Can you really sell your business tax-free?

Answers to this and other questions about ESOPs from Alan Carlyle, Managing Director, ESOP Finance Group

Owning a business is always a challenge; few entrepreneurs take up the role thinking it will be easy. While many will attest that the rewards outweigh the risks, times of market upheaval and volatility can strain even the most resilient business owner, inspiring them to consider ownership succession.

There are several viable methods for passing on a business—to a co-owner, an heir, a key employee, or an outside buyer. Often overlooked, however, is the Employee Stock Ownership Plan, or an ESOP. Its low profile has led to occasional misconceptions. We’ll answer a few key questions about ESOPs to help you determine if it is a succession option you should continue to explore.

1. What even is an ESOP?

An ESOP transfers ownership of a business, not to a third-party buyer nor to just one or a few key employees, but to a newly formed Trust set up for the benefit of most/all full-time employees. Shares of company stock are allocated to employee accounts over time, which makes them employee owners who are literally invested in the success of the business. The stock becomes part of the employees’ retirement plan, governed by similar regulations as 401(k) plans but without requiring any cash contributions from employee owners. Many companies who decided to create an ESOP have reported increased employee morale and loyalty, as well as a smoother transition by shifting leadership internally.

2. Why wouldn’t I just sell the company?

There are a variety of business succession options, and it’s important that you determine which one best meets your goals. There is a misconception that ESOPs are more complicated than selling, but selling a company has its own complexities, including a wide variety of contingencies. Choosing a succession plan works best when you have a holistic vision of your business’s worth, your ideal timeline, and a list of succession candidates. These details will help point you towards the succession strategy that is right for you.

3. Aren’t ESOPs more expensive?

ESOPs do involve set-up costs and fees which can cause “sticker shock.” This is largely because the company will fund both buyer and seller costs. You should remember, however, that sales to a third-party require finding an interested buyer and often include a variety of contingencies. Not only do ESOPs have fewer contingencies, but they also come with valuable tax benefits. In fact, taxes on the sale can be deferred, even permanently.

Moreover, an ESOP owned company has the ability to use pre-tax dollars to pay for the ESOP purchase. Companies that are 100% ESOP owned can also be free from Federal Income Taxes, altogether.¹

4. What is the most common reason that people choose an ESOP?

While tax benefits and more seamless operations are appealing, legacy is often cited as the primary consideration for those who pursue the ESOP. When selling a business to a third party, there is the risk that the buyer will quickly sell again or even restructure or dismantle the company. An ESOP supports business continuity in leadership, values, and strategy as ownership transfers to people who already understand the vision and culture. The concept of turning employees into owners is also a way of rewarding loyal employees, an appealing prospect for leaders who have spent their careers investing in their talent.

ESOPs can be an excellent business succession option, but it would be foolish to think that you can know whether it is right for you after reading one blog article. Always consult trusted financial advisors and partners to learn more about how this would work for your unique situation. You can also reach out to the ESOP professionals at First Financial Bank, a team dedicated to and possessing robust knowledge about the process.