One of the most sophisticated and tax-friendly ways of selling your business may come by selling your business to the people who already know it the best – your employees.

Unlike selling it to your children (who may lack the technical expertise or personal desire to carry on the family business) or third party buyers (who may not have the same commitment to your business’ mission and your customers’ satisfaction) the employees and officers of your Company may provide an attractive Buyer for your business.

The Employee Stock Ownership Plan (ESOP)

The Government has an established interest in keeping your business intact, making money and paying taxes, long after your retirement. Selling your business to people who may not be qualified to run it, or who may be interested in chopping it up and selling off the pieces, is not good public policy.

Accordingly, the ESOP was established in 1974 under ERISA (the Emp0loyee Retirement Income Security Act) as a tax qualified retirement plan.

Because an ESOP is tax qualified under ERISA, an ESOP allows the Employees of a Company to purchase stock of their Company - with government regulation and supervision - with pre-tax dollars.

The Tax Advantaged Sale

Because Employee-Buyers are using pre-tax dollars to purchase their Company, they often have greater buying power than an outsider, who has to factor taxes in to their purchase transaction.

Consider the following hypothetical:

An outside Buyer of a business worth $1,000,000 actually has to come up with $1,300,000 in real dollars - assuming a 30% tax bracket.

However, an Employee-Buyer, purchasing through an ESOP, can pay the $1,000,o00, but is pays the effective cost of $700,000 – because they didn’t have to pay taxes when raising that $1,000,000.

Tax Advantages to the Owner-Seller

But that is not the only tax incentive that the Government provides to ESOP's.

Under § 1042 of the Internal Revenue Code – when the Owner of a business sells their Founder’s Stock to the ESOP – they may qualify for deferred capital gains taxation on the sale.

There are numerous requirements for this tax benefit - the Owner must originally sell no less than 30% of their stock in the initial transaction; proceeds must be invested in qualified replacement property, such as domestic securities.

However, for the Owner who qualifies under § 1042, they will not pay capital gains on the sale of that stock until the replacement property is sold. Under California law, if that property is held as Community Property, the Owner will receive a full step-up in basis in the value of their replacement property at the death of either spouse - thereby completely eliminating capital gains owed by the Owner-Seller.

Returning to the hypothetical above:

The Owner sells his 100% of Founders Stock to the ESOP established by his Company;

If he qualifies under § 1042 of the IRC - he should save $243,000 in long-term capital gains taxes, that would otherwise be due at the time of the sale. This assumes a Federal rate of 15% and a California maximum rate of 9.3% on long-term capital gains.

Calculating the Tax Advantages

In our example, the Employee-Buyers have to come up with $300,000 less than an Outside Buyer, and the Owner pockets $243,000 more than if he sold to outsiders – a whopping $543,000 tax savings in the sale of a $1,000,000 company!

It's no wonder that many business owners have looked to see how they might benefit from selling their business to an ESOP. We encourage you to contact our office to see if this might be an appropriate step for your business.