How to Reap More From Selling a Business

Last update on: Aug 10 2020
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Business sellers often leave a lot of money on the table. They pay extra taxes on the sale, because they do not use some key tax breaks. We’ll look at one of those strategies in this visit.

There are two problems a business seller must solve. One is liquidity. The seller wants cash for the value built up in the business over the years. A buyer with the ability and willingness to pay full price in cash can be difficult to find. The other problem is taxes. The seller looks for ways to avoid losing 15% or more of the business’s value to taxes immediately after the sale. The strategy we will look at can solve both problems.

Here’s how the standard business sale often works. The seller has a very low tax basis in the business and its assets, so the gain often is close to the sale price. Federal capital gains taxes are 15% of the gain, and there might be state taxes. Paying those taxes could be the biggest check the owner ever will write.

A better result can be achieved by using an employee stock ownership plan (ESOP). The law encourages ESOPs by providing significant tax breaks. The tax advantages can increase the sale price of the business and leave both buyer and seller better off.

In a standard ESOP sale, the business first sets up an ESOP. The ESOP borrows money to purchase stock of the employer. The loan is secured by the stock and might be guaranteed by the employer, but the employees are not personally liable for repayment. The stock can be purchased either directly from the corporation or from the original shareholders. Over time, the ESOP repays the loan using contributions to the ESOP from the employer.

Here are the tax breaks that make the deal so attractive.

  • The lender to an ESOP in such deals is allowed to exclude from income the interest earned on the loan. This creates a pool of banks and other firms willing to provide loans to ESOP deals.
  • The employer gets special deduction limits for contributions to the ESOP. The result often is that all contributions made to the ESOP are deductible. The employer is essentially deducting both principal and interest on the loan used to buy the business. The business might not have any taxable income for years.
  • A benefit for the seller is that gain on the sale of stock to an ESOP can be deferred by rolling over the proceeds into securities of domestic operating corporations, either public or private. In other words, the owner defers taxes to the extent he purchases either a diversified portfolio of securities or another business. The replacement securities must be purchased within three months and 12 months after the business sale. To qualify for deferral of gain, the securities sold to the ESOP must have been owned for at least three years before the sale. The gain eventually is taxed when the replacement securities are sold.
  • There are incentives for the remaining employees. Each employee owns a share of the company through the ESOP. The ESOP provides a ready market for their shares when they leave the business. They also are likely to qualify for capital gains on the sale of their stock, instead of the ordinary income treatment accorded distributions from other qualified retirement plans.

All these tax breaks increase the amount the buyers are able to pay and increase the after-tax amount the seller retains. Some ESOP experts say the tax breaks can double the amount available to the seller when compared with a traditional sale.

In addition, the seller can retain some residual equity in the company if he desires.

The entire business does not have to be sold. An ESOP can buy a division or a portion of the business.

An ESOP-assisted sale isn’t for every business owner. It is best used when the owner’s children have interests other than taking over the business. There should be employees at the business who will be able to run it and will view the ESOP as a long-term incentive to stay at the business and help it grow. A business with few employees or high turnover of employees might not be appropriate for an ESOP.

In addition, the company must have a history of strong cash flow to ensure it can repay the loan. The company also is a good prospect if it pays substantial income taxes.

The seller doesn’t have to leave the company. The seller can set up the ESOP and sell all or most of his stock to it. Then, the seller can continue running the company and lining up employees to take it over in a few years.

An ESOP-assisted sale is a complicated vehicle. Many detailed requirements must be met to qualify for all the tax breaks. An appraisal is needed to determine the sale price.

The seller needs to work with professionals who are experienced in ESOP-assisted buyouts, not with regular business brokers and attorneys. One experienced firm with multiple offices is Benefit Capital Companies (www.benefitcapital.com). Or, if you cannot find a local referral from your accountant or attorney, go to your favorite search engine and type in “employee buyouts.”

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