Family business owners ready to start the feasibility process for an Employee Stock Ownership Plan came to our team with three key goals. They wanted a fair valuation for the business, a way for certain family members to remain with the company, and the most tax efficient transaction possible by maximizing their net proceeds via an ESOP. Unfortunately, the second goal at was odds with the IRS Code that provided for the tax deferral that could maximize their net proceeds. Could they have it all?
Owned and operated by the Murphy family for over 20 years, CPT sells and services UPS backup systems to businesses throughout southern California. After considering the pros and cons of a third-party sale, Mike Murphy asked our team to assess the feasibility of and ESOP and then ultimately design the plan and execute the sale.
The Goals and the Challenge
In order to qualify for the tax deferral (and ultimately tax avoidance) under IRS Code Sec. 1042, direct family members of the seller had to be precluded from participating in the ESOP. This not only resulted in the need to develop a structure that could provide for similar benefits to these family members outside of the ESOP, but it significantly reduced the eligible payroll that would be available to amortize the inside loan. This would potentially result in the employee base receiving an unsustainable level of ESOP benefits that put the entire program in jeopardy of breaking down over time.
The Challenge Met
After developing a feasibility analysis, we recommended several design features to help accomplish their goals. One was to create a longer term for the inside loan that would help ensure that benefit levels were generous but manageable. Another was to create a pool of synthetic equity, or stock appreciation rights (SARS) for key management, several of whom were family members. These design features were acceptable to the trustee, provided the desired outcome for all the parties, were fair to the ESOP, and gave the Company the flexibility it needed in future years.
Following a rigorous diligence process on the part of the buy-side team, including the trustee, its financial advisor, and trustee counsel, the transaction was closed at a purchase price and other terms that were satisfactory to the seller and agreeable to the buyer. Following the transaction, the seller was able to procure appropriate floating rate notes to perfect the tax deferral under Code Section 1042. The seller expects to hold the notes for a sufficient timer period to avoid the capital gain altogether.
Careful plan design, appropriate analysis of feasibility, and creative structuring of the transaction can help bring about a successful ESOP transaction despite apparent hurdles. The implementation of an ESOP is a complex process that is best undertaken with the guidance, advice, and experience of a trusted transaction advisor.
There are many possible outcomes to a transaction. Navigating the obstacles that can impede your goals is what we do. We’ll get you the right result.