Using ESOPs to Cash Out

Brown Rudnick Berlack Israels LLP

About The Author: Harvey M. Katz. Mr. Katz is a partner with Brown Rudnick Berlack Israels and is experienced in all aspects of pension and employee benefits law. He represents both plaintiffs and defendants in connection with benefit plan related litigation (claims denials, fiduciary responsibility, prohibited transactions, plan disqualification, tax related issues, etc.) and also counsels clients about the employee benefits aspects of merger and acquisition transactions.

Employee Stock Ownership Plans (ESOPs) are a great way to generate liquidity for owners of closely held businesses. In ESOPs, a type of defined-contribution benefit plan used in closely held companies, assets are invested in company stock.

Owners of closely held businesses often have much of their net worth tied up in the business. This can become a problem if the owner dies or becomes disabled. Assuming they remain blessed with good health, many owners want to diversify their holdings at some point and take advantage of the wealth created by years of hard work. At the same time, they may not be ready to relinquish control and want to stay actively involved in the business.

Unfortunately, it is usually hard to find someone to buy a minority share in a closely held business, even a highly profitable one. The most likely buyers—other key employees of the business—rarely have the financial resources to acquire a significant portion of the company, and they want to be given the stock as a reward for past efforts. Third-party investors are not a good option because usually they are unwilling to pay what the company is worth and seek some level of management control.

ESOPs Give Fair Price for Equity

Here’s where an ESOP comes in. By selling a minority interest to the ESOP, the business owner can “cash out” part of his equity at a fair price and keep control of the business. What's more, in a properly structured transaction, the owner can sell his minority interest without taking a “minority interest discount ” and pay no tax on the proceeds of the sale.

Consider this example. John, age 55, owned 100% of ABC Corp., a closely held business worth $5,000,000. He decided to sell 30% of ABC to an ESOP. To finance the transaction the ESOP borrowed $1,500,000 from a bank, for which ABC guaranteed repayment. John sold 30% of ABC’s stock to the ESOP for $1,500,000 in cash. Provided John invests the $1.5 million in stocks or bonds of any domestic corporation, he pays no tax on the gain he realized on the sale.

Over the next several years the ESOP will pay back the loan to the bank from annual contributions the company makes to the ESOP. Because these company contributions are fully deductible for federal income tax purposes, the government, in effect, pays almost 40% of the cost of repaying both the principal and interest on the loan. In most cases, the trustee of the ESOP (i.e., John, because there is no rule preventing the owner from serving as trustee as long as he acts in the best interest of the ESOP) retains the authority to vote the ESOP’s stock. In other words, John retains complete control of ABC Corp. even after he has sold 30% to the ESOP.

Expert Valuation Has Key Benefits

The cornerstone of these benefits is an expert valuation of the business. The law requires that an appraisal expert—independent of the owner and the company—determine the stock's value. This usually precludes the company's certified public accountant (CPA) from performing the valuation, even if the CPA is trained in the science of business valuation.

How did John receive full value for selling the ESOP a minority interest in the company? Usually a minority interest in a company—in this case, a 30% interest—would be appraised to be worth less than 30% of the total value of the business. The “discount” springs from the fact that a minority owner has no control over major business decisions. So why doesn't a minority interest discount apply in this example?

Because before John sold his shares to the ESOP, ABC Corp. underwent a nontaxable reorganization. John surrendered 30% of his old shares for an equal number of new, dividend-paying preferred shares. The new shares have a dividend approximating the “control premium” a buyer would be willing to pay for a controlling interest in the company. By purchasing only preferred shares, the ESOP will receive nontaxable dividends in addition to the equity value of the stock. The ESOP is willing to pay more (using dollars borrowed from the bank) for John’s preferred shares, since they pay a hefty dividend each year. A good appraisal helps establish that the ESOP paid a fair price to buy John’s stock from him.

If you own a business, taking advantage of ESOPs and other financial strategies depends on knowing what your company is worth. Owners often think they know, but in reality they may be shockingly misinformed. In 2001 SPARDATA, a leading national business appraisal firm, surveyed thousands of business owners and concluded most misjudged the value of their businesses by 50% or more—sometimes by millions of dollars! So be sure your business is properly appraised before implementing any financial plan.