Business Owners Looking to Sell Can Use ESOPs to Their Advantage – Bloomberg Law

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Selling a company is one of the most important decisions business owners make in their lifetime. And tax obligations introduce a new layer of complexity for owners considering a sale.

Owners must assess all available options, which may include a third-party sale to either a competitor or a financial buyer. But alternatives such as a sale to an employee stock ownership plan, or ESOP, can provide substantial tax benefits to sellers compared to a third-party sale.

The overall after-tax economic benefits of an ESOP transaction can even exceed those of a third-party sale for owners eligible for advantages under Section 1042 of the tax code, which covers stock sales to ESOPs.

What’s Different Now

ESOPs have become a compelling choice for business owners planning to sell within the next five years. An estimated 12 million Baby Boomers have ownership in privately held businesses, and roughly 10,000 of them reach retirement age every day. This demographic shift has led to a high number of baby boomers wanting to sell their businesses.

However, many of their potential heirs would prefer cash from a sale rather than taking over the family business, causing many baby boomers to retain ownership and postpone retirement longer than they would have liked. As the baby boomer retirement era continues and ownership stakes are passed to next generation of leadership, an estimated $10 trillion worth of business assets are expected to be transferred.

The traditional sell-side market, meanwhile, has stabilized with valuations normalizing over recent short-term premium years, making ESOP value on a sale more competitive.

Increased interest rates also enhance the value of Section 1042 as a tax-deferral option. As the cost of capital rises, third-party buyers aren’t as willing to pay up for a business as they were when capital was cheap.

Capital Gains

The federal capital gains tax rate for business owners who sell is 20%, plus state taxes, and an additional 3.8% surtax on investment income to fund the Affordable Care Act. These tax consequences can substantially impact a business owner’s succession planning or sale to a third-party buyer.

To illustrate using a mean state tax rate of 6.65%, the following chart demonstrates the effect of capital gains taxes on a business owner selling their company to a third party for $60 million. For comparison, we look at what the same sale would look like in California, which has one of the highest state capital gains tax rates in the US.


When a business owner finalizes the sale of their company to a third party for $60 million, capital gains taxes will affect their overall proceeds from the transaction. In this situation, more than $18 million of the sale proceeds will be allocated towards taxes, and in states such as California, tax implications are far greater at over $22 million.

ESOP Advantages

ESOP transactions, unlike third-party sales, enable business owners to defer taxes on gains, contingent on meeting specific criteria. While tax deferral may be a motivating factor, ESOPs are pursued primarily for their capacity to maintain an owner’s legacy and inspire employees who, now with a greater stake in the business, are more motivated to ensure the company’s success.

In an ESOP transaction, if an owner sells a minimum of 30% of the company to the ESOP, and then reinvests the sale proceeds in qualified investments, they become eligible to defer tax on the gain. This tax deferral opportunity is made possible through Section 1042.

The Section 1042 election operates as a “like-kind” exchange, allowing selling shareholder(s) to defer proceeds from the sale by reinvesting them in comparable assets. The provision aims to offer business owners incentive to sell the business to the ESOP, giving employees a stake in the upside of the company going forward.

Most business owners are unaware of ESOPs as a viable sale option because most advisers representing businesses for sale don’t consider ESOPs as part of their options. Only a small subset of advisers have the expertise to guide a business owner through the full set of sale options, including ESOP buyouts.

Another reason ESOPs are frequently overlooked is that ESOP transactions pay a durable long-term fair market value but don’t pay a premium value that might be driven by short-term market forces. Therefore, a strategic or financial buyer might offer a higher price.

Consequently, sellers aiming solely to maximize sale value often lean towards a third-party sale. ESOPs frequently emerge as the preferred sale mechanism for owners prioritizing considerations beyond mere sale value, such as after-tax considerations.

ESOPs are also favored by those who value preserving the company’s legacy, ensuring job security for employees, and maintaining the company and its jobs within the local community.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Keith Butcher is managing partner at ButcherJoseph & Co.

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