ESTATE PLANNING ADVISOR

ESTATE PLANNING ADVISOR[i]

Vol.2, No. 14 May, 2001

ESOP’S FABLE, NO ONE WANTS MY BUSINESS!

This Advisor discusses the use of a leveraged employee stock ownership plan (ESOP) buyout of a closely held company. The Advisor uses the question and answer format so as to allow for focus on one issue at a time.

I want to sell my business, how do I go about it?

Are any of your family members interested in the business?

No, is that a problem?

No, I was just narrowing the market for potential buyers.

3. That’s why I came to you, no one seems to want to buy my business, is there anything you can do?

Yes, there is. Have you ever heard of a leveraged ESOP buyout?

4. No, what is it?

An ESOP is a particular type of retirement plan that is intended to invest in the stock of the corporate employer. The government offers significant tax benefits to encourage corporate employers to allow their employees to purchase stock in the corporation.

5. You must be kidding if you think I am going to sell my business to my employees. I worked too hard to build it up. Isn’t there something else?

Well, you told me no one wanted to buy your business. If that is true, you don’t seem to have much choice in the matter. The ESOP is a buyer you can create and cause it to buy your business.

6. You mean I either sell the business to this ESOP or let it die?

I don’t see any alternative, do you?

7. Well no, but where are my employees going to get the $2,000,000 to purchase the business?

That’s where the leverage comes in. Assuming your business is worth $2,000,000, and we will need an expert appraisal, a bank will likely be most willing to lend the ESOP the money to allow the ESOP to purchase all of your stock for the assumed $2,000,000.

8. Where are you going to find a bank that is going to lend my employees $2,000,000?

Actually, it shouldn’t be difficult at all for you to find a bank willing to lend the money. Let me explain the cash flow for a minute, because I want to show you how the government will put $900,000 in tax savings into the transaction to enable you to sell at an advantage and for your employees to repay the debt in a very tax efficient manner. The steps are as follows:

Step One: You go to your bank and explain that you want to borrow $2,000,000 so that you can create an ESOP retirement plan to purchase your business.

Step Two: You pick up your banker from the floor and ask me to explain the transaction to him or her.

Step Three: I will explain to your banker that the income tax laws allow you to sell your business to a special type of retirement plan and if you invest the $2,000,000 in qualified domestic securities, likely top grade bonds, you do not have to pay any income taxes on the sale. That means that you save $400,000 over selling to an non ESOP buyer.

9. Are you seriously telling me that the Internal Revenue Service will give me an extra $400,000 just to sell to the ESOP so that my employees can own the company?

Absolutely, starting to sound interesting?

10. Yes, but no banker is going to lend 100% of the value of the business, what do we do about that?

Well, I want you to take a deep breath and think carefully about what I am going to suggest.

Step Three: You give the bank a security interest in the $2,000,000 in bonds that you have purchased so as to avoid the $400,000 in capital gains taxes.

11. Just what makes you think I am going to put my $2,000,000 on the line for my employees?

Well, I don’t see how you have any choice. If you sold on an installment sale to your employees, and remember, that’s your only choice, all you have is an installment note and an ultimate tax liability of $400,000. Your risk is not increased by the ESOP, it is actually decreased.

12. What do you mean decreased, everything I have is on the line for the loan?

Let me explain a couple of points. First, the business is the only source of funds to pay you or the bank. The ESOP has already saved you $400,000 over a cash sale. However, the real savings are for the employees. If your employees bought your company on an installment sale, how much would they have to earn to pay you $2,000,000 for your stock?

13. I don’t know, how much?

Since they are buying the stock, they would need to earn, at an average income tax rate of 20%, $2,500,000 in pre-tax income to pay $500,000 in income taxes and have $2,000,000 left over to pay you. However, the ESOP enables the company to deduct all principal and interest payments on the loan from the bank. That means the company only needs to earn $2,000,000 in pre-tax earnings to pay the bank the $2,000,000. As you can see, the government has given you $400,000 and your company $500,000, or a total of $900,000 to assist in this transaction. Now, let’s go back to the steps:

Step Four: The ESOP pledges the stock of the company for the $2,000,000 loan. Your bank is now double collateralized. It has the $2,000,000 in high grade corporate bonds and the stock of the company so there is a total of $4,000,000 securing the $2,000,000 loan.

14. What happens to my bonds, by the way, why do I have to buy bonds?

Two reasons, if you purchase stock, there is little income for you to live on and the bank will not feel as secure with stocks instead of high grade bonds. While you could sell some stocks, you would recognize gain on the sale with a carry over basis based on your basis in the stock of the company. As the company contributes funds to the ESOP, either as a pension contribution or a tax deductible dividend, the bank releases the appropriate portion of your securities.

15. Well, your idea doesn’t sound so crazy after all. I don’t see any other choice for me.

I think it is something you should consider.