How Retiring Shareholders Can Divest Completely Tax-Free

Nabity Business Advisors with Dave Nabity

When a shareholder retires and sells their stake to younger employees, the tax cost of the transaction is more than 60%. An ESOP lets you create a completely tax-free transaction.

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If you're a retiring shareholder who wants to sell your company stock to younger employees or future company leaders, an Employee Stock Ownership Plan is one the most tax-efficient ways for you to sell your business and retire.
Let me explain with an example.
Say you have a corporation and you're the majority stockholder and you're getting ready to retire.There are two young stockholders in the company who intend to buy your stock when you retire. They may pay you with corporate earnings or borrow from the bank, but one of the biggest things that gets overlooked in this scenario is the tax cost of buying out a retiring shareholder.
For simplicity's sake in this example, let's say your stock is worth $1. The corporation and our two young stockholders need to come up with that dollar to buy your stock. That means the corporation needs to earn $1.43 in income so they can pay $0.43 in taxes to the government (if you're in a 30% bracket).
You just got your dollar for your stock, but that's not the end of it. The key question is whether you profited by selling the stock. Let's say you had almost no basis in the stock when you sold; you could turn around and give another $0.20 in capital gain tax to the government.
Between you and the corporation, just to sell your $1 stock, you lost a combined 63 cents in this hypothetical. In short, 63% goes out the window if you buy stock the way most people buy it when someone retires.
There's a unique alternative to this, however. This option would be of interest to someone who really cares about allowing the company's employees to become stockholders and manage the future of the business.

By selling your shares to the ESOP, create a completely tax-free transaction.

You can do this by setting up an Employee Stock Ownership Plan, or ESOP.
This is a retirement plan that requires you to follow all the federal rules for 401(k) plans, pension plans, and profit sharing plans. The good thing is that the federal government likes these plans because wealth—in the form of stock—gets handed down to rank-and-file employees, so there are big time incentives.
With this option, your stock is bought by the ESOP rather than the corporation when you retire. The ESOP needs money to do this, so you would arrange financing from a bank. When retiring, you sell your shares right back to the ESOP, which is funded by the bank.
The first major benefit is that if you set things up right when selling your stock to the ESOP, you can completely eliminate capital gain tax. In our hypothetical example, you're then saving $0.20. Another great thing is that the government allows you to put up to 25% of your payroll into the ESOP as well, which can then be deducted as a business expense. That eliminates the 43% tax.
By selling your shares to the ESOP, you create a completely tax-free transaction.
The payments needed to pay the bank for the ESOP's financing are made on a tax-deductible basis as well. This is where it gets good for the employees.
Your debt to the bank gets really high when first starting. A typical amortization schedule drops that debt down to nearly nothing; your typical loan is usually something like a seven-year loan. As you begin to pay down that debt and equity starts to build, the equity goes out to your employees in the form of stock shares in the ESOP.
In the long run, your employees will build wealth, which they would never have been able to do if you hadn't set this sort of strategy up.
Now, I don't believe you should set up an ESOP unless your company is worth $5 million or more and your annual payroll is $1.5 million or more. It's pretty expensive to set up an ESOP compared to your typical retirement plan. For the right company though, it's a really great strategy.
If you'd like help, we prepare a preliminary assessment that will go through all the details of setting up an ESOP, examine the financing you need, anticipate the potential tax savings, and help you work out all the details before you make the next step.
If you're interested, just give me a call or send me an email. I'd love to work with you to find a solution for your business.