One of the most critical decisions business owners make in their lifetime revolves around selling their companies. Complications arising from tax obligations add a further layer of complexity for owners contemplating a sale. In assessing the available options, these may include a third-party sale to a competitor or a financial buyer. But alternatives, such as a sale to an Employee Stock Ownership Plan (ESOP), can offer substantial tax advantages to sell compared to a third-party sale.
After-tax economic benefits of an ESOP transaction can, in fact, surpass those of a third-party sale for owners who are eligible for the perks under
Section 1042 of the tax code that covers stock sales to ESOPs.
ESOPs have attained attractiveness for business owners intending to sell within the next half-decade, due to an estimated 12 million Baby Boomers owning privately held businesses, roughly 10,000 of them reaching retirement age daily. This has resulted in a significant number of baby boomers desiring to sell their businesses.
However, with many potential heirs favoring cash from a sale over taking over the family business, several baby boomers have decided to maintain ownership and postpone retirement longer than they would have expected. The resultant effect, with ownership stakes being handed over to the next generation of leaders, is an expected transfer of approximately $10 trillion worth of business assets.
The traditional sell-side market has normalized with valuations after recent short-term premium years, resulting in ESOP value on a sale becoming more competitive. The rise in interest rates also intensifies the value of Section 1042 as a tax-deferral option. With the rise in the cost of capital, third-party buyers are not as inclined to pay more for a business as they were when capital was more affordable. Find Out More.
Business owners need to account for a federal capital gains tax rate of 20%, in addition to state taxes, and an additional 3.8% surtax on investment income invested toward the Affordable Care Act. These tax ramifications can heavily influence a business owner’s succession planning or sale to a third-party purchaser.
Unlike third-party sales, ESOP transactions enable business owners to defer taxes on gains, provided they meet certain criteria. The primary reason for pursuing ESOPs is not tax deferral but rather their capacity to maintain an owner’s legacy and motivate employees who, now having a larger stake in the business, are more geared to ensure the company’s success.
In a typical ESOP transaction, if an owner sells a minimum of 30% of the company to the ESOP and then reinvests the sale proceeds in qualified investments, they become qualified to defer tax on the gain, through Section 1042.
Despite the explicit benefits, many business owners remain unaware of ESOPs as a viable sale option, primarily because most advisers who represent businesses being sold do not consider ESOPs as a part of their options.Learn More. A small group of advisers have the knowledge necessary to guide a business owner through the complete set of sale options, including ESOP buyouts. Find out More.
An original piece by Keith Butcher, managing partner at ButcherJoseph & Co., this informative writeup and more can be found at Bloomberg Tax.