Employee Retention and Succession Planning for Closely Held Businesses

Owners of closely held businesses face unique challenges on every front. According to a study by KPMG, 78% of family business owners say that the COVID-19 pandemic and its lingering effects have impacted them, with 83% of those business owners saying they have seen a decline in income. To make matters worse, the threat of increasing capital gains and corporate gains taxes has created even more financial uncertainty. All of these factors make business succession planning even more critical to the overall success strategy of closely held businesses.

The survival and growth of a closely held business takes thoughtful, detailed planning. Succession planning can be a complex topic because founders typically want to protect what they have worked hard to build. This can be challenging when it comes to loosening the reins and planning for others to step up and in.

Owners who have a real passion for their company, the succession of their business and the retention and success of their employees should consider an Employee Stock Ownership Plan (ESOP).

The ESOP Solution

An ESOP is a succession planning tool that allows an owner to determine his or her desired mix of liquidity and control, while also preserving and enhancing the owner’s legacy and providing a potentially life-changing benefit to employees. An ESOP involves the sale of a business to a retirement trust established for the benefit of the business’s employees. Federal law provides large incentives for sales to ESOPs that allow for the tax-efficient sale of a company in which an owner receives fair market value for the interest in the business.

What is an ESOP? 

An ESOP is a defined contribution plan, similar to a profit-sharing plan or 401(k) plan. Like a participant in one of those plans, each ESOP participant has an account that is subject to vesting and other requirements under federal guidelines. Unlike 401(k) and profit-sharing plans, which require diversified investment of plan assets, an ESOP is invested primarily in employer securities.

What are some of the tax benefits that incentivize sales to an ESOP?

Several tax benefits are used to incentivize the sale of a business to an ESOP. For instance, in most states, a selling shareholder can defer paying federal income tax on capital gains from the sale of his or her shares of stock to an ESOP if the sale proceeds are reinvested in accordance with IRS guidelines. For an owner to take advantage of the tax deferral, the company must be a corporation taxed as a C-corporation, and the sale of shares must be made directly to the ESOP.

If an owner wants to sell their entire business to an ESOP and the business meets certain criteria, there can be other tax advantages, including tax-exempt status. Without the need to make tax distributions, qualifying corporations can pay down the debt used for the ESOP transaction more quickly and use the tax-free cash flow to make investments in the business. Such actions enhance the value of the warrants held by the selling business owner.

What are the other benefits of using an ESOP for succession planning?

In addition to the tax advantages provided by ESOPs, there are several other benefits to utilizing an ESOP for succession planning:

  • Legacy:  As opposed to a company acquired by an unrelated third party, it is more likely that a company purchased by an ESOP will keep the company name and remain locally owned.
  • Time/Efficiency: A third-party sale process typically takes more than a year and may not result in an offer that appeals to a closely-held or family business owner.  In contrast, a feasibility study for an ESOP transaction takes just 60 to 75 days, and an ESOP transaction can be negotiated and closed three to four months after that.
  • Flexibility: Utilizing an ESOP allows an owner to sell all or a portion of his or her business. This flexibility may appeal to a business owner looking to pass on control of the company to some children while getting liquidity that enables the owner to provide for other children who are not involved in the business.
  • Employee “Benefits”: In addition to receiving a share in the ownership of the company, employees in ESOP companies are more likely to retain jobs during a recession than employees in companies that are not ESOP-owned.

Is my business an ideal ESOP candidate? If so, what are the next steps?

If you are advising a closely-held or family business, an ESOP should be considered as a potential succession planning tool. When evaluating whether an ESOP is right for a particular business, it is important to keep in mind the following core attributes of an ideal ESOP candidate: a profitable business with a trusting environment and at least 20-25 employees.

ESOPs are most utilized in industries like construction and trucking, by companies that have long-term employees and have a culture that feels like family. By structuring an ESOP, there’s a greater chance your business will transition smoothly and flourish in the future, ensuring the legacy you have built lives on after you’ve moved on.

At Trucking Proud Insurance, powered by C3 Risk & Insurance Services, we are always looking at how we can take a different approach, collaborate with new partners, and provide creative solutions for our clients. That’s why we are proud to partner with DPH Financial Services to offer our clients additional expert resources for their specific needs in the areas of advanced estate planning and business succession planning. If you’re interested in learning more about whether an ESOP might be the right choice to secure your business and financial legacy, reach out to Dave Harris at (888) 313-5644 for a complimentary formal business valuation and/or additional information from the experts at DPH Financial Services.

An article for Caltrux written by Dave Harris, C3’s Director of Life & Financial Services