Legal Watch: ESOPs as a Transition Plan

Nov. 5, 2014
Employee stock ownership plans can be a succession alternative for closely held companies

Most owners of closely held companies struggle to transition from their businesses. Should they take a smaller role, retire or sell a business that may have been the focus for a large portion of their working lives? Owners want the economic rewards of a lifetime of work, but have also developed strong feelings of identity with their companies and a sense of loyalty to both employees and customers.

Stable exit, with continuity of management and customer service may be as important as fair market value and liquidity to transitioning owners. These all may be hard to guarantee with outside buyers, who may want to acquire the company for its assets and accounts, or who may just want to eliminate a competitor. Some advisers also predict that, as Baby Boomers begin to retire in record numbers, the increased supply of family-owned or closely held businesses for sale may outpace demand, potentially causing depressed purchase prices and longer timelines for sales.

Employee stock ownership plans, or ESOPs (“e-sop”), can be an effective and tax-efficient succession alternative.

The Advantages

With ESOPs, transitions can be effectuated all at once or gradually, for as little or as much of the stock at a time as the owners prefer — enabling owners to remain with the company in whatever capacity they want and for as long as they want before ultimately selling control.

ESOPs are also advantageous for employees, since they receive shares in their company without paying directly for the owner’s shares. ESOPs can provide employees significant incentive to excel at their jobs.

Changes in corporate control and management can also be minimal. While trustees vote the shares in the ESOP, boards appoint those trustees, so the board and the trustee can work together to promote corporate culture. The board and management continue to run the company and can decide what level of input employees should have, and customer service need not be affected at all.

In addition to allowing owners to facilitate a transition of control at the pace they desire, ESOPs permit a seller to self-finance a stock sale, even in a challenging credit market. ESOPs also offer potentially significant tax advantages, both to owner-sellers and to the companies. In certain sales, the seller can defer the capital gains on the sale of stock, and the company owned by the ESOP may enjoy a substantial reduction in federal income taxes.

Don’t forget that ESOPs are also company-funded employee benefits that both motivate employees to make their companies more profitable, and may inspire employee loyalty — an important factor in our highly competitive industry.

ESOPs are not just for small or closely held companies, either. They exist in companies across the geographic and size spectrum.

How to Set it Up

An ESOP is a qualified benefit plan — similar to a profit-sharing plan — designed to invest primarily in the stock of the employer company. The company sets up a trust into which it may contribute cash to buy existing or new shares of stock. The plan can also borrow — typically from the company — to buy new or existing shares. The company then makes cash contributions to enable the plan to repay the loan.

Regardless of how the ESOP acquires the stock, company contributions to the trust are tax-deductible, within certain legal limits. The plan owns the stock for the benefit of the company’s employees. The stock is allocated to employees on an employer-determined basis — in most cases, the ratio of an employee’s compensation relative to the company’s payroll.

Is an ESOP right for your company? Possibly. If you think you have an interest in pursuing an ESOP, you need to find counsel who specializes in these transactions, since an ESOP requires in-depth understanding of the tax laws (FYI- I have a partner who specializes in ESOPs). While ESOPs can be very effective succession vehicles, they are not one-size-fits-all solutions. One misstep could be costly and diminish the effect of its benefits.

Eric Pritchard is a Philadelphia Lawyer who spends his workday making the world safe for electronic security providers. He can be reached at [email protected]. This column does not constitute legal advice; please contact an attorney with questions. 

About the Author

Eric J. Pritchard

Eric Pritchard is a partner in FisherBroyles, a law firm with offices throughout the United States and in London. He spends his days trying to make the world safer for the security industry. You can reach Eric at [email protected].