If you are a 50-something HVACR business owner, there is a strong likelihood that you, as the owner, may be leaving your company in the next 10 years. Do you have an exit strategy? If not, you are not alone. Recent surveys estimate that some 60 percent of business owners lack a succession plan. That's worrisome because after working so hard to build your business, it is important to devote time and attention to building your graceful exit.

Options include finding a buyer or passing the business on to your children. But an often-overlooked option for a corporation is an Employee Stock Ownership Plan (ESOP). Simply, an ESOP allows you to sell your business to your employees. It is a qualified retirement plan designed to invest primarily in the employer's stock. Typically, a corporation forms the ESOP to purchase some or all of the outstanding stock from a selling shareholder at a price determined by an independent appraiser. Based on HVACR industry projections, the increasing demand for your services might help support a higher purchase price.

To fund the ESOP, the corporation will generally borrow from a lender the dollars necessary for the ESOP to purchase the corporation's shares. The corporation loans the proceeds to the ESOP, and the ESOP in turn buys the shares from the selling shareholder. We typically call this a leveraged ESOP, and it operates very much like any existing qualified profit-sharing plan. In fact, the plan has a trustee who controls the ESOP shares for most purposes.

As the mergers and acquisitions climate has cooled somewhat, the ESOP environment has been getting renewed interest. There are a number of sound reasons why you should thoughtfully explore an ESOP.

Tax Incentives

If, after the transaction, an ESOP owns at least 30 percent of the outstanding stock of the corporation, and the selling shareholder elects to roll over the proceeds into “qualified replacement property,” the federal income tax otherwise due from the sale by such selling shareholder is generally deferrable. (This benefit does not apply to an S corporation. An S corporation is one where the shareholders have elected to be responsible for paying the taxes on the company's income.) Even if the deferral is unavailable, the federal tax rate is generally only 15 percent to the selling shareholder. If structured correctly, the corporation will, in effect, get a tax deduction for the interest and principal payments ultimately paid to the lender.

What Are the Benefits to the Selling Shareholder Under Current Tax Law?

  • If the selling shareholder holds the qualified replacement property until his or her death, the deferral of federal income taxes may be permanent.
  • Selling shareholders can continue to work for the corporation.
  • Selling shareholders can transfer the qualified replacement property received by gift without triggering the deferred gain.
  • Depending on the ESOP's percentage ownership of the company, the selling shareholders can still maintain control of the corporation.

Selling Shareholders Should Be Aware of the Following:

  • You must reinvest the proceeds from the ESOP within 12 months to take advantage of the income tax deferral.
  • Qualified replacement property includes stock or securities issued by a domestic operating corporation.
  • Reinvestment in shares of a mutual fund or government securities does not qualify as replacement property.
  • Interest or dividend income on replacement securities will still face a tax when received.
  • Recognition of the gain deferred occurs when selling the replacement property.
  • Some shareholdings may not be eligible for income tax deferral.

What Are the Benefits to Other Shareholders?

  • An ESOP may alleviate or limit the need for insurance on the selling shareholder's life.
  • The ESOP may establish the vehicle for future sales of additional stock of the corporation.
  • The ESOP may relieve remaining shareholders and the corporation from the requirement of buying out selling shareholders' shares upon their death.
  • Depending on the ESOP's percentage ownership of the corporation, the remaining shareholders can still control the business.

What Are the Benefits to the Corporation and Employees?

  • An ESOP provides a tax-advantaged financing vehicle to effectively redeem selling shareholders. The interest and principal payments by the corporation on the ESOP loan are usually fully tax-deductible. Thus, the corporation is able to fund the buyout of a selling shareholder with pre-tax dollars.
  • The ESOP will create a stock-based, incentive-oriented retirement program for your employees.
  • Current pension plan assets typically can remain in the plan.
  • Employees will share effectively in the equity growth and profits of the business, which will often lead to increased productivity and morale.
  • In some cases, the formation of the ESOP can have a positive impact on cash flow.
  • In general, dividends used to make payments on the loan of a leveraged ESOP are deductible.
  • If the company is an S corporation, whatever percentage the ESOP owns of the corporation, then that portion of the corporation's taxable income will, generally, not be subject to federal income tax.

The Corporation and Employees Should Keep the Following in Mind:

  • In general, the ESOP must hold the shares sold to it for three years to avoid an excise tax.
  • The ESOP must operate for the exclusive benefit of the participants and on a nondiscriminatory basis.
  • ESOP participants have the right to require the corporation to repurchase their vested stock upon termination of employment.
  • The ESOP must be coordinated with other company plans.

How Do You Determine if Your Business Is a Viable ESOP Candidate?

Consider several factors before implementing an ESOP. Ideally, an ESOP candidate is a corporation that has:

  • Sufficient debt capacity.
  • A strong management team and a corporate culture that is comfortable with employee ownership participation.
  • Relatively low employee turnover and sufficient annual payroll to take advantage of the tax benefits associated with an ESOP.
  • The ability to grow without requiring large capital expenditures or working capital.
  • A low percentage of employees who will retire during the ESOP loan phase.

Overall, the ESOP can be an excellent succession planning strategy. Clearly, you must explore all of your options and seek the best professional advice. An ESOP is complicated and technical, but with the right information, you can make an informed decision. If the ESOP is the right fit for your business and your succession planning goals, you will have the added satisfaction of offering a valuable benefit to your employees. But most importantly, you can move on with your life knowing that the business you worked so hard to build will continue to grow and prosper.

Carl J. Grassi is president of McDonald Hopkins LLC, a Cleveland-based law firm with additional offices in Chicago, Columbus, Detroit and West Palm Beach, FL. The firm has 130 attorneys and a more than 75-year history. Grassi is both an attorney and a certified public accountant who has extensive experience advising clients concerning a wide range of complex business issues including succession planning and all aspects of ESOPs. Grassi is also a part-owner of an HVACR business. Contact Carl at 216/348-5448 or at cgrassi@mcdonaldhopkins.com.