Selling to employees: the underappreciated exit strategy

The recently passed federal legislation widely known as The SECURE 2.0 Act of 2022 brings a raft of helpful changes for retirement savers. But some of the least well-known provisions apply to a business succession opportunity that itself is often overlooked. For many business owners looking ahead to their exit from the company, an employee stock ownership plan (ESOP) has many unique benefits.

“In its simplest terms, an ESOP involves the sale of some or all of a business to its employees,” explains Brian Roth, National Executive, ESOP Finance and Advisory at Bank of America. All of the company’s workers, if they meet certain requirements, must be covered by the plan, through which they accumulate shares of company stock in their retirement accounts. When they retire or leave the company, the business buys back the shares, helping fund their retirement.

“From a business owner’s perspective, an ESOP offers several distinct potential advantages,” says Roth. “It keeps the company’s future in the hands of those who have the most to gain if it thrives, and it allows the owner to reward their valued employees for their hard work.

“That could reduce turnover, increase productivity and help the company recruit and retain talent,” he adds.

Roth cites several other reasons an ESOP might be appealing: An ESOP provides a ready buyer for the business and ensures that it will be sold for its fair-market value; it enables the company to keep its financial and strategic information confidential; sellers have the option of staying involved in the company’s governance and operations; and if certain conditions are met, sellers may be able to defer part or all capital gains taxes on the sale.

Most ESOPs are financed with loans that leverages company assets. The company borrows money from a bank and then lends the proceeds to a trust, which uses those funds to buy the owner’s shares. In order to qualify as an ESOP, the trust must be operated in the interest of employees, according to the rules of ERISA, the Employment Retirement Income Security Act of 1974. And since the shares reside in what is essentially a retirement account, the company, which repays the loan out of its earnings, may be helped (if it’s an S corporation) by the elimination of federal (and some state) income taxes. “This feature, of course, might help provide the business with breathing room enough to repay the loan without jeopardizing investments it may wish to make to grow the company or increase productivity,” Roth says.

SECURE 2.0 adds incentives for business owners who opt for an ESOP. It will extend some tax advantages to S corporations that were previously available only to C corporations, and it establishes an employee ownership initiative within the Department of Labor. According to Roth, “these rather technical changes could help make employee ownership, which has been relatively rare as a business succession strategy, more appealing to a wider range of business owners.”