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Is an ESOP a Viable Exit Strategy?

Employee stock ownership plans (ESOPs) can be a viable exit strategy for business owners looking to realize a fair sale price for their business while allowing the business to continue to be directed by a new generation of leaders. While many business owners have weathered the storms of previous economic cycles, the COVID pandemic has created another period of uncertainty and many business owners are thinking it’s time for the next generation to take the reins.

How ESOPs Work:

ESOPs are a specialized form of a qualified retirement plan. Similar to a 401(k) or profit-sharing plan, it’s designed to provide retirement income to plan participants. However, an ESOP also serves as a way of transitioning the ownership of the business to the next generation of leaders which allows for business continuity.

With the creation of an ESOP you are essentially selling your business to a new entity that you have created. The process initially starts with the current owners having a third-party appraisal to understand the potential worth of the business on the market, generally in the form of a range of values.  Assuming the ESOP is appropriate, the parties to the plan negotiate the final valuation of the business and meet with lenders to discuss financing. Upon the terms being finalized, the ESOP trust is formed and it purchases the stock from the owners.

The new entity is an ESOP trust that’s created to hold the shares of the company for the benefit of the employee owners. The ESOP trust is subject to IRS and Department of Labor (DOL) regulations and reporting requirements; including the regular filing of a Form 5500 Annual Return/Report of Employee Benefit Plan.

Primary Tax Benefits of an ESOP:
  • Contributions of stock are tax-deductible
  • Cash contributions are deductible
  • Contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible
  • Sellers in a C Corporation can obtain a special tax deferral known as 1042 treatment
  • In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level
  • Dividends are tax-deductible in C Corporations
  • Provides for the transfer of ownership value to employees without creating an immediate tax impact. The value transferred to employees is done through a qualified retirement plan and any amount accrued is tax-deferred.
  • Only employee distributions of their accounts are taxed and then at potentially favorable rates – similar to a 401(k) or profit-sharing
An ESOP strategy works best for businesses with a strong company culture and a next generation of employee leaders who are prepared and willing to become company executives and move the company forward. ESOPs also offer tax advantages for the business and the retiring owners that few other exit strategies can match.  However, substantial risk of failure of the business, which could have a devastating financial impact on the retiring owners, could occur if the business doesn’t have a strong culture and a next generation of suitable leaders.
For more information on determining whether an ESOP is right for you, contact Michael Ceschini, CPA, CCIFP, CM&AA, Managing Member, Ceschini CPAs.