While the entire world has been reeling from the economic impacts of COVID-19, family businesses are especially susceptible. A recent KPMG study found that 78% of family businesses saw their revenues affected directly by the pandemic, with 83% of those companies experiencing a decline.
Factor in the threat of rising corporate and capital gains taxes, and establishing a secure path to business succession is more important than ever. An employee stock ownership plan (ESOP) is one often overlooked solution.
Helping family business owners understand their options
The survival of a family-owned business has always been a topic best handled thoughtfully and meticulously. Succession planning is a sensitive subject. Founders are often highly protective of the company into which they poured so much of their effort and resources. They want to keep their legacies intact, and, as such, they wouldn’t want to transition ownership to just anyone. Multigenerational assets are just too valuable to give up.
Traditionally, we would almost invariably see ownership pass to a family member, but that’s no longer a given. In fact, according to research published by private business nonprofit SCORE, only about one-third of family businesses survive the transition from first- to second-generation ownership—and this number drops precipitously through subsequent generations. If the founder/owner doesn’t put a plan in place ahead of time, this can lead to unnecessary conflict and friction within the family, along with estate tax burdens that could jeopardize the company and even require a premature sale.
When it’s time for a transition, wealth managers are in a unique position to help owners understand their M&A alternatives. Third-party sales and private equity deals are common options, but these often come with significant tax burdens and generally result in the end of a family’s involvement in the business.
Introducing your clients to ESOPs
On the other hand, an ESOP is an advantageous succession and exit planning alternative that wealth managers can introduce to clients. Working with an employee ownership advisor, wealth managers can help walk business owners and their families through the potential structures, mechanics and wide-ranging benefits of ESOPs.
In a typical ESOP transaction, owners of a privately held company sell some or all of their stock to an employee trust at a fair market valuation. To facilitate the purchase, the company arranges financing on the ESOP’s behalf.
Explaining the advantages of an ESOP
For selling shareholders, perhaps the biggest advantage is the ability to create liquidity and diversification of wealth from the business—which typically is their largest asset. Additionally, if certain requirements are met, selling shareholders can defer and potentially eliminate capital gains taxes on the sale by reinvesting the proceeds into certain qualified securities. This is known as a 1042 rollover.
ESOPs also provide flexibility, as the shareholders can consider partial sales (sometimes in stages over time) or full 100% sales. This flexibility creates opportunities for families to diversify their wealth while maintaining a meaningful interest in the companies they’ve built.
Their companies also receive income tax deductions equal to the ESOP sale value, which can substantially reduce the amount of cash flow lost to income taxes. This cash flow advantage can even be made permanent, since 100% employee-owned S corporations are not subject to federal and most state income taxes.
Finally, when it comes to securing their legacies, an ESOP allows owners to keep their companies independent and locally owned, while fostering a culture of employee ownership. The latter has been shown to drive productivity and retention—thanks to employees having a real stake in the company. By reinforcing a family business’s foundation, an ESOP can help these companies thrive for years to come.
Taking the next steps toward employee ownership
If an ESOP makes sense for a client, it’s essential that a wealth advisor connect with a specialized advisory firm. While employee ownership carries significant potential benefits, these transactions are complex and federally regulated. An experienced guide should understand all facets of ESOP structuring, financing and administration.
A skilled ESOP advisor can quantify financial benefits, estimate a company’s fair market value and explore competitive financing, while comparing with other potential options available to the company. This even-handed analysis should help determine whether an ESOP is the appropriate strategy.
If a client and their company opt to move ahead with an employee stock ownership plan, an advisor can map out and quarterback a transaction process. That includes pulling in any necessary third-party professionals, arranging financing and driving the overall deal process from start to finish.
An ESOP-oriented succession strategy demands collaboration
Due to the options and relative complexities of employee ownership, it’s important that company leaders, family members and trusted advisors be engaged early in a process. Education and communication are vital. The needs and goals of all parties must be considered, and everyone should understand how an ESOP works.
Wealth managers who introduce the ESOP option to family businesses, and put proven feasibility and transaction processes in place, can drive value for all stakeholders. Employee ownership may not be in your standard toolkit, but advisors that appreciate this tax-advantaged liquidity alternative are best positioned to demonstrate their value in helping business owners determine the right path toward succession.
George Thacker is a managing director at CSG Partners.