America’s federal deficit has grown significantly in recent years, accelerated by Coronavirus-related spending in 2020. How to reduce this deficit is one of the early major challenges facing President Biden’s administration. When President Biden announced his tax plan prior to the election, he proposed a number of major tax revisions (discussed in great detail in this GBQ webinar). Now that the Democratic Party has gained control of the Senate, giving it both houses of Congress and the Presidency, the likelihood of tax law changes in the near term has skyrocketed.
For business owners who are interested in selling their businesses or getting some level of liquidity, President Biden’s proposed tax reform should encourage them to consider an underutilized option — selling stock to an Employee Stock Ownership Plan (ESOP).
Why an ESOP Makes Sense Under Proposed Tax Changes
An ESOP is a qualified retirement plan, similar to a 401(k), which rewards employees with ownership of their employer, while at the same time providing an attractive business succession plan for selling shareholders. These shareholders receive “fair market value” at close or over time for the stock they sell.
There are numerous benefits to selling stock to an ESOP (for the company, seller, shareholders, and employees), both financial and non-financial:
| Financial Benefits | Non-Financial Benefits | |||
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As shown in the table above, many of the financial benefits are tax-related, and in a higher tax environment, these benefits become even more meaningful. Here is how an ESOP’s unique tax benefits help under a few of President Biden’s most important proposed tax changes:
| Tax Category | Proposed Tax Change | Related ESOP Benefit |
| Income |
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| Capital Gains |
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Many Sellers Will Want to Act Now
Not all sellers are interested in electing an IRS section 1042 rollover and deferring the capital gain on the sale of their stock to an ESOP. Instead, they may prefer to pay the capital gains immediately, before rates (possibly) rise under the Biden administration. In that case, the time to act is now, as any sale of a business (including an ESOP sale) takes months to achieve.
An ESOP as an Alternative to M&A Sale
One of the most common ways shareholders in privately held companies exit their investment is through a traditional merger and acquisition (M&A) sale. However, M&A activity fell drastically during the early months of the pandemic, and even with the arrival of the Coronavirus vaccine and the promise of a return to normalcy, there may be fewer acquirers willing and capable of buying companies.
Because an ESOP transaction is essentially an “internal” sale to employees, there is no need to search for an external buyer. Rather, a trustee will negotiate the sale on behalf of the employees. The lack of an external buyer means the transaction process is often smoother (translation: less disruptive to the business), with a shorter timeline and greater certainty of closure. Lastly, because the employees own the company, it remains independent, and operational control of the company does not need to change.
Conclusion
At the end of the day, there are a number of factors to consider when determining the right succession plan for your company. To learn whether an ESOP will fit your sale objectives, contact us today, or join us via webinar on February 2nd for an overview on ESOPs.
Article written by:
Joseph Borowski, CFA
Director, Valuation & Financial Opinion Services
Disclaimer: This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax advice. You should consult your tax and accounting advisors before engaging in any transaction.
