Should you sell your business to your employees?

As a business owner, you can spend so much time thinking about how to grow your company that you neglect to plan how you’ll eventually walk away from it—and who will run it after you’re gone. While some business owners have family members who can take over the operation, others assume they’ll have to find an outside buyer.

But there may be another option—one that offers financial benefits to you as well as a powerful reward to your loyal workers: an Employee Stock Ownership Plan (ESOP). ESOPs are a type of employee benefit plan that allows owners to sell portions of a closely held business to their employees, providing tax benefits for both parties in the process. “An ESOP not only gives employees a stake in their company; it also lets business owners create a market for their shares and provides important tax advantages for selling,” says Andrew Guise, a UBS Senior Wealth Strategist.

These benefits have made ESOPs a popular exit strategy for owners of closely held companies. The National Center for Employee Ownership estimates that there are about 7,000 ESOPs in the United States, with about 13 million employees participating. But they’re not right for every situation, so be sure to weigh the benefits and costs.

An ESOP not only gives employees a stake in their company; it also lets business owners create a market for their shares and provides important tax advantages for selling.

- Andrew Guise

Key takeaways

  • Owners of closely held businesses should plan a strategy for selling their company.
  • Employee Stock Ownership Plans (ESOPs) create a new market for selling shares, and provide owners and employees with tax benefits.
  • Selling to an ESOP can help defer capital gains taxes and diversify assets.
  • Establishing the plan takes time and might not be the best option for owners who need immediate liquidity.

How ESOPs work

To establish an ESOP, a closely held company becomes the plan sponsor and creates a special trust with which to buy its own stock back from the company founders and other current owners. Then, the company funds the trust through cash on hand or by borrowing money, and those funds are used to purchase shares from the owners.

Employees receive shares based on a percentage of their salaries in accounts that function like other qualified retirement plans such as 401(k)s: The value of the shares grows tax-free, and upon retirement employees can take distributions equal to the value of their company stock. Employee distributions are subject to income tax.

As with other qualified retirement plans, ESOPs offer tax benefits for the sponsoring company. A portion of the cash contributions made to the trust is considered a tax-deductible business expense, as are principal and interest payments on loans used to purchase shares.

Advantages

One of the clearest benefits of ESOPs is goodwill. Shares of the company can be a great way to reward existing employees and attract talented newcomers. And, as part owners, workers will have that much more incentive to protect your company and help it prosper.

There are also clear financial benefits for owners, compared with selling the company outright to another private buyer.

  • Tax management. Business owners may defer some or all of the capital gains taxes they owe—taxes that often take a substantial bite out of the profit from the sale of a company. Owners are allowed to sell their stock (provided the ESOP owns at least 30% of the company after the sale) and invest the proceeds into new assets called qualified replacement property (QRP), avoiding capital gains taxes until they sell the QRP. QRP must meet specific IRS criteria, but many traditional investments, such as stocks and bonds, may qualify.
  • Diversified retirement benefits. Many business owners have a large portion of their wealth tied up in their companies. Transferring shares to an ESOP provides cash that owners can use to invest for retirement. “Even if you’re not ready to retire, you can sell some of your shares to the ESOP and either pay the capital gains tax or invest in QRP to diversify your wealth,” says Guise.
  • Flexible ownership levels. Business owners can sell as much or as little of their company to an ESOP as needed to meet financial goals or business needs. For example, the patriarch of a family-run business who sells 30% of the shares to the ESOP could take advantage of the tax benefits of QRP and still be able to leave the majority of the company to his children, retaining family control of the business.

Important considerations

Along with those advantages, be aware of these considerations:

  • Setup and maintenance. Establishing an ESOP requires many steps, such as a detailed company valuation, establishing the trust and filing government paperwork. This typically requires an attorney specializing in employee benefits. There are also ongoing plan administration requirements. For some business owners, selling the company outright is a quicker and simpler option.
  • Future career plans. If you plan to sell your company to fund the startup or purchase of a new venture, it might make more sense to sell the company outright to receive the full proceeds of a sale immediately.
  • How much QRP can you buy? If you need the proceeds from a sale to fund other lifestyle needs, you might not be able to invest a substantial portion of sale proceeds into QRP. In that case, the tax advantages of an ESOP may be limited.

Consider each of these factors in the context of your overall wealth management and estate plans, with input from your business partners, family and Financial Advisor. Because of the complexities, it’s best to start examining potential sale strategies long before you decide to step down from your closely held business. As Guise says, “The earlier you plan, the more thoughtful you can be.”