ESOP Pro’s and Con’s

ESOP Pro’s and Con’s

Making decisions about your business succession plan requires critical thinking.  It’s a big and potentially expensive step.  Conversely, the cost of not planning can be huge.  These range from a business that dies with your retirement or demise to lost money for you and your heirs.

An Employee Stock Ownership Plan (“ESOP”) is a succession strategy often considered.  What are the key pros and cons?

While we recommend that your situation be reviewed with your attorney and accountant.  The following pros and cons are general observations and not hard and fast rules or guaranteed results.

Sale to ESOPSale to Third PartyComment
You receive fair market value.A higher price may be attained.

Finding a buyer for a closely held business is a challenge.  While you may receive a higher offer from an outsider, the purchase price often includes cash plus a note; there is a risk that the note will not be paid in full or at the stated terms.  Payment of notes is often contingent on future results, over which you have zero control.

Selling to key management or family members is a possibility that often requires resolving the “how will they pay me” question.

While private equity firms buy companies in the closely held business arena, their modus operandi involves consolidating operations of similar companies. They have no emotional attachment to your employees. The staff’s future employment is at risk.


Owners of S Corps selling to an ESOP have potentially significant tax deferral and other benefits.While certain tax mechanisms can be employed, taxes will be due from you to the IRS and potentially state and local authorities.Your tax expert is the best resource for your personal and your company’s pros and cons regarding taxes.
As trusts, ESOPs pay no federal income taxes. Often, they don’t pay state and local income taxes. Most businesses and their owners pay federal, state, and local taxes at either the company or at the owner level. Sometimes both.This tax advantageous position provides more cash flow to the ESOP-owned company, which in turn can accelerate the growth of the business.
ESOPs can borrow funds at advantageous interest rates and terms. The buyer’s credit determines their borrowing interest rate and terms.If the buyer is financing the deal, it may take longer to pay you back.  The longer the payback, the higher the risk. Conversely, entrepreneurs understand and manage their business’ various risks.   In an ESOP, the owner may continue to manage the company, which mitigates business risk and improves cash flow and financing success.
Cash and stock contributions by the company to the ESOP are tax deductible. This includes contributions to repay the ESOP’s loan. In essence, you can deduct loan payments (with certain limitations).A buyer may need to finance the purchase with unknown terms and rates. Sellers are often asked to accept financing as a portion of the purchase price.ESOPs generate potential tax benefits to the owner and the Company. Seller financing adds another layer of risk to the seller.
Employees terminate and need to be bought out. They have a right to diversify out of the company’s stock if age and employment longevity requirements are metNot an issue ESOPs and the related company must maintain sufficient funding to meet expected retirement and diversification obligations.  Routine studies are required to quantify this liability and the timing of expected payouts.
Employees continue to run the company.Not your concern any longer.Acquirers often replace key personnel.  Who’s to say the new management can run the business as well as you and your management team?  Having a trained and skilled management team is a must regardless of your succession plan.
Ownership can be transferred graduallyOnce purchased, the company belongs to the buyer.

The owner may be asked to stay for 6 months to a year, but then they are forced to leave.

A sale to an ESOP over time gives the owner a level of comfort that the business can continue without them. It provides the opportunity to fine-tune the management team’s training.

In many instances, you can remain in charge if you want.

Disclosure of your company’s confidential information is limited to people who already know about you and to the trustee of the ESOP. As a fiduciary, the trustee cannot disclose this information.Your business becomes an open book to potential buyers.

While potential buyers sign non-disclosure agreements, if the deal does not go through, the potential acquirer (a competitor?) now has information you may not want them to have – customers, suppliers, internal processes and more.

Setting up an ESOP can be costly. Lawyers, a trustee, a third-party administrator (“TPAs”), and a valuation firm, among others, are involved. Fees can add up.Merger and acquisition/broker fees and other costs of preparing your business for a sale (lawyers, accountants) can be high. There is a significant investment of your time. A sale to a third party happens only once. An ESOP sale may happen several times if the transfer to the ESOP is staged.
Maintaining an ESOP can be costly. Lawyers, TPAs, the trustee and the valuation firm are engaged annually to handle the filings for the ESOP with the IRS, the Department of Labor, and potentially others.Once an acquisition is complete, the costs borne by the seller cease.Having a strong cash flow is essential for an ESOP.  These costs may be more than offset by the potential tax advantages of an ESOP.
Employee productivity and morale have been proven to rise.The impact on employee productivity and morale is questionable. It depends on the acquirer and their management style compared to yours.Studies uniformly show employees enjoy being owners.
For employees, a retirement plan in the form of an ESOP depends on the success of the company. This adds risk. While there are protections available for non-ESOP retirement plans (such as potentially the federal Pension Benefit Guaranty Corporation, there is no equivalent for ESOPs currently.About 68% of private industry employees have pension plans available in which only 51% of employees participate (US Bureau of Labor Statistics, March 2021). This includes 401(k) plans.Many ESOP companies also offer 401(k) plans. A 401(k)is employee money partially or fully matched by the company
Interview on ESOPs With A Third-Party Administrator

Interview on ESOPs With A Third-Party Administrator

Interview with Carla Klingler, Vice President, Swerdlin & Company

Kevin: We’re meeting today with Carla Klingler, Client Relations specialist of Swerdlin & Company, a third-party administrator based in Atlanta.  Carla is a recognized industry expert on retirement plans.  Today, she will be sharing with us the basics of an Employee Stock Ownership Plan, also known as an ESOP.

Welcome, Carla, and thank you for joining us.

Carla: Thanks for inviting me.

Kevin: Can you tell us a bit about your firm and your background?

Carla: We are a 3rd party administration firm (known in the retirement industry as a TPA) and ERISA Consulting firm.  We provide consulting, recordkeeping, and compliance services for all types of retirement plans and we specialize in business transitions using Employee Stock Ownership Plans (ESOPs).

Kevin: There is a good deal of literature about ESOPs from various organizations.  They seem complicated but also appear to offer a good number of benefits to both owners and employees.  What is an ESOP?

Carla: An ESOP is an employee benefit plan which owns the stock of the company for the benefit of the employees.  It is often seen as a great motivating tool for employees to work hard, be more productive, and share in the wealth of a growing company.  For companies, it can become a method of lowering tax burdens.  For owners, it provides a means to sell their interest often at a great tax advantage and on their own timeframe.

Kevin: What are some specific advantages of an ESOP?

Carla: An ESOP is the only business transition tool that allows an owner to sell their interest in their company gradually over time or all at once (as in a traditional sale to a third party).

For an owner, it can be a great way of ensuring a smooth transition to the next generation of managers, whether that be the next generation of family members or a trusted management team.

It also can provide significant tax savings to the owner and the company as well as being a unique employee motivator and value driver.

Kevin: Can you tell us more about the benefit?

Carla: The Employee Ownership Foundation recently tracks economic performance of esop companies.  Over the last 23 years, 76% of survey respondents said their esop improved the overall productivity of the employee owners. 70% reported revenues increased and 64% stated profits rose.  93% agreed creating an esop was “a good business decision that has helped the company”.

Kevin: How can it help companies with their taxes?

Carla: Contributions to esops are tax deductible.  There are limits as there are with most plans.  If an esop is leveraged, the deductibility is even higher.

Kevin: How can an ESOP be leveraged?

Carla: The esop or its corporate sponsor borrows money from a bank or other qualified lender. The company usually gives the lender a guarantee that it will make contributions so the trust can pay back the loan.  A company which repays an esop loan gets to deduct principal as well as interest from taxes.  Dividends paid on esop stock passed through to employees or used to repay the esop loan are also tax deductible if the sponsor is a C corporation.

Kevin: What other ways can an ESOP save a company taxes?

Carla: A huge advantage to having an esop in an s-corporation (where profits are passed through to the shareholders via a K-1) is that the ownership % owned by the esop trust is tax free.  The esop trust is a tax-exempt entity; therefore, no tax is due on the esop’s share of the sponsor’s income.  In a 100% esop owned s-corporation, there are no corporate taxes due.

Taxes are paid when esop participants receive a distribution from the retirement plan with the same tax advantages and rollover opportunities to the employee that are available on distributions from all other types of qualified retirement plans like 401(k)s.

Kevin: What can an ESOP do for an owner?

Carla: Owners of closely held C corporations can sell their stock to the esop and defer federal income taxes on the gain from the stock sale.  The esop must own at least 30% of the company’s stock immediately after the sale and the seller must reinvest the proceeds in securities of domestic operating companies within either three months before the sale or twelve months after the sale.  There are some other restrictions.  In a nutshell, the seller can cash out fully or partially tax free.  Not until the securities he or she bought with the sale proceeds are sold are any federal taxes payable.

Kevin: Thanks, Carla for your time.  If readers have any questions, how can they contact you?

Carla: You can reach me at or call (678) 775-5506.

The ESOP Trustee – Selecting the Right Candidate is Important

The ESOP Trustee – Selecting the Right Candidate is Important

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Employee Stock Ownership Plan (ESOP) trustee selection can have important regulatory implications, particularly with the Department of Labor (DOL). While it is not unusual for a business owner to want to serve as trustee for the ESOP, an external trustee is almost always a better course, particularly when the trustee is also the selling shareholder.

Anyone providing ESOP trustee services should be sufficiently independent to ensure that they cannot be influenced by the company’s management and owners. They should follow the prime directive of trusteeship, namely, to focus solely on the benefit of the ESOP and its participants.

With increasing frequency, we hear of the DOL recommending in its review findings that an external trustee is suggested.  Court cases such as Perez v. Bruister, support this.

The sole owner of Bruister & Associates was one of three trustees in a staged sale of all of his stock to an ESOP.  The other two trustees were an employee and the outside CPA, respectively.  The Fifth U. S. Court of Appeals, in its decision, stated that while Bruister abstained from voting on the transactions, he influenced the valuation with actions ranging from firing the ESOP counsel, firing the initial appraiser and influencing the second appraiser by adjusting assumptions and financial information.  The Court further stated all the trustees violated their fiduciary duty by failing to act solely for the benefit of ESOP participants.  Clearly, an owner should not be a trustee in a transaction in which his/her ownership interest is involved.

We recommend that ESOP trustee selection be limited to external parties with no conflict of interest.

Changes in the Wind for Estate Taxation

Changes in the Wind for Estate Taxation

Section 2704 Proposed Changes: Much Ado About Nothing? A Different Kind and Level of Estate Taxation? A Golden Opportunity? All the Above?

Estate TaxesThe December 1 IRS hearings on proposed changes to the Section 2704 Regulations demonstrated the significant opposition from taxpayers, advocacy groups and other interested parties. Thousands of comments, almost all against the proposals, were submitted. A record crowd attended the five-hour hearing. No supporter (or just one depending on the reporting source) came forward.

The controversy includes limits to valuation discounts many see in the proposed regulations. Experts disagree on the extent and intent of these limits.

After the hearing, some believed the IRS would rework their proposals. Others thought it may be moot.

As part of his sweeping tax plan, President-elect Trump calls for the elimination of estate taxes. Most presume this would include gift taxes. When/if this broad-reaching tax plan is passed depends on how many Senate Democrats Mr. Trump can persuade to join him to reach the 60 votes required. And where in his list of tax changes do estate taxes fall? Many times, we have seen proposed tax changes negotiated away.

Trump spoke of implementing a capital gains tax at death. Most agree stepped-up asset values would remain. The Tax Foundation thinks otherwise. They read into Trump’s proposal that estates over $10 million would effectively lose their stepped-up basis. They further believe the capital gains tax would be deferred until the inheritor disposed of the asset. (Interestingly, the Tax Foundation projects a repeal of estate taxes would lower federal government revenues by $240 billion between 2016 and 2025 and would have a positive 0.9% effect on GDP over the same period).

A capital-gains-at-death tax could mean an effective tax of 20%. It’s uncertain if the federal exemption would continue. In 2017, that exemption rises to $5.49 million ($10.98 million for a married couple).

Estate planning professionals are understandably unsure how to proceed. Many unknowns are in play.

One strategy is certain: with no change, a new tax or a tax repeal, moving assets out of an estate remains beneficial.

  • If no change occurs, the benefits seen today remain.
  • If a new tax is enacted, the benefits diminish but will still exist.
  • If the tax is repealed, this becomes a golden time to move assets, potentially federal tax free.

The biggest uncertainty: What happens when Democrats regain control?

Estate of Giustina V Commissioner

Estate of Giustina V Commissioner

This recent estate tax case is rife with valuation issues.  And it is one of the few that the issues are clearly defined and resolved.

The United States Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) remanded the case to the Tax Court to reconsider its decision on the valuation of the Estate’s interest in the Giustina Land and Timber Company Limited Partnership (the “Partnership”).

On January 1, 1990, the Partnership was formed to operate a sustained yield timber harvesting company.  (A sustained-yield timber harvesting company looks to harvest timber and replace it with new plantings at a rate that will allow it to continue into the foreseeable future).  The partnership agreement stated the Partnership would continue in business until December 31, 2040, 50 years after it was formed.

The partnership agreement placed all control of the partnership into the hands of the two general partners.  This control included the ability to sell off the land and harvested products.  The agreement stated a general partner could only be approved or replaced by limited partners owning at least two-thirds of the limited partnership (“LP”) interest. (Note the two GP’s were family members operating through corporate structures.  The decedent was not a GP.  All limited partners were either family members or trusts for the benefit of family members).  To dissolve the partnership, the backing of the same two-thirds ownership of LP interests would be required.

Natale Giustina passed away on August 13, 2005 holding a 41.128% LP interest.  The Estate’s valuation expert and the IRS’ valuation expert opined widely divergent values, primarily from the IRS expert’s reliance on a net asset method and from very different results from the guideline company method.

The Tax Court primarily agreed with the IRS.  The Court ultimately derived a value based on the net asset method and the cash flow method.  The Estate appealed.

The net asset method, in my view, is associated with liquidation, not with a going concern.  Under a net asset method, the value derives from the analyst’s belief of what the assets sell would for and liabilities be settled for in an orderly sale.  At the date of death, this Partnership had been in successful operation for almost 15 years.  Predecessor companies existed, dating back to the early 20th century.  The GPs had never expressed any intent to cease operations or sell off major assets.  This Partnership definitely qualifies as a going concern.  The Ninth Circuit apparently agrees.

In its initial decision, the Tax Court weighted the net asset method 25%.  It presumed there was a one-in-four chance a limited partner could either replace the two general partners or force a partnership dissolution.  As the Ninth Circuit pointed out, not only would this require the backing of limited partners holding two-thirds of the total LP interests, it would mean a new limited partner would turn against the GPs who just admitted him or her to the partnership.  (Alternatively, a transfer could occur to an existing limited partner without GP approval).  In such a cohesive family partnership, turning other family members against the GPs appears more hopeful than possible.  And, as I stated above, the GPs never expressed any intent to sell assets.  The fact the entity and its predecessors had been in operation for decades was significant evidence the Partnership was a going concern.

On remand, the Tax Court weighted the cash flow method 100%.

The Tax Court took issue with a component of the company-specific premium the Estate’s expert included.  All income-generating assets were timberland in Oregon, significant revenue and geographic dependencies.  The Estate expert added a 3.5% risk factor.  The Tax Court halved it under the presumption a buyer could force diversification.  The Ninth Circuit stated the Tax Court did not provide support for cutting this premium in half.  The Tax Court rescinded it.

The Estate expert applied a 35% lack of marketability discount.  The IRS expert applied a 25% discount. The Tax Court, in its initial decision, applied a 25% discount, but only to the cash flow result.  The Ninth Circuit did not question the Tax Court’s use of a 25% discount.  It pointed to the Estate expert’s statement that these discounts can range from 25% to 35%.  This supports the standard that all factors used needs to be thoroughly supported.  Support for discounting is among the most difficult parts of a valuation.  It’s one of the many reasons why a valuation is an opinion.

Normalizing Adjustments and Valuations

Normalizing Adjustments and Valuations

Valuations frequently assume a third party will purchase a business and primarily run it unchanged.  This does not mean a buyer will continue to pay expenses or a level of expense not considered typical.  Non-operating assets are typically excluded from a valuation, too.  Normalizing adjustments take the atypical expenses or portion of expense (or income) out of the mix.

Non-operating and one-time items include but are not limited to gains and losses from the sale of assets, income and expenses related to investments and legal settlements.  Expenses related to layoffs are an example of operating but non-recurring expenses generally removed.  If an income source or expense is not related to ongoing operations, it is subject to adjustment.

Discretionary adjustments look to income sources or expenses over which an owner has a choice.  Compensation paid to owners and officers as well as rent paid to related parties are frequent candidates for a discretionary adjustment.  Rent paid to a related party is often based on the cash flow requirements of that related party.  For a property with no mortgage, for instance, below market rent may be paid.  This is an example of how adjustments can work as a reduction of expense or an addition to expense.

Various authoritative sources report officer/owner compensation based on industry type, size and location.  These sources can form the basis for this adjustment.  Real estate appraisals are frequently used as the source for an adjustment to market rent.

Controversy exists over whether to include “discretionary” adjustments when valuing a minority interest.  Opponents say no, correctly stating a minority owner has no control over these discretionary expenses.  Proponents argue these adjustments should always be considered.  Shareholders of publicly-traded companies will invest elsewhere if they deem company management is overpaying executives, for example, resulting in a lower return on their investment.  A growing lack of investor interest leads to a decline in share price.

Proponents point to the derivation of yields used when calculating value based on cash flow.  These yields are often based on data from public equity markets.  As investors price shares and the related returns based on how well management is running the company, a perceived overpaying of expenses will lead to lower share prices and returns.