The ESOP alternative

Have you ever tried selling a minority share of your privately held business? Did this feel like you were trying to sell beachfront property on the moon? There is an easier, more profitable way for you to liquefy your assets and diversify your stock without having to make the deal of the century.

As a successful business owner, you may know one of the most difficult endeavors is to convert a company's equity into cash.

You may be worth $5 million on paper, but your inability to exchange your equity into cash may be affecting your current lifestyle or retirement plans.

Don't be discouraged.

This is a common problem for many privately held businesses.

Consider a private business owner approaching retirement.

The business has several long-term, key employees who would like to take over management when the owner retires.

At this point, the retiring owner has several alternatives when deciding how to proceed.

Third-party sale This involves the sale of the entire business to an outside third party.

Competitors may be potential buyers, but may not be willing to pay fair market value and may decide to close the business as a way to gain that market share.

Investment bankers can also be hired to find potential buyers, but the fees and the low rate of success can make this option cost-prohibitive for many businesses.

Additionally, the seller may have to carry a promissory note for a portion of the sales price.

Besides that, the federal taxes for selling your stock for $5 million can be as high as $750,000.

This is a hefty chunk of change to lose to Uncle Sam.However, this may be the only way to sell an entire business in one transaction.

Furthermore, the seller effectively loses control of the direction of the company, and thereby surrenders any chance of passing the business to key employees or assuring that the business survives long enough to pay off the promissory note to the seller.

Company buyout/back A company can buy back all or a portion of the owner's outstanding stock by taking back a company note or borrowing money from a bank to finance the transaction.

Neither option provides a tax relief as the owner pays a large capital gains tax and the company will not be entitled to any tax deductions in connection with the payments.

Taxes are paid once by the company, as income, and again, by way of capital gains, as a shareholder.

Essentially, the taxes are paid by the owner twice on the same dollar earned by the company.

In this case, the retiring owner can still pass the business along, retain control of the company, and assure job security, but the taxes may far outweigh the benefit.

Employee Stock Ownership Plan A third alternative is to sell the stock to a retirement plan known as an Employee Stock Ownership Plan.

An ESOP is not a typical retirement plan because it is designed to invest primarily in the company stock.

A company using an ESOP as a pass-through conduit is able to borrow money at a preferred rate from a bank to purchase the stock due to the corporate tax benefits.

When an ESOP purchases at least 30 percent of the company stock, the sale qualifies for tax-free "rollover" treatment as long as the selling shareholder buys other qualified securities (i.e.

IBM, Microsoft, bonds...).

Thus, the owner can diversify his portfolio in preparation for his retirement.

In addition to tax benefits and liquidity, in many cases, owners can sell 51 percent or more of the company to an ESOP and retain effective control of the company.

Depending on the company finances, the ESOP can purchase all the stock over a period of three to seven years and in extremely rare cases the ESOP is able to purchase 100 percent of the company in one transaction.

So this alternative normally does not provide a way for owners to sell their entire business quickly.

The positive financial impact on the company is simple.

Borrowing funds to repurchase an owner's stock with an ESOP loan allows the company to deduct the principal repayments on the loan as well as the interest.

If the company borrows the full $5 million purchase price, the company will be entitled to $5 million in federal income tax deductions that it would not otherwise be allowed to deduct for repaying the loan.

This will resultin a $1.75 million federal tax savings over the term of the loan.

Combined with the $750,000 in capital gain taxes that is deferred for the seller, the total tax savings can be at least $2,500,000, or 50 percent of the total purchase price.

There are other benefits as well.

Through their indirect participation, employees will share in both the profitability and long-term growth of the company.

Similar to the way that pension and profit-sharing plans (or 401(k) plans) benefit employees, an ESOP can defer taxes for retirement benefits.

Studies have shown that, if properly communicated, an ESOP can result in increased employee productivity and reduced employee turnover.

ESOPs are not for everyone.

Some business owners are not particularly concerned with the liquidity of their wealth or may not be contemplating their retirement.

Moreover, some business owners may prefer to retain sole ownership of their company.

ESOPs may also be inappropriate for businesses that are unprofitable or have only a short-term industry outlook.

There are many ways to liquefy and diversify your stock as well as provide for your retirement.

ESOPs provide a viable solution by creating a ready market for privately held company stock while maintaining employee interest and profitability of the company.

An ESOP will also allow you to diversify your investments on either a tax-free or taxdeferred basis.

When it comes time to retire, or sell part or all of your business, consider an ESOP and the rewards it can provide for your loyal employees and your own pocketbook.

Matthew D.

Goedert is a partner in Goedert & Associates, a Reno-based law firm.

Goedert focuses his practice primarily on employee benefit plan matters.

His office is at 457 Court St., 329-9300, mgoedert@goedertlaw.com.