Don't Sweat the Small Stuff . . . and It's All Small Stuff is an enjoyable little book that has spent a long time on the New York Times bestseller list. In it, Dr. Richard Carlson points out that many of the 'insurmountable' problems we face in life will become manageable if we simply change the way we look at them. In many cases, he's right-but then, he has never had to face the problem of agency perpetuation!
It would be wonderful if there was one logical, tax-wise, simple way to accomplish the transfer of agency ownership, but many alternatives are available. Depending on the structure of the deal, some methods favorably benefit the seller (the outgoing shareholder), some the buyer (the agency, or another shareholder), and some provide tremendous financial gains to Uncle Sam.
During the past decade, tax law changes have regularly juggled the tax effects of different deal structures. At various times, win-win strategies could include deferred compensation, non-compete agreements, consulting agreements, and/or straight stock redemptions. One method, however, has consistently provided tax benefits to both the shareholder and the agency-an Employee Stock Ownership Plan (ESOP). Of our Best Practices agencies with revenues higher than $2.5 million, 30% have used an ESOP to accomplish a major stock redemption and/or to provide an employee retirement benefit (frequently in preparation for an upcoming stock redemption).
The thought of trying to understand an ESOP has caused many an owner to sweat. It just sounds too good to be true that both the shareholder and the agency get tax benefits. But it is true-the shareholder can sell his stock and defer taxes, potentially indefinitely, while the agency gets to pay for the stock with pre-tax dollars because both the principal and the interest are tax-deductible. The exhibits at the end of this article provide a quick comparison of an ESOP transaction and a traditional stock transaction. In addition, recent tax changes have made it feasible for an S corporation to have an ESOP.
That's the good news. Contrary to Carlson's philosophy, however, some issues don't quite fit in the category of 'small stuff.' The Department of Labor and the Internal Revenue Service both regulate ESOPs, and that results in hoops through which you must carefully jump. In addition, strategic issues must be addressed in the process of determining the best method for a major stock redemption. The stock purchased by the ESOP is distributed to the agency's employees as a retirement benefit. That is, it will supplement or replace the agency's retirement plan-profit sharing or 401(k) plan. This can be a real plus in many situations. On the other hand, however, agency stock is a precious resource when used to motivate key people: If it's spread too thin, you may have trouble attracting and retaining superstars. (The ESOP must purchase a minimum of 30% of the agency's outstanding stock for the seller to get a §1042 rollover and defer taxes, potentially indefinitely.)
Other issues include:
- Plan administration requirements that exceed those of a traditional retirement plan
- The future cost of redeeming the ESOP shares as employees terminate or retire
- The employees' perception of employer stock as part of their retirement benefit
In spite of the potential headaches, these issues can become 'small stuff' with the assistance of qualified advisors. An ESOP may not be the best solution for perpetuation in every situation; but, as many of the Best Practices agencies have found, it can provide a win-win solution.
Agency perpetuation may never get a chapter in Don't Sweat the Small Stuff, but it can certainly get past the point of seeming insurmountable with some careful planning and knowledgeable advice. It's possible to design a transaction that's win-win for the shareholder and the agency-and that makes the payments to Uncle Sam the small stuff!
Sample ESOP Transaction:
The shareholder sells his or her stock to the ESOP at fair market value. The shareholder then uses those funds to purchase qualified replacement stocks, deferring the taxes, potentially indefinitely, on the gain on the sale if the ESOP holds more than 30% of the stock and qualifies for the §1042 rollover.
The ESOP borrows the purchase price from the agency and pays the shareholder (thus creating a note payable to the agency). The agency may have borrowed the funds from a bank or an insurance company, sometimes at a preferred interest rate.
When the ESOP's note payments to the agency come due, the agency funds the ESOP with a retirement contribution equal to the ESOP's note payment amount. That contribution (principal plus interest) is totally tax-deductible.
Traditional Stock Transaction:
The shareholder sells his/her stock to the agency or to another shareholder and pays capital gains taxes at the end of the year. The agency or the other shareholder either:
- Borrows money to repurchase or purchase the stock and can deduct only the interest (thus making the principal payments with after-tax dollars)
- Has accumulated sufficient after-tax retained earnings to fund the purchase