Business Succession Planning: How to Increase After-Tax Proceeds Using an ESOP

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Mon, Sep 22, 2014
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ESOP profitThe results of the ESOP Economic Performance Survey (EPS) were released last week – 93% of ESOP companies found that establishing an ESOP was “a good business decision that has helped the company.”  If a business owner is interested in preserving the long-term success of the company and its employees after he/she leaves or sells the company, this is a pretty strong indicator that an Employee Stock Ownership Plan (ESOP) would be an ideal way to accomplish that objective.

While most business owners are very interested in protecting the interests of the various company stakeholders, including the company and its legacy, the key management and employees that helped build the company, and the community that supported the company throughout the years, they also have to take great care to make sure they are taking care of their own interests.  The good news is that incorporating an ESOP into a business succession plan will often maximize the benefits for all of the stakeholders, including the business owner.

Considering the Total After-Tax Proceeds

When analyzing a sale to an ESOP, it is essential to consider the total after-tax proceeds, especially when comparing an ESOP transaction sale to a third party sale.

When a business is sold to a third party, the buyer generally prefers to purchase a company’s assets rather than its stock. The decision of asset sale or stock sale is often subject to the negotiation process and is an important consideration when developing a business exit strategy, but in many cases, the third party buyer succeeds in negotiating an asset sale.  This can have negative tax (and legal) consequences for the seller.

Tax Benefits of a Stock Sale

A very powerful benefit of incorporating an ESOP in a business exit strategy is that an ESOP transaction is always a stock salewhich is generally more favorable from a tax standpoint than a traditional asset sale. 

In a stock sale, the seller is generally eligible for long-term capital gain treatment at the current long-term capital gains rate.  The top capital gains rate is currently 20% plus the additional 3.8% surcharge for the Health Care and Education Reconciliation Act of 2010, resulting in a total capital gains rate of 23.8% in most cases.  

In the more common third party sale alternative, the asset sale, some or all of the sales proceeds are generally taxed at the higher ordinary income rate.  The top ordinary income tax rate is currently 39.6% plus the additional 0.9% FICA tax above a certain threshold for the Health Care and Education Reconciliation Act of 2010.  

 

ESOP Key Takeaway #1: 

An ESOP may not end up being the right fit for every situation, but every company would benefit from learning about and seriously considering an ESOP.  ESOPs are NOT too expensive and are NOT too complicated when compared to a third party sale.  They are NOT just a niche solution – they are a viable and often the top alternative for many situations.


IRC Section 1042 Tax Deferred Sale to an ESOP

If a sale involves a C Corporation, a stock sale to an ESOP may offer additional tax savings.  A C Corporation asset sale may be subject to double taxation since the company pays taxes on the gain on the sale of the asset, and in addition, the seller pays taxes when a dividend is subsequently paid.

There is an alternative ESOP sale, the Section 1042 Sale to an ESOP, which allows the seller to defer or avoid altogether the taxation on the sale to an ESOP.

Comparing the After-Tax Proceeds

The following chart compares the after-tax proceeds of a company sale under the three approaches discussed above:

 

ESOP Stock Sale (Section 1042)

ESOP Stock Sale

(non-Sec 1042)

Third Party Sale

 Gross Sale Proceeds

$1,000,000 

$1,000,000 

$1,000,000 

 Federal Income Taxes

(238,000) 

(396,000) 

 After-Tax Sale Proceeds *

$1,000,000 

$762,000 

$604,000 

 Additional After-Tax Proceeds
 Compared to 2014 Asset Sale (%)

66% 

26% 

— 

The above analysis does NOT contemplate STATE INCOME TAXATION.  It also assumes the top individual tax bracket but does NOT contemplate the impact of the additional 3.8% Medicare Tax above a certain threshold and/or the 0.9% FICA Tax above a certain threshold.

Additional Ways to Increase the After-Tax Proceeds in an ESOP Sale

In addition to the after-tax sale proceeds, there are additional ways to increase the after-tax proceeds in a sale to an ESOP, including:

  1. Deducting 25% of company payroll to reduce the company (and business owner’s, in case of pass through entity) taxable income, saving cash by minimizing personal federal and state income taxes;
  2. Earning a 10-15% ROR on any seller financing involved in the transaction;
  3. Sharing in the unlimited upside future potential of the company, even after the sale, with synthetic equity growth in the company via stock warrants and/or stock appreciation rights (SARs); and
  4. Receiving ongoing ESOP allocations of company stock by participating in the ESOP.

Including the additional ways to increase after-tax proceeds will help paint a more complete picture of what an ESOP sale would look like compared to the alternative sale approaches.

Benefits of an ESOP as Business Exit Strategy eBook

Topics: ESOP Benefits, Employee Stock Ownership Plan (ESOP), Business Succession Planning

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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