Consider ESOP Tax Benefits to Maximize a Business Sale
By Mark Klopfenstein, Managing Director
Corporate Finance Associates
Many business owners stand to benefit greatly from special tax benefits available exclusively in ESOP transactions. The CFA professionals can help business owners understand and evaluate how these opportunities might apply to a specific client situation. We can objectively quantify the anticipated results of various sale alternatives, including a traditional asset sale, a traditional stock sale, and a partial or complete sale to an ESOP. We can also assist owners in considering all relevant intangible factors. Our role is to assist clients in choosing and executing the best transaction for their unique goals and circumstances.
Capital Gain Tax Planning Opportunities Exclusive to ESOP Transactions
Unlike a traditional asset sale or stock sale, the ESOP alternative enables statutory capital gain tax savings opportunities. Under the provisions of section 1042 of the Internal Revenue Code, sellers of C corporation stock can defer (in many cases permanently) their capital gain taxes. With the increase in federal tax rates applicable to capital gains from 15% to 23.8% effective January 1, 2013, this provision has taken on increased importance in sale planning. Generally, the gain is deferred to the extent the sale proceeds continue to be re-invested in stocks and bonds of U.S. issuers and when at least 30% of the company’s stock is owned by the ESOP immediately after the transaction. Other requirements apply as well, but many owners will qualify for this benefit. The investment strategy can include long-dated notes from blue chip issuers that meet the requirements and can usually be combined with estate tax planning to allow for a permanent benefit. Nearly all states follow the federal provision as well.
C Corporation Issues Related to ESOP Capital Gain Tax Planning Opportunities
Because the section 1042 benefit applies only to C corporations, the sale analysis must account for the two layers of taxation of C corporation income—one at the corporate level and another at the shareholder level. For existing C corporations, the section 1042 benefit is readily available. For other businesses, it may or may not make sense to convert to C status prior to a sale to enable the owners to save the capital gain taxes.
C corporation (or former C corporation) sales generally involve a conflict between the objectives of the sellers and the buyer as to the legal structure of the transaction. Sellers typically want to sell corporate stock to incur only one layer of tax at favorable capital gains rates. On the other hand, buyers want to buy assets directly from the corporation to qualify to allocate the entire purchase price to the assets and to enhance (“step-up”) the tax basis in the assets, which can be deducted over time. But the second layer of tax inherent in an asset transaction usually makes it prohibitively expensive for the seller. The normal resolution is that the buyer is willing to buy stock and forego the step-up benefit, but only after discounting the purchase price at least in the amount of the foregone benefit. The ESOP structure skirts this conflict as it involves a friendly buyer of stock, not assets, for full value, delivering the preferred legal form of the transaction for the sellers.
Quantifying the Benefits to a Typical C Corporation Shareholder
To quantify the above factors in an example, let’s assume that a C corporation has net asset value of $100 with zero tax basis in its net assets. The stock is held by a sole individual with zero tax basis. Assuming a combined federal and state corporate tax rate of 40% (35% federal tax plus 5% net state tax), if the corporation sells assets for $100, it will pay a corporate-level tax of $40. Assuming a shareholder-level combined federal and state capital gain tax rate of 30% (23.8% federal tax plus 6.2% net state tax), a distribution of the remaining $60 attracts a shareholder-level capital gain tax of 30%, or $18, leaving the shareholder with net proceeds of $42 ($60-$18).
As discussed, if the asset value is $100 and the corporation has no net asset basis, a rational marketplace will assign a lower value for the stock than for the assets. The discount imposed for a stock rather than an asset transaction theoretically will include the present value of the foregone step-up as well as some amount for increased inherited legal liability risks and other factors. This discussion assumes such discount from asset value to by 20%; thus, the implied stock value is $80.
The table below summarizes the seller’s transaction under the following three basic scenarios: (1) a traditional asset transaction, (2) a traditional stock transaction (with no ESOP), and (3) a 100% ESOP Transaction. The asset transaction yields $42 in net after-tax cash to the shareholder; the traditional stock transaction without an ESOP yields $56; while the 100% sale of stock to an ESOP yields $80. Thus, the ESOP transaction delivers 90% more after-tax cash to the shareholder than an asset transaction and 43% more cash than a traditional stock sale:
Post-Transaction Considerations: Company-Level ESOP Tax Benefits
In addition to the shareholder-level section 1042 capital gain benefits, the corporation itself will qualify for post-transaction income tax benefits, beginning with certain deductions that are exclusively available to ESOP-owned C corporations. This includes the ability to deduct (1) the entire purchase price of the transaction over the life of the ESOP loan (subject to annual limits based on size of payroll), along with interest, and (2) reasonable dividends paid to the ESOP. In some situations, these C corporation deductions are large enough to create a taxable loss, which can offset taxes previously paid in the year of the transaction and the two prior tax years.
The ultimate ESOP corporate-level tax savings, however, involve 100% nominal ownership of S corporation stock by the ESOP. Because S corporations are pass-through entities and the ESOP shareholder is not subject to tax, no federal income tax on the profits of the business is paid to the extent of the ESOP stock ownership. Most states follow this federal treatment. Deductions are unnecessary as the entire structure is effectively tax-exempt. The enhanced cash flow from tax savings can be used to repay the acquisition debt faster, on a pre-tax basis. Once the acquisition debt has been paid down, the tax savings produce substantially more cash flow which can be used to grow the business faster.
The typical sequence for an existing C corporation is to complete the ESOP stock sale as a C corporation to allow the shareholder to qualify for the capital gain benefit, then to elect S status at its earliest opportunity, which is the beginning of the following tax year. As discussed below, the deal consideration for shareholders can include participation in these future corporate-level benefits.
Converting an Existing S Corporation or Limited Liability Company to C Status
As indicated above, the favorable section 1042 capital gain treatment is only available to C corporations. If the owner of an S corporation wanted to capture this benefit, the existing S status could be terminated before closing, causing the corporation to default to C status. Such a termination can typically be easily effected in a number of ways. While such a termination would enable existing shareholders to save capital gains taxes, it would have certain consequences for the company.
First, the corporation would have to wait five taxable years before re-electing S status. Second, for this five year period as a C corporation, the company may be subject to a corporate-level tax. But any C corporation tax issue is mitigated, oftentimes entirely, by the deductions described above that are exclusively available to ESOP-owned C corporations. After five years, S corporation status can be re-elected to achieve the structural tax-free status discussed above. Additional technical issues apply to corporations that convert from C to S status, and these need to be managed.
Similarly, a limited liability company could incorporate tax-free prior to completing the sale to the ESOP. As discussed above, if the transaction is closed as a C corporation, the sellers generally could elect the section 1042 capital gain benefit. The company would then normally elect S status effective as of the beginning of the following tax year. In each situation, the consequences generally require financial modeling by qualified advisors to determine the effects and to inform sellers’ decisions.
Some Additional Considerations in ESOP Transactions
The legal definition of value in an ESOP transaction is the traditional “willing buyer, willing seller” standard established by the IRS in 1959. As a matter of practice, however, this definition is usually interpreted in an ESOP structure to be the value to a financial buyer, not to a strategic buyer that may factor in synergies not available under a stand-alone structure. If this scenario is applicable, appropriate adjustments to the analysis can be made. For example, if the stock could be sold to a strategic buyer for a 20% premium over $80, or $96, the after-tax proceeds to the seller would be $67.2 ($96 less capital gain taxes at 30%) and the ESOP enhancement would shrink to 19% ($80 versus $67.2).
Also, financing considerations are important. The cash at closing available to sellers into ESOPs structures is a function of the credit capacity of the company, which may be less than 100% of the purchase price. Accordingly, some residual seller subordinated financing is typically indicated. Depending on the objectives of the seller, this could be advantageous or disadvantageous. In many ESOP transactions, the terms of the seller financing are quite attractive, with high yields and/or synthetic equity that enables the seller to participate in the continuing upside of the company.
This example also does not contemplate certain other factors involved in the sale of a business, many of which are intangible or qualitative. These factors can include (1) the perpetuation of the business and the legacy of the founder, which is generally not available in a sale to a strategic or private equity buyer, (2) the impact on the employees and the larger community, and (3) the additional dimension of tax and other benefits exclusively available to ESOP-owned companies (separate from the shareholder capital gain benefit described above) that could benefit sellers receiving synthetic equity as partial sale consideration.
In maximizing a business sale, it is crucially important to objectively quantify the tax and economic consequences of all alternatives. This effort will often demonstrate tremendous advantages under the ESOP alternatives as compared to traditional alternatives; it is very difficult for non-tax-advantaged structures to compete with the ESOP tax advantages in today’s environment of higher tax rates. Multiple non-quantitative considerations are also highly relevant, however, and not every sale situation is appropriate or conducive to an ESOP solution.
Many traditional investment banks and other financial advisors are not well-versed in the intricacies of ESOP-based solutions. For this and other reasons, they sometimes do not give adequate consideration to these alternatives. On the other hand, some ESOP boutiques transparently push ESOPs when other structures may be more appropriate. Additionally, some tend to force the analysis into preconceived, “cookie-cutter” structures that are likely to be suboptimal in any given fact pattern.
In contrast, CFA’s ESOP Group has the experience of over 300 ESOP transactions, large and small, in multiple industries. We are extraordinarily well-situated to navigate the complexities of ESOP transactions and the many multi-disciplinary issues, involving M&A, tax, valuation, finance, financial accounting, ERISA, and other areas. We also have tremendous capabilities to assist clients with traditional strategies.
Above all, we agnostically seek to help clients understand all alternatives and maximize the transaction, quantitatively and qualitatively, to meet the client’s specific objectives. Let us help to maximize your situation.
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