. Realize, these contributions are immediately utilized to re-pay the loan utilized to obtain the stock of the company. The tax advantages are even greater when the company elects to be taxed as an S-corporation. In that instance, the profits of the company which are attributable to the company’s stock held by the ESOP are retained by the company tax-free. This is because the typical pass through of the tax liability to the shareholders of an S-corporation doesn’t result in the payment of any tax liability for the shares owned by the ESOP trust since the ESOP trust is a tax-free entity which is not typically subject to tax liability.

Finally, unlike other business transition strategies, an ESOP will often provide for the continued operation of the company in the same means in which it was operated prior to the sale. For example, a sale to a strategic purchaser will often result in a loss of jobs. In addition, a sale to private equity fund will often result in significant corporate reorganization. In contrast, a sale to an ESOP typically results in a desire to have the company continue on the same trajectory in which it was operating prior to the sales transaction. Thus, the company often continues to be operated on the same basis as it was prior to the sales transaction with largely the same board of directors and management.

Thus, a sale to an ESOP can provide significant benefits both to the shareholders of a family owned business and to the company and is a strategy that should be investigated by any family owned company that is investigating the potential of a business transition.