Owners of small and midsize companies who want to take equity out of the business will save a lot of money if they do it before year-end, when the tax rate on long-term capital gains (which applies to assets held for more than a year) is scheduled to leap.
Under a sunset provision that is an element of the impending “fiscal cliff,” a temporary reduction in the long-term rate that took effect in 2003 and has since been extended twice is set to expire on December 31. Unless Congress acts to keep the current 15% rate intact, it will rise by a third to 20% on January 1.
“Most people watching this don’t think the 15% rate will be extended again,” says Tim Stewart, an attorney with Dewitt, Ross, & Stevens, which has a growing practice in helping companies, set up employee stock ownership plans (ESOPs). “And once it goes up, it’s not coming back down, at least for awhile.”
From a practical standpoint, it’s too late for a cash-seeking business owner to sell to a third party by year-end unless the transaction is already well under way. But an ESOP can be done from start to finish in about 60 days, Stewart says. That still leaves only a razor-thin window in which to sell before the tax hike hits, so if a business owner hasn’t already been thinking along those lines, the opening could be too narrow.
Selling before January also will save the business owner from paying a new 3.8% tax on unearned income that was included in the Affordable Care Act to help pay for health-care reform.
Many of Stewart’s ESOP clients are companies that have sought a third-party buyer for some time, often years, without finding one with the right price and right expertise to take over the business. “There are so many Baby Boomers who want to retire and have been waiting to sell their businesses, but they can only wait so long,” he says.
There are currently about 10,000 ESOPs in the United States, according to The ESOP Assn. The bulk is at companies with up to about 500 employees. But some larger enterprises have them; too, including Publix Super Markets (one of the country’s largest private companies, reportedly with 2011 revenue of $27 billion) and car-rental company Avis Budget Group.
For some business owners, the opportunity to entirely control the sale transaction is appealing, as is the fact that in most cases the owner retains at least some control over the company, even though employees become the owners upon the closing of an ESOP deal.
To execute an ESOP, the selling business owner creates the new entity, and then transfers part or all stock in the company into it. The seller typically comes away with a promissory note from the new employee owners, who agree to pay the purchase price out of company profits over a certain time period and at a certain interest rate.
There are significant tax advantages to an ESOP, the biggest one being that the former owner can roll proceeds from the sale into equities and defer capital-gains taxes until the equities are sold. And if that former owner dies, his or her heirs inherit any remaining investments — tax free.
But there are also downsides to an ESOP, Stewart acknowledges. A third-party buyer could pay partly in up-front cash, which never happens with ESOPs because they have no start-up capital other than company stock.
Also, a business owner who sells the company to an ESOP often retains a fiduciary liability under the Employee Retirement Income Security Act for making sure the purchase price is fair. By law, a third-party valuation company must set that price but typically relies on information provided by the business owner, including future projections.
Therefore a lawsuit for fiduciary breach is possible at some point. But, Stewart notes, that risk can be mitigated by hiring an independent fiduciary as the ESOP trustee, who acts as the legal buyer of the stock, or by procuring fiduciary liability insurance.