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Selling to employees: the underappreciated exit strategy

New changes to retirement plan rules add incentives for employee stock ownership plans.

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Key takeaways

  • As an exit strategy, an ESOP provides business owners — and their employees — with several distinct advantages.
  • ESOPs can reward long-time employees, provide business continuity, retain a role for the owner and provide liquidity to the owner — potentially with tax advantages for all parties.
  • The SECURE 2.0 legislation contains provisions that might increase the appeal of an ESOP.

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 Solutions 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.

"An ESOP may provide business owners with an opportunity to completely or partially exit the business, allowing them to create liquidity from their concentrated position in the company or to diversify their personal assets.” 

Javier Romero Managing Director and Wealth Strategies Advisor at Bank of America Private Bank

“From a business owner’s perspective, an ESOP offers several distinct potential advantages,” says Jason Miller, National Executive, ESOP Solutions Advisory at Bank of America. “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.

How selling to employees works

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 Miller, “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.”

The benefits to the seller

An ESOP also offers flexibility from a personal and estate planning perspective. Javier Romero, Managing Director and Wealth Strategies Advisor at Bank of America Private Bank explains, “An ESOP may provide business owners with an opportunity to completely or partially exit the business, allowing them to create liquidity from their concentrated position in the company or to diversify their personal assets. It’s also a potential tool for those founders who may not have an apparent successor or family heir.”

To learn more about whether selling to employees through an ESOP is right for your business, contact your team at Bank of America.

Illustration of to hands shaking  with the text How to find the right ESOP partners

While an ESOP can be a compelling and uniquely advantageous way for an owner to build a graceful exit from their company, such transactions and their aftermath require regulatory and technical knowledge and experience. For a successful execution that delivers all the benefits that an ESOP can potentially provide, you’ll need to assemble a team of partners with the requisite depth of expertise in this very particular corner of the business succession landscape.

You’ll benefit from working with a team of professionals with experience and knowledge about these key considerations:

Pre-exit planning — If you are considering selling your business, whether by ESOP or to private buyers, it is essential to begin planning as early as possible by speaking to a financial planner or wealth manager. Pre-liquidity planning entails weighing the personal and financial implications of exiting your business to find the right approach for your desired outcome.

Federal regulations for retirement plans — Since in transferring ownership of your company to your employees in this way, you are in essence creating a defined contribution retirement plan governed by the Employee Retirement Income and Security Act of 1974 (ERISA), it’s critical that you are complying with the rules and requirements each step of the way.

Corporate tax law — With specific rules (and advantages) depending on whether you are an S corporation or a C corporation, and the potential for significant tax savings and deferment for both your company and yourself, it’s critical to have a knowledgeable accounting partner to offer guidance.

ESOP financing — The degree of leverage your company will require to fund the ownership transfer aside, having a banking partner as your lender who knows the ins and outs of the ESOP process will enable a smoother transaction.

ESOP maintenance and administration — Establishing an ESOP is not a set-it-and-forget-it matter, so it’s important to have someone at the table who understands retirement benefit administration as well as the specifics of ESOP structuring and finance and can play an advisory role not only during the transaction but afterwards as well.

Bank of America, a leading national ESOP lender, has been deeply involved in this field for over a quarter of a century. In addition to bringing vast experience to financing all forms of business succession strategies, the bank has a deep know-how in ESOPs specifically. And with hundreds of relationships with ESOP-owned companies, Bank of America has the team to work with your company both before and after a transfer of ownership. And on a personal level, given the demands of a sudden influx of liquidity, Bank of America can provide you direct access to the wealth management and estate planning expertise at Merrill and Bank of America Private Bank.

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