The key assets of the firm, your employees, walk out the door every night. The associates dream of one day making partner. The junior partners dream of paying off their debt. Retiring partners look forward to cashing out, but they are not psyched about installment payments and capital gains taxes.
Firms do not have cash lying around to pay off the retiring partners. This means that the retiring partners are paid out over numerous years. Sometimes the firms will have to borrow money to pay off the partners.
Associates becoming partners need to buy into the partnership. Most often, these new partners need to take out a loan to buy into the partnership.
It’s very tax inefficient.
Setting up an ESOP fixes this problem
An ESOP is a way to sell the company to the current partners, while the retiring partners can cash out, and defer their capital gains taxes. Congress designed ESOPs to incentivize partners to sell to their employees by giving the partners 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 partners (no personal guarantee)
1. The partners pocket the proceeds and do 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. Management will get warrants to buy back a large chunk of the company in the future.
6. Associates and new partners see a great future of becoming owners without taking out huge loans.
The government subsidizes the ESOP Loan
The government subsidizes the loan to pay off the partners. 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 enables the company to use this money to pay down this loan.
Partners pocket money from sale, tax free
The partners will earn more money by selling to the ESOP. When the partners receive their money from the sale of the company, they don’t have to pay taxes. They can defer the taxes indefinitely by putting the money into another asset like stocks or bonds.
With an ESOP, the firms 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.
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.