It was the end of a cold Friday in the deep recesses of COVID-19. I had one last zoom conversation with a seasoned Wealth Manager from a large midwestern firm. He was super bright, had vast tax knowledge and he was eager to understand. One of his clients with grown children, wanted to figure out a tax efficient way to get them the business.
Gifting it to them was way too expensive. Selling the business to the kids would create a huge annual liability for the company, and the father would have to take a huge tax bite for years to come.
Selling to private equity or a competitor would mean, for all intents and purposes, that the kids would be out of the company in a couple of years; many employees would be fired, and the culture would be ripped to shreds. This didn’t work either.
An ESOP is meant to be used for family transition. You can use an ESOP structure, along with Trusts to ensure the future of your kids. This article will take you about 3 minutes to read, but it will give you a base of understanding.
What is an ESOP
An ESOP is a way to sell your company to your employees. It is simply a corporate finance tool created in the 1970s. Congress designed ESOPs to incentivize owners to sell to their employees by giving the owners and the companies a package of substantial tax incentives.
Benefits of an ESOP at a glance
Similar to Private Equity, the company takes out a loan to pay the owner (no personal guarantee)
1. The owner pockets the proceeds and does not have to pay capital gains tax on it (deferred indefinitely).
2. The company will pay no taxes going forward (IRS and State Tax Free),
3. The company pays down the debt rapidly,
4. The people that get the equity will be your employees, not a 3rd party.
5. Your children will get warrants to buy back a large chunk of the company in the future.
a. Trusts are used with the ESOP structure to minimize tax for your children, but I will get into that in another article
6. Employees keep their jobs; become employee/owners; work hard and produce more.
The government subsidizes the ESOP Loan
The government subsidizes the loan to pay off the owners. It’s all about the right deduction in the right place. The IRS allows the company to deduct the principal of the loan. Typically, a company can deduct only the interest paid on the loan. For ESOPs, the government allows the company to deduct the principal. So…. Instead of paying taxes to the IRS, the government will enable you to use this money to pay down this loan.
Owner pockets money from sale, tax free
The owner will earn more money by selling to the ESOP. When the owner receives her money from the sale of the company, she doesn’t have to pay taxes. She can defer the taxes indefinitely by putting the money into another asset like stocks or bonds.
With an ESOP, your cash flow doubles overnight.
An ESOP pays no taxes on the earnings. This means the company has twice as much money to pay down debt, use it for CAPEX and acquisitions.
Your Family can get warrants
to buy back a portion of the company in the future
Your children and your current management will manage the firm into the future. You can structure it so they can get warrants to buy as much as 40% equity into the future. The Corporate culture that you created will stay the same. Nobody gets fired unnecessarily.
You can easily sell 30% or 50% or 75% or 100% of your firm. You choose. An ESOP has tremendous flexibility.
If this idea is of interest to you, make sure to contact Darren Gleeman at dgleeman@mboventures.com, and we can have a conversation. Our team has structured over 300 ESOPs – we know what we are doing.