The specialty nature of some businesses, combined with the large number of baby boomers reaching retirement age (over supply and under demand) requires that CFOs be that much more creative in their succession planning  efforts. One option in the succession planning arena can address both concerns by providing incentives for the transfer of ownership to employees. These plans are commonly referred to as Employee Stock Ownership Plans (or “ESOP’s”). Because these plans are technically administered pursuant to a tax exempt trust, they are sometimes referred to as Employee Stock Ownership Trusts (or “ESOT’s”).

While many succession planning vehicles seek to convey ownership to a third party (many times family directed), an ESOP for all practical purposes provides for the transfer of beneficial ownership to the employees without their having to invest their funds directly into the Company. As an added incentive they do so with pre-tax dollars, which is not necessarily the case in the other transfer strategies. Considering recent increases in capital gain and ordinary tax rates, CFO’s should give careful consideration to utilizing an ESOP as a viable alternative in the transition process.

ESOP’s are considered tax exempt entities for Federal and state tax purposes. As a result, a company makes deductible cash and/or stock contributions to the plan (trust) which are used to purchase company stock on behalf of employees. For this reason employees are able to obtain ownership using pre-tax dollars. This benefit theoretically enables employees to acquire up to 50% more stock than they could otherwise, with after tax dollars. On the other hand, the company receives a tax deduction for its contribution, which in turn provides the ESOP with funds to help finance company growth and create liquidity relative to future employee retirement.

Good ESOP candidates include:

  1. Privately held companies with strong cash flow and increasing sales. Because annual ESOP valuations typically involve discounted cash flow models (and often are leveraged through bank financing) , an increasing revenue stream provides the foundation to obtain bank financing and provide for sufficient annual contributions to fund loan payments and retirement distributions. In addition, ownership’s goal of exiting the business and realizing the value of the business it created typically requires outside funding.
  2. Companies with strong management. A CFO must remember that the main purpose of any succession plan is that of ownership’s exit strategy, which in turn requires a successor management team to replace the existing one. In addition should the ESOP be leveraged, lenders place a strong emphasis on continuity and the ability of the next generation of management to ultimately repay underlying loans.
  3. Companies with 30 or more employees, and a varying age base. There needs to be a balance between cash flow generated by the company, disbursements for retirement benefits, and a sufficient/talented workforce to maintain a growing operation.
  4. Companies with sufficient taxable income to warrant the related tax benefits. More taxable income (at the shareholder and/or corporate level) means greater benefits. Consider that companies receive the benefit of fully deductible contributions to the trust, which are in turn used to repay debt, support operations and fund retirement benefits, all with pre-tax dollars. Among other tax benefits, “S” corporation shares in the tax-exempt ESOT trust receive the added benefit of not being taxed.

Shareholder tax benefits can also be instrumental in electing to transfer via an ESOP. For example, under certain circumstances shareholders of “C” corporations may be eligible for tax free rollover of sales proceeds to the shares of other companies, including publicly-traded stock. CFO’s should also be aware there are disadvantages of transitioning via an ESOP. These would include:

  1. ESOP participants must be given voting rights on certain major issues.
  2. Because there is a fiduciary responsibility by the ESOP trustee, they will normally work with outside consultants resulting in increased costs, potential delays in decision making, approaches which may not be consistent with existing management, etc.
  3. Cash flow constraints, which would include outflows resulting from debt service coverage, and payment of retirement, death or disability benefits (through stock repurchase requirements).
  4. In cases of partial ESOP transfers, secondary transactions could be hindered. The scope of this article is to give a brief overview of utilizing an ESOP as a succession planning tool. CFO’s must carefully analyze the advantages and disadvantages of instituting an ESOP in their particular circumstances, and should involve their outside legal and tax advisors in making their decision.