InSight

Exit and Growth Strategies for Middle Market Businesses

Taxes Increasingly Important in Sale Strategies

By Robert Massengill | Aug 03, 2015

Upward Chart Money SignBusiness owners evaluating transition alternatives for their companies have a variety of  choices.  They can take their companies public, merge, sell to a third-party or sell internally.  While each of these alternatives has their benefits and limitations, prioritizing goals for the sale is a big step is narrowing down the choices.

Regardless of the method chosen for the sale, taxes play an important role and there’s a saying that “it’s not what you get, but what you keep.”  In today’s environment of increased capital gains rate, the ACA surcharge and growing state income tax rates,  more and more owners are seeking tax advantaged sale structures.  For owners with transition goals that include more than just price, there is no transaction more efficient than selling internally using an employee stock ownership plan, ESOP.

Sellers have the ability to indefinitely defer their capital gains tax, employees receive a deferred retirement benefit and companies can eliminate federal and most state corporate income taxes.  While tax efficiency isn’t the only criteria for a sale, it’s a strong motivator.

Consider the following example of a company generating cash flow of $3MM.  Assume the valuation is 6X cash flow and the company has no debt.  This yields an enterprise and equity value of $18MM.  The business is a C corporation, has an asset basis of $4MM and the owner has a stock basis of $3MM.  We’ll further assume an offer has been presented from a third-party and the owner is comparing a sale of assets or stock to the third-party and an ESOP.

The following table summarizes the after-tax proceeds from different transactions.

Massengill Net Proceeds

Your CPA reports back that an asset sale will yield, after paying corporate and personal taxes, $9.5MM while a sale of stock would net $13.7MM.  They also report a sale to an ESOP incurs not corporate or personal taxes and thus yields $18MM on an $18MM sale price.  Many owners using the ESOP say they’d rather give that value to the employees directly than the taxing authorities.

To look at this example differently, let’s calculate the sale price needed to net the same $18MM.  Using the same assumptions as before, you can see an asset sale to the third-party would require an 83% premium to the ESOP sale and a 33% premium to the stock sale.

Massengill Net Sale Price Comparison

This analysis focuses solely on the owners’ proceeds, but let’s also consider corporate taxation.  For over ten years, an ESOP has been an eligible shareholder of an S corporation.  We all know the S-corporation is a flow through entity and is taxed at the shareholder level.  But did you know the ESOP doesn’t pay taxes?  Imagine a 100% ESOP owned S-corporation.  Can you say “tax free company?”  In 2000, only 5% of ESOPs in the US owned 100% of their companies.  Today that number is over 45% and you can see why.

Eliminating corporate taxes frees up cash flow to repay debt faster.  On average, we see a comparative difference of 2-3 years.  Once the buyout debt has been repaid, the tax holiday doesn’t go away (as it does when a financial buyer purchases the business).  Imagine again competing without the burden of corporate taxes.

Keep in mind that the government isn’t giving away the store. Despite all the current tax savings, it will ultimately realize its income when employees are cashed out of their ESOP accounts and pay income taxes.

While this blog has focused on the extraordinary tax benefits afforded ESOPs, we know there are other equally important criteria as well.  If you are considering how to transition the ownership of your business and would like our perspective on whether or not a sale to an ESOP, makes sense for you, give us a call.

Posted by Robert Massengill.

Subscribe to The Middle Market Pulse


Leave a Comment