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Using an ESOP to Liquidate a Portion of the Value of a Family Business
By Martin StaubusPreviously published by the Family Firm Institute
Family business consultants should be aware of the opportunities available through the innovative application of an employee stock ownership plan (ESOP).
Consider Bill Fisher and his wife Joan, who had built a business that had recently been valued at $20 million. They had also built a great family. Their oldest, Bill Fisher Jr., worked in the business, taking increasing responsibility for operations. At just 32, many said he was too young for that role, but having grown up working summers and after school in the stock room or on maintenance, he knew the business very well. Daughter Suzie Fisher was a school teacher and the youngest John Fisher was in medical school.
At age 62 and 60, respectively, Bill and Joan Fisher were convinced it was time to retire and pursue their lifelong ambition to travel while they still had the vigor to do so. Bill Fisher Jr. had made it clear that he hoped to run the business one day – something his parents hoped to see. But what about Suzie and John Fisher? “And what about us,” thought Bill and Joan Fisher. “We certainly want to be financially comfortable.”
The challenge, in short, was devising a plan that would assure attractive futures for themselves and their loved ones. For that they turned to Fred, an experienced financial advisor.
The Nature of the Challenge
Fred worked with the Fishers to identify a short list of goals that pretty well defined their aspirations:
A financial analysis of the business showed that, while it was solidly profitable, it could not be expected to generate enough cash from operations to provide for all the needs listed above. Bill Fisher Jr., and his management team would need to be compensated; and the company itself would need cash to fund continuing growth. The projected cash flow simply wouldn’t be sufficient to meet the needs of the business and provide $400,000/year for the Fishers, fund philanthropic contributions and provide for Suzie and John.
The ESOP-Based Solution
Fred suggested they consider an ESOP. Technically, an ESOP is a retirement plan and serves the purpose of accumulating retirement savings for the company’s employees. In practice however there is more to it. While it’s true these programs have accumulated significant retirement savings for the covered employees, the biggest reason for the popularity of ESOPs is that they can act as a cash buyer of private company stock, thus creating a source of liquidity for the company's owners.
Unlike other tax-deductible retirement plans, an ESOP is authorized to invest its assets entirely in the stock of the sponsoring company – and to borrow money to buy such stock. Loans to an ESOP must be backed by the company itself, but this borrowing capability turns an ESOP into a potent – and friendly – buyer of stock from company shareholders.
There are also substantial tax advantages that add to the attractiveness of an ESOP. The main ones:
The Fishers Succession Plan
“The challenge in meeting your goals,” said Fred, “is not that you don’t have enough wealth.” You are financially successful people! Rather, your challenge is that so much of your wealth is tied up in an illiquid asset – the family business. If you could liquidate some of that wealth you could easily achieve all of the goals you have laid out. That’s where an ESOP can help. Here is the full plan, step by step.
1. Fisher Enterprises establishes an ESOP, to which the Fishers will sell 51 percent of their company stock (the company will arrange with its bank for a loan to the ESOP for this purpose). Based on the company value of $20 million, this sale will bring them $10.2 million. They will claim the special ESOP capital gains tax deferral to avoid the $2 million in capital gains taxes they would otherwise have to pay. At this point they have liquidated 51 percent of their shares without losing any of the proceeds to taxes and can now diversify those assets to reduce the family investment risk. Moreover, they retain control of the company (despite having sold 51 percent), since the ESOP laws allow them to control the ESOP. Still, at this point the $10.2 million in sales proceeds remain part of their estate and will eventually be subject to estate taxation. And the assets still carry the original tax basis of their company stock (virtually zero). The capital gains tax is only deferred, not eliminated.
2. Next, the Fishers establish a “charitable remainder uni-trust” (or CRUT) at the charitable institution they have long supported, to which they contribute the $10.2 million from their sale of stock. The CRUT will pay them an annual income for the rest of their lives of 7 percent on the principal. Upon their deaths, the principal will be turned over to the charity.
The result of this step is:
3. Step three is to provide for Suzie and John Fisher. At Fred’s recommendation the Fishers form an irrevocable life insurance trust (ILIT). Recall that they want $400,000 for their annual income; but the CRUT will provide $714,000. The extra amount is more than enough to pay the premiums on a $10 million life insurance policy to be held in the ILIT. Suzie and John Fisher will receive the pay-out tax free upon their parents’ deaths. Their futures are now assured.
4. What about Bill Fisher Jr., who hopes to take over the business? That brings us to step four – transferring the family's remaining interest in the company to Bill Fisher Jr. Now that the Fishers have sold $10.2 million of their $20 million company, one might assume their remaining 49 percent interest is worth $9.8 million. Not so – and here’s why. To buy that stock, the ESOP borrowed the $10.2 million. That debt is reflected as an obligation of the company itself, which reduces the value of the firm. In fact, because of the debt the actual value of the company dropped to about $12 million. In addition, the Fishers' 49 percent stake is now a minority interest. As such, it is subject to a minority discount of roughly 25 percent. Bottom line: the value of the Fishers’ 49 percent interest is for the moment only about $4.4 million. The Fishers can therefore transfer shares to their oldest son by gift or sale over the next several years with limited tax costs.
There is one more advantage to this plan. As a result of the sale to the ESOP, all employees will receive a substantial allocation of company stock to their ESOP retirement account. Studies have looked at thousands of companies with ESOPs and found that in most cases the ownership of company stock motivated employees to improve performance and drive business growth. The Fishers like the idea that when Bill Fisher Jr. takes over as a rookie CEO, his job may be a little easier because the employees will be pulling for him to succeed.
That was Bill and Joan Fisher’s path. Is it the right path for every family business? Of course not – one size never fits all. Consider some limitations:
Given these issues, it is highly advisable to consult with a knowledgeable advisor (one who isn’t simply in the business of “selling” ESOPs) for assistance in exploring the ESOP idea. Serious evaluation usually begins with a “feasibility analysis” to assess the pros and cons before making a final decision on an ESOP.
In the right situation, an ESOP can be a very attractive tool. It is unique in the flexibility it provides. That’s partly because, in arranging the transaction, there is no adversarial buyer sitting across the table. Instead, company owners can draw up the arrangement based entirely on what they would like to see. They can choose how much of the company to sell, when to sell, and how active they will remain in management.
For family business advisors, being aware of the ESOP as one of the available strategies for business succession can improve your ability to serve your clients. Encouraging your clients to explore this strategy may add immeasurable value for them.