Partial ESOP Ownership as an Exit Strategy

According to the National Center for Employee Ownership (NCEO), the United States has over 6,600 Employee Stock Ownership Plans (ESOPs) with nearly $1.4 trillion in total assets. While ESOP companies are not required to report ownership percentages, the NCEO estimates that only 30% to 40% of those ESOPs are 100% employee-owned.

A partial-ESOP formation can be very beneficial under two common scenarios: a minority shareholder wishes to exit the company or a controlling owner wants to diversify their holdings by selling a portion of their interest.

When assessing an ESOP as a potential option, it is important to consider a partial ESOP sale in addition to 100% employee-ownership.

100% Employee Ownership Versus a Partial ESOP

One of the most attractive aspects for a controlling owner is the ability to diversify their net worth through a partial sale of company stock, yet retain control of the company. The ESOP, represented by a trustee, may obtain some ownership characteristics through voting rights or participation on the board of directors. However, when the ESOP owns less than 50%, the selling shareholder can still retain control of the company.

As with 100% ESOP-owned companies, a partial ESOP company structured as an S corporation does not pay federal income taxes on the portion of the business owned by the ESOP. Taxes are deferred until participants withdraw their ESOP proceeds. This S corporation tax advantage may allow the company to accumulate cash for future ESOP transactions such as majority or 100% conversion.

A partial ESOP transaction may also allow selling shareholders to receive similar tax benefits as a 100% transaction would. Shareholders who sell to an ESOP may be able to defer capital gains tax payments on their proceeds when following the guidelines set forth under Section 1042 of the Internal Revenue Code (IRC). Under an IRC section 1042 tax deferral, the gain on the sale of stock is deferred if the proceeds from the sale are reinvested in accordance with IRC section 1042 guidelines. Most notably for a partial ESOP transaction, the 1042 tax deferral is only available to selling shareholders of C corporation stock. Additionally, the ESOP must acquire at least 30% of the outstanding shares.

Establishing a partial ESOP can also create an ‘ownership culture’ within a company and pave the way for future ESOP transactions.

Fair Market Value

There are unique implications of a partial ESOP transaction. An ESOP is legally bound to pay no more than fair market value for the company’s stock. The percentage of shares sold to the ESOP can affect the per share price the ESOP is able to pay. To ensure an ESOP pays a fair price, a valuation expert will determine the fair market value of the shares being acquired by the ESOP, similar to the annual ESOP valuation process. This expert will take into consideration the ownership percentage being acquired by an ESOP when determining fair market value. All else equal, an ESOP would be willing to pay more on a per share basis for a controlling block of stock as opposed to a minority interest.

Post Transaction Considerations

A partial ESOP may have less annual ESOP contribution expenses than a 100% ESOP company. Once an ESOP is established, annual administrative costs would need to be incurred including the annual valuation, plan administration, and trustee costs. These annual administrative costs would not be substantially lower simply because the ESOP is a partial owner.

Finally, if structured as an S corporation, all shareholders are required to receive proportionate distributions. Accordingly, if distributions are made to non-ESOP shareholders to cover individual income tax liabilities, proportional distributions must also be made to the ESOP. These distributions can potentially limit the cash available within the company to fund capital investments or pre-pay debt obligations. These distributions can, however, accumulate in the ESOP to fund future repurchase obligations or fund additional share purchases.

Weighing the Options

A partial ESOP can be a great liquidity option for a minority shareholder looking to exit or for a controlling shareholder looking to diversify their holdings. A partial ESOP provides both the tangible and intangible benefits for employees and can be a great stepping stone into a 100% ESOP down the road. If you are considering an ESOP as an exit strategy, a feasibility study is the first step in assessing how this unique business structure might work for your company.