COVID-19: Is an ESOP Still a Viable Exit Strategy in These Uncertain Times?

June 16, 2020Article

Given the economic uncertainty created by the COVID-19 pandemic, business owners seeking a succession plan in the face of the unsettled mergers and acquisition and private equity markets may want to consider an Employee Stock Ownership Plan (“ESOP”) to provide a viable, but complex, exit strategy for the ownership transition of the company. While the ESOP structure is subject to strict regulatory standards and oversight that must be carefully considered in any transactional setting, an ESOP may permissibly offer flexibility for business owners to structure a transition through a single sales transaction, or a series of partial sales, and allows the owners to offer seller financing in order to implement a succession plan in a tax-favored manner. There are potential tax-deferrals to selling shareholders and tax deductions for employer contributions to an ESOP trust that corporations and ESOPs should consider in designing an ESOP that might make sense for them.

Although challenging, the current economic climate does not mean that an ESOP is not a viable business succession planning alternative. It does mean that the potential corporate sponsor of the ESOP should be very realistic and develop a comprehensive plan in deciding upon the viability of an ESOP. This process will require financial, legal and tax analysis and the commitment of the seller, the corporate sponsor, and executive management. The selling shareholders, the corporation, and the ESOP will all require separate advisors. The considerations should include careful documentation regarding the impact of COVID-19 on the fair market value of the company and the company’s ability to pay for the debt service that would be incurred in an ESOP transaction. If, after careful analysis, a decision is made to implement an ESOP, careful attention also must be focused on establishing and documenting procedural prudence in all corporate and fiduciary decisions made in the process, including, without limitation, the prudent selection of a qualified independent trustee and fiduciary to negotiate and document pricing and other terms with the business owners. The process will include the need to educate key decision-makers with respect to corporate and ERISA fiduciary standards and the retention of legal, accounting, and valuation experts. The process also needs to address securing adequate directors’ and officers’ and ERISA fiduciary liability insurance protections.

An ESOP provides a market for stock of an S or C corporation and is a versatile financial and motivational tool that can be used by selling shareholders to obtain substantial tax benefits for the corporation and the selling shareholders. Subject to satisfying a number of specific rules under the Internal Revenue Code of 1986, as amended (the “Code”), a shareholder of a C corporation may be able to sell at least 30% of the plan sponsor’s stock to an ESOP trust, reinvest the proceeds in other equity or debt securities of U.S. domestic operating corporations and defer taxation of any gain resulting from the sale. This might be particularly advantageous if federal or state capital gains rates increase in future tax legislation (which is highly likely given the $4 Trillion of stimulus funds that the U.S. House of Representatives and Senate have approved and the President has signed into law). Furthermore, there are several post-transaction structuring options such as the election of S Corporation tax treatment for the ESOP sponsor that benefit eligible ESOP companies. Given that there is no taxation at the corporate level for an S corporation, a 100%-owned ESOP S corporation could conceivably have no corporate or shareholder taxes on its income.

While there are many advantages to an ESOP, the parties to a potential transaction should be very careful to ensure that the implementation of the ESOP is appropriate given the current financial situation caused by COVID-19. First, an ESOP trust may pay no more than “adequate consideration” to selling shareholders for company stock. “Adequate consideration” is defined as the “Fair Market Value” (FMV) of the shares of the plan sponsor’s company stock as determined in “good faith” by the trustee of the ESOP based upon an independent appraisal of company stock. The FMV component of this “adequate consideration” standard is the same valuation standard used throughout the tax law and commonly defined as “what a willing buyer would pay to a willing seller when neither are compelled to buy or sell”. The good faith requirement ensures that the trustee or other ERISA fiduciary carefully evaluate the financial data underlying the projections used in the valuation and negotiate for the protection of the ESOP.

A trustee will not pay a strategic price for an ESOP acquisition. That said, a potential seller in a strategic transaction to a third-party may not have the tax benefits associated with a sale to an ESOP. Moreover, an ideal candidate for an ESOP must have sufficient cash flow from operations to cover all ESOP acquisition debt and other long-term debt service requirements. In addition, the plan sponsor’s historical and projected operating performance (i.e., revenue generation and profit margins) must be reasonably sufficient in the context of the COVID-19 pandemic economic world in order to make it possible for an ESOP transaction to be prudent under current circumstances. While the costs of an ESOP transaction may be substantial because of the need for advisors to represent the corporate sponsor, the sellers and the ESOP trust, they are typically not more than the costs of a business broker or investment bank offering third-party sales opportunities.

On an ongoing basis, it should be noted that plan administration costs and expenses for an ESOP are typically greater than those associated with other retirement plans due to the need for independent ESOP advisors and annual independent valuation of company stock, as well as annual information reporting on Form 5500. While such costs can be substantial, they must be balanced by the many benefits of an ESOP, including tax benefits and potential growth associated with newly motivated employee owners.

In order to maximize the enhancement of productivity and profitability associated with implementing an ESOP, many corporations develop ownership culture communications programs that help educate employee owners about the direct connection between profitability and the increase in fair market value of company stock, and which also will, in general, increase the fair market value of ESOP participants’ accounts for retirement purposes. Many independent studies have shown the benefits to corporations of combining broad-based employee ownership with such employee ownership communications programs. Business owners that are seeking to pursue business succession plans during the continued uncertainty of the COVID-19 pandemic should include the prospect of an ESOP as one alternative for their ownership transition goals.

Authors: David R. Johanson (Partner-in-Charge, Napa), Rachel J. Markun (Partner, Napa), Robert S. Thompson (Partner, Atlanta)

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