This Esop Is No Fable


Andy was approaching his 69th birthday and had struggled with this issue for at least four or five years now. It had been almost 25 years ago when Andy resigned his position as a local sheriff and started making fishing rods in the back room of Emmett’s Fixit Shop. It was a struggle at first, to be sure, and if it hadn’t been for the extra income from the pies Aunt Bea and Miss Clara sold, why he may have given up. Yet, Andy persevered, and today Mayberry Fishing Tackle, Inc. is producing a nice steady profit and putting food on the table for almost 60 employees and their families.

So, what is it Andy has struggled with? What exactly has preyed on his mind almost day and night for years now? It’s the question of, “Now, what do I do with this thing?!”

You see, Andy has come to the realization that he can’t run Mayberry Fishing Tackle indefinitely. Death or ill health – one of the other – is a certainty. In addition, many of Andy’s friends have retired and are enjoying their golden years down in Florida: Floyd, Barney, Howard, and the like. Andy bought a place on the Gulf a few years back, and he would dearly love to be there full time, fishing and boating every day. And, let’s face it. He’s just plain tired of working so hard and is ready to hang ‘em up.

Thus, the big issue: How can Andy turn his business into liquidity for retirement? What is his best exit strategy, tax-wise, without ruining the lives of his long-term employees?

Andy’s CPA, Larry Ledger, thinks Andy ought to sell the business. Larry believes it could be worth upwards of $5 million! And, Larry points out that the business comprises roughly 75% of Andy’s gross estate. The estate tax liability could be as high as $2.5 million! With a highly illiquid estate, if Andy dies today without sufficient life insurance, the business is sunk. It would have to be liquidated or sold on a “fire sale” basis at a significant loss. Andy’s legacy would be wiped out in one fell swoop, and his son, Oppie, would be left with one big mess on his hands

Larry has even brought in a couple of Andy’s competitors to discuss a purchase. But, Andy just can’t bring himself to pull the trigger. Why not? He feels responsible. Some of his employees have been with him for what seems like forever; folks like Gomer and Goober and Otis and Earnest T. Bass. And, Oppie is in the business now and seems dedicated to working his way up to the top. Andy knows what’s going to happen if he sells. The new owner immediately will have a duplication of employment positions, and those who helped bring Andy to the dance will be discarded without a second thought. Further, what about the taxes? He can expect enormous capital gains taxes, because his cost basis is so low.

Larry and Andy eventually meet with tax attorneys form the firm of Dewey, Helpum & Howe. A decision is reached. An “exit strategy” is formulated for Andy. The company will in fact be sold! Everyone begins working on the details and putting the deal together.

At the plant, rumors fly. Andy’s employees hear through the grapevine that he is trying to sell the company. They all are justifiably worried, as one can imagine. After all, there are not that many job alternatives in a small town like Mayberry. Morale hits the skids. Some employees have begun circulating resumes, and already the company has lost a couple of their better people. Uncertainty abounds.

A few weeks later, Andy announces there will be a mandatory meeting of all employees the next Saturday morning in the plant. They are asked to bring their spouses with them. As they arrive, doughnuts and coffee are available, and there are a bunch of strange “suits” standing around. This is it – “D” day. The mood is somber and the air is thick with fear. Andy rises, takes a position behind a small lectern, and calls everyone to order. He begins:

“You all have heard rumors that this business has been up for sale. This morning, I am here with these other gentlemen to address those rumors and confirm them. It’s true, Mayberry Fishing Tackle has in fact been sold.”

(There is a loud gasp from the crowd.)

“But, you won’t have to deal with outsiders, nor are any of your jobs in jeopardy. You see, I have sold the company to YOU! As of right now, each and every one of you are stockholders in our company – and I emphasize, our company. From this day forward, our new corporate logo will be proudly displayed on every piece of literature and every fishing rod we make: ‘Mayberry Fishing Tackle, An Employee-Owned Company’.”

And, Andy thinks to himself, the beauty is, the cost is fully deductible, and I don’t have to pay a red cent in capital gains taxes!

How in the world could he pull this off? The answer is a LEVERAGED ESOP ….

What is An ESOP?

ESOP stands for Employee Stock Ownership Plan. This is a qualified, defined contribution retirement plan that must follow all the normal rules that any profit sharing or pension does.

The big difference is that an ESOP invests primarily in employer stock. The shares are valued by an independent valuation firm each year to determine fair market value. When an employee retires or otherwise separates from service, the corporation or the ESOP itself redeems his/her stock at the appraised value.

Okay, Then What is a “Leveraged” ESOP?

Andy wants the ESOP to buy his stock, right? But, where does it get the money? The law permits the ESOP to borrow it. The ESOP negotiates a loan from a bank. But, wait. How does it service this debt? It has no money! The corporation makes the loan payments, which are characterized by the law as deductible plan contributions. The limit? The debt service limit is 25% of payroll for the principal, and no limit on interest. Have you ever heard of a fully deductible loan – both interest and principal?!

Here’s is another fabulous little twist Congress allows for ESOP’s. If 25% of pay isn’t enough to buy as much of the owner’s stock as he/she desires, dividends can be declared on ESOP shares to permit more cash flow — and get this, these are deductible dividends!

You’re Joking… No Capital Gains Tax?!

No joke. We call this a “Section 1042 Rollover”. Section 1042 of the tax code says that if after the sale the ESOP owns at least 30% of the company, the selling shareholder(s) can reinvest in a portfolio of publicly-traded securities and avoid the capital gains tax. Further, his/her heirs still get a step up in cost basis at death, so no capitals gains then either! Incredible, huh? And, if later on, the ESOP buys more of the owner(s)’s shares, same deal applies.

Who’s Left in Control?

Just like your 401(k) plan or profit-sharing plan, trustees are named for the ESOP. Those are going to be the management team, obviously. The trustees vote the ESOP shares on all matters except a few major ones, such as sale or liquidation of the business.

Normally, the founder will gift or sell a few shares to his/her successor management team. And, normally, the founder can’t sell all his/her interest at one time. So, in a nutshell, nothing changes!

What About Estate Taxes?

Bear in mind that we haven’t changed the value of Andy’s estate one penny. We’ve transformed illiquid assets into liquid ones, which makes it a bunch easier to pay the tax, but life insurance is always the most efficient option. How about this. The ESOP can own a policy on Andy to buy the rest of his stock when he dies, and the premium is fully deductible! Or, if the successor management team doesn’t want the ESOP to get any larger, proportionately, the corporation can own the policy (nondeductible) and do the redemption.

How Do Employees Feel About ESOP?

They love them! Every study that has been undertaken shows increased morale…lower operational expenses…lower turnover…and higher profits.

To Summarize… .

For a closely-held or family business owner, ESOP can be the perfect exit strategy.

ESOP allows the owners to create a market for their shares, sell out with no tax bill, and even get their estate tax problem solved.

ESOP perpetuates the business legacy for long-term employees and/or children.

ESOP promotes esprit de corps, increases corporate profits, and reduces the expense of employee turnover.

Can ESOP Work for You?

It starts, just like any financial planning, by setting goals – deciding what you want to happen and when. Here are just a few examples of when ESOP might fit….

It’s a family business. Dad wants to get on down to Florida and let the kids run things. But, how do he and Mom get the kind of income they need to support the standard of living they desire in their golden years? And, how can they not be dependent on their children making the right decisions back home?

Or, maybe it comes from the other end. The business and the high-tech world have passed Dad by. The kids ask, “If this business is to prosper in today’s world, we need a change of command. What can we offer to Dad that will encourage him to turn over the reigns?”

Mary and Sue, the founders, are ready to retire and enjoy life a little. But, the key employees can’t possibly come up with the money to buy them out. They sell a few shares via options or such to the successor management, and use ESOP and its 1042 rollover.

Harry died without a business perpetuation plan. The stock went to his wife, Sally, under the marital deduction. She has moved to California to be near her grandchildren. The key employees are stuck. What now? When they need to do something that requires board approval, she says, “Oh, let’s don’t change anything. Harry wouldn’t like that.” And when Sally dies and the estate taxes are due, the business is in the drink. ESOP may be the perfect solution.

We can’t say if ESOP is right for you. But, we can say this with confidence. If you own a small business, you owe it to yourself to find out as much as you can about this technique.

Thomas Yearian, CLU, ChFC … Vice President and Director of Estate & Business Planning Services for J. Smith Lanier & Company … Vice President of The Small Business Council of America and president of The Georgia Chapter of SBCA