Utility Merger Toolbox for Labor (outline)
2013 tax changes improve tax benefits to owners selling stock to ESOPs or Co-ops
Deferral of capital gains tax on sale of C corporation stock to an ESOP or Eligible Worker Owned Cooperative has become more valuable since capital gains rates increased from 15% to 20% after 12/31/12 for individuals with income over $400,000, joint filers over $450,000, under the American Taxpayer Relief Act of 2012 (ATRA).
Thinking of selling your business?
An ESOP or Worker Co-op can save you money!
An ESOP is an employee benefit plan that invests primarily in employer stock. There are a host of tax incentives, briefly described below, to encourage business owners to take advantage of ESOPs.
Six reasons to consider an ESOP
1. You can get a fair price for your stock.
Many owners of closely held businesses are unable to find a buyer who will pay a fair price for their stock, especially if they are initially offering only a minority block of shares. An ESOP provides a market for closely held stock, at a fair price determined by an independent appraiser.
2. Your company can write off the expense of buying your stock.
The Company can deduct from taxable income the amount of contributions made to finance the purchase of your stock by the ESOP (within limits). In a leveraged ESOP, this means that the Company can, in effect, deduct interest and principal payments on the loan used to purchase your stock, and in some cases the use of stock dividends to repay purchase debt. Without an ESOP, only interest payments would be deductible. This savings boosts after tax profits and the Company’s ability to buy your stock.
3. Your Sub-S company’s ESOP pays no income tax.
An ESOP trust can be a shareholder in your Sub‑S company. In fact, the more stock in the S company the ESOP holds, the more tax-free cash remains in the company. An ESOP has greater tax advantages than any other Sub S shareholder, in that its income is not taxed (due to its exemption from UBIT tax). Instead that income is only taxed to the ESOP participants when they take their distribution upon leaving the company. Employer contributions are deductible for up to 25% of covered compensation. There are no additional deductions for repayment of loan interest. An ESOP in combination with a 401(k) plan, allows the company match to be made in Company stock. A Sub-S ESOP is not eligible for the expanded tax or dividend deductions of a leveraged ESOP, nor the capital gains rollover.
4. Your proceeds from an ESOP stock sale may be tax-free.
If you sell your stock in a Subchapter C company to an ESOP and reinvest the proceeds from the sale in stock of another U.S. Company, your capital gain from the sale will not be taxed until you sell the newly acquired stock. If you decide not to sell the new stock during your lifetime, you may avoid taxation of the ESOP sale income entirely (depending on the estate tax basis rules applicable on the date of death). This tax “rollover” is only available if, after the sale, the ESOP holds at least 30% of the Company stock. Certain other federal requirements must also be met.
5. ESOPs are very flexible.
ESOPs are very flexible. You can cash out all your shares immediately, or you can gradually sell your shares to an ESOP over many years.
6. Sale to an ESOP preserves the company’s independence and rewards the people who made it a success.
You may be reluctant to sell your company to a buyer with no ties to the community. Frequently the sale of a local business to an outsider results in alienation of the work force, curtailment of operation, sale of assets, plant shutdown, or relocation. Sale to your employees through an ESOP may be the best way to ensure the continued success of your business.
How an ESOP Works
In a “leveraged” ESOP, the ESOP borrows money and buys the owner’s stock. The Company usually guarantees the loan, and contributes enough money each year to enable the ESOP to repay the loan. In a “non-leveraged” ESOP, the ESOP uses company contributions to purchase stock each year rather than to repay a loan.
The company deducts the contributions from its taxable income. The ESOP stock is allocated to employee trust accounts and when employees retire they receive their shares, or the cash value of those shares. There are many variations on this arrangement. ESOPs are extremely flexible.
Example – Complete buyout of a C corporation shareholder, followed by a corporate S election
Mr. Fulton owns 100% of the shares of Tool & Die, Inc., a Sub Chapter C company worth $6 million. Mr. Fulton is getting older and would like to sell his company and enjoy the proceeds. If he sells to an outside buyer, he will pay taxes, perhaps at the 20% rate, on his net long-term capital gain. If his original basis in the stock was -0-, he would pay $1,200,000 and keep $4,800,000 after taxes.
If the company, instead of an outsider, buys him out by borrowing money or using cash reserves, Mr. Fulton faces the same tax sting. In addition, the payments will not be deductible to the company and might impoverish it (perhaps making it impossible for the company to complete a gradual buyout).
These problems can be avoided if Mr. Fulton creates a company ESOP. The ESOP finances the purchase with company contributions, or by borrowing from a lender through the ESOP. The company typically would guarantee the loan. The purchase price of the stock is set by an independent appraisal. If Mr. Fulton initially sells at least 30% of outstanding company stock to the ESOP, he can “rollover” the proceeds of the sale into stock or bonds in U.S. companies and avoid paying any tax on the proceeds unless and until he sells that “replacement” stock. Any replacement stock that remains in his estate until his death may get a stepped-up basis (depending on applicable estate tax laws in the year of death). Where the stepped up basis applies, the capital gain is never taxed.
The company deducts the full amount of contributions to the ESOP used to buy Mr. Fulton’s stock, or to make interest and principal payments, within limits, on a loan used to buy Mr. Fulton’s stock. If the company is taxed at a corporate rate of 36%, this deduction would mean that $2,160,000 (36% of $6 million) of the cost of cashing out Mr. Fulton would be paid out of company funds that otherwise would have been used to pay taxes.
The stock is held in trust for employees. When they retire or leave the company they are paid their vested and allocated stock or the cash value of that stock, usually in installment payments over five years (or longer if the company stock was purchased with borrowed funds).
There are several permissible vesting schedules so that employees who leave with less than five years of service need not get any stock upon termination.
The net result is:
Four Reasons to consider an Eligible Worker Owned Co-op (EWOC)
1. You can get a fair price for your stock with less regulation.
Owners of closely held businesses are often unable to find a buyer who will pay a fair price for their company. A worker co-op provides a market for closely held stock, and is not subject to the ERISA regulations of an ESOP stock valuation.
2. Your proceeds from a stock sale to a worker co-op may be tax-free.
If you sell your stock in a Subchapter C company to an “eligible worker owned co-op” (EWOC) and reinvest the proceeds from the sale in stock of another U.S. company, your capital gain from the sale will not be taxed until you sell the newly acquired stock. If you decide not to sell the new stock during your lifetime, you may avoid taxation of the EWOC sale income entirely (depending on the estate tax basis rules applicable on the date of death). This tax “rollover” is only available if, after the sale, the EWOC holds at least 30% of the Company stock. Certain other federal requirements must also be met. The Sub-chapter S corporation tax benefits do not apply to EWOCs.
3. Co-ops are less expensive and less regulated than ESOPs.
A co-op is a business entity not an employee benefit plans. There is no trust, no trustee, and no pension regulation.
4. Sale to Co-op keeps your company independent and rewards those made it a success.
You may be reluctant to sell your company to a buyer with no ties to the community. Frequently the sale of a local business to an outsider results in alienation of the work force, curtailment of operation, sale of assets, plant shutdown, or relocation. Sale to your employees through a worker co-op may ensure the continued success of your business.
Our firm is dedicated to helping local companies and communities successfully compete in the global marketplace, by building strong, sustainable, local businesses. We are a two attorney law firm providing non-litigation business law services. Our specialty is employee ownership and cooperatives.
Attorney Deborah Groban Olson has 32 years’ experience creating and advising employee-owned companies using ESOPs, cooperatives and other structures, representing sellers, buyers, companies, trusts, unions, employees and consumers. Olson is Executive Director of the Center for Community Based Enterprise, Inc. (“Center”) (c2be.org) which supports and connects entrepreneurs, community and resources to grow sustainable, locally-rooted businesses that pay living wages. The Center also provides education and consulting on community-based enterprise best practices.
Olson is president of Ingenuity US, L3C (IUS) a community innovation broker and business developer, with plans to create a crowd sourced social venture fund. IUS currently works with Detroit entrepreneurs to start-up worker owned businesses. IUS developed labor patent strategies to keep union jobs in the US and aid inventors, including the Hawaii Sustainable Business Corporations Act of 2011.
Olson is a board of directors’ member of Circle Pines Center (co-op education and recreation center since 1938 in Delton, MI); and a board member of the employee-owned Once Again Nut Butter in Nunda, NY. She is past board chair of the National Center for Employee Ownership, and previously served as founding Executive Director of the Michigan Employee Ownership Center, JointCities Development Corporation and the Capital Ownership Group.
Attorney Jacquise A. Purifoy has just begun her formal practice of law, but previously worked for Congressman Hansen Clarke as his Community Grants Coordinator who assisted constituents in acquiring over $9 million in grants. She is on the Board of Directors of Kiva Detroit and Church of Messiah Housing Corporation. She also serves as an active mentor with the Business and Professional Women Foundation’s Joining Forces for Women Veterans and Military Spouses Mentoring program. Purifoy is the Outreach and Development Director of the Center.
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