Is an ESOP the Right Succession Plan for Your Trucking Company?
What will happen to the trucking company that you’ve spent a lifetime building when you retire? Can selling to an ESOP make the transition of your company and the start of your retirement any easier?
The use of employee stock ownership plans (ESOPs) as a succession plan for trucking companies has become an attractive alternative to selling to a third party. ESOPs offer a variety of advantages, such as reducing tax liabilities for both the shareholders and the business and fostering a culture of ownership by rewarding employees for their service and loyalty. Additionally, ESOPs play an even more important role in a succession plan: they provide a simple mechanism for transferring ownership over time, while providing more flexibility to existing owners than a third-party sale ever could.
Why Your Trucking Company Needs a Succession Plan
It can feel a bit gratuitous to outline a succession plan of any type if you intend to own and operate your business for decades to come. However, establishing a succession plan early can alleviate more than just a few headaches and surprises.
First, succession plans require you to identify one or more candidates to take over when you leave whether that successor be a family member, a trusted employee, or a third party. Having a succession plan will help you market yourself to that buyer and give you a road map to follow so the transition goes smoothly.
Second, succession plans take more than just your business into account. Succession plans in closely held businesses often consider the needs of the individual owners as well. For example, if you wanted to slowly transition out of the business between the ages of 55 and 65, your succession plan can help support that goal. In closely held businesses, personal financial planning should always be done in conjunction with business planning. Understanding your recurring financial needs after the sale of your company is paramount to gaining comfort in your retirement. The structure of an ESOP sale can relieve some of those concerns.
Third, succession plans can alleviate conflict between family members and key employees. You want the leaders of your business to understand their role in the company’s future, and a succession plan when shared with those key employees will ensure all players are on the same page.
How an ESOP Works
As the name suggests, an employee stock ownership plan provides employees with the opportunity to own shares of stock in the company they work for. Although ESOPs can be used in conjunction with other retirement plans such as a 401(k), they are often used in lieu of another qualified plan. They provide many of the same benefits to the workers – a tax-deferred investment vehicle that gets paid out in retirement – but rather than depositing cash into your employees’ accounts, you allocate shares of company stock to your employees’ accounts. The goal is for the stock to appreciate over time with the end result that those tax-deferred gains on the stock are paid out when employees retire.
Benefits of ESOPs for Employees
Implementing an ESOP is beneficial for both employees and company shareholders. For employees, receiving company stock as a retirement benefit is valuable in a few ways.
- Employees do not contribute to the ESOP out of their paycheck, as they do with 401(k) contributions, which means that their retirement benefits are fully funded by you, their employer.
- Employees’ retirement investments are tied to the success of your business. Employees feel more empowered when their goals are aligned with those of the company.
- ESOP assets grow tax deferred until your employees retire.
- Your employees have a guaranteed market for their shares. When they retire, the ESOP agrees to buy those shares back at the fair market value.
Benefits of ESOPs for Shareholders
ESOPs are also beneficial to existing shareholders. If an ESOP purchases at least 30% of a C corporation’s outstanding stock , the departing owners can employ a tax tool know as a Section 1042 Rollover. When the ESOP purchases their stock, selling shareholders can roll their sales proceeds into other qualifying investments without paying the capital gains tax. The selling shareholders will owe capital gains tax on that initial sale only when they sell their replacement investments.
Benefits of ESOPs for Companies
The tax benefits for a company with an ESOP structure can be significant.
Funding an ESOP Is a Tax-Deductible Expense
Not only are businesses required to make annual contributions to fund the release of ESOP shares, the company also must ensure the ESOP plan is funded so they can buy out departing owners’ shares when they retire or terminate. This can be done in one of three ways:
Fund With Cash
Businesses that choose to fund their ESOP with cash can deduct those cash contributions.
Fund With Stock
Businesses can issue new shares and allocate those shares to the ESOP. The value of these shares is deductible, but this method will dilute the value of all other outstanding shares.
Fund With Debt
Some businesses instead structure their ESOPs to borrow funds directly. This is known as a “leveraged ESOP,” where the ESOP inside loan payments are deductible. This effectively permits the business to fund their ESOP with after-tax dollars, an advantage that many business owners utilize even if they are able to fund their ESOP with cash.
Dividends Paid on ESOP-Held Stock Are Tax-Deductible
Normally, C corporations cannot deduct the cost of dividends paid. However, they may be able to deduct dividends if they are paid to ESOP-held stock. Those dividends will generally be deductible if (1) the dividends are paid to ESOP participants directly or through the ESOP, (2) employees voluntarily reinvest those dividends in company stock, or (3) dividends are used to fund debt payments on leveraged ESOPs.
Business Earnings in S Corporation ESOPs Are Not Taxed
S corporations pay no federal tax directly; they instead pass business earnings through to their owners. When an S corporation is owned by an ESOP, those business earnings will pass through to the ESOP (rather than to individual shareholders) and escape taxation. For example, if an ESOP holds 40% of outstanding company stock, 40% of the S corporation’s earnings are not subject to federal income tax.
ESOPs provide a simple mechanism for transferring ownership over time, while providing more flexibility to existing owners than a third-party sale ever could.
ESOPs and Trucking Companies
Historically, many trucking companies have shied away from ESOPs. Establishing an ESOP requires having available cash on hand or the capacity to take out more debt, both of which can be difficult for trucking companies who are often highly leveraged and require annual intensive capital investment. But trucking companies that decide to establish an ESOP will experience several benefits.
ESOPs Save Tax Dollars
ESOP-owned trucking companies – even those that are only partially owned by an ESOP – will receive all the tax benefits previously discussed. S corporation trucking businesses often benefit the most by saving federal income taxes on the earnings attributed to ESOP-owned shares. Although the business may still be liable for state activity/excise/income taxes, the federal tax savings alone can provide the business with cash to purchase new machinery, pay down debt, or expand into new business sectors.
ESOPs Create a Marketplace for Company Shares
Selling shares of privately held trucking companies can be tricky. An ESOP establishes a marketplace for those shares, making it easier for current owners to transition out of the business.
ESOPs Can Eliminate Retirement Stress
The emotional fatigue that comes from finding a buyer for the business you have grown and nurtured is all but eliminated when you establish an ESOP. The ESOP allows you to leave the business when you want to leave it without going through the stressful mergers and acquisitions (M&A) process. Although there might be some downsides to avoiding a third-party sale, establishing an ESOP lets you keep your shares within the company. If you curated a good pool of employees, you know the new owners will treat your company right.
Stock Sale Versus Asset Sale Considerations
While an ESOP transaction is structured as a stock sale, most third-party trucking company sales are structured as an asset sale. Selling stock can be more tax-favorable for trucking company owners, especially when an asset sale can trigger tax consequences and depreciation recapture on equipment. Tax attributes could lead to less after-tax proceeds on an asset sale, even when the asset sale price is higher than an ESOP price.
Valuing ESOP (and Non-ESOP) Transactions
ESOPs are required to have an independent appraisal to determine the price the ESOP Trustee will initially use to purchase the trucking company shares. Valuations must also be performed at least annually once an ESOP is established. In publicly held businesses, they can simply look to the public marketplace to determine trading value, but privately held businesses do not have a market for their shares. They must use other methods to determine value.
The IRS requires businesses to value their shares at “fair market value,” which is the price a share of stock would sell to a willing buyer. An independent third party – CPA firms and valuation experts – can ascertain this fair market value by using the following information about the business:
- Capital market conditions
- Financial history
- Sales projections
- Customer data
- Industry outlook
- Employee makeup, employment history, and turnover rates
- Key members of management
Armed with this information, the valuation consultant will apply one or more methodologies for determining value. The trucking company will then use this fair market value when purchasing the company shares in creating the ESOP, buying back departing owners’ shares of stock, recording the ESOP transaction in the financial statements, and when issuing new shares.
Selling to an ESOP Versus a Third-Party Sale
Valuation is also important in non-ESOP transactions. While the valuation will set the initial sales price that the ESOP Trustee will offer for the trucking company, owners may be able to use the valuation results to demand more money from a third party. A third-party buyer might pay a premium if they believe the target business will create synergies when combined with their own. ESOPs generally cannot pay premiums, so often an ESOP’s offer to purchase the company is less than may be extended by a third-party buyer. However, it is important to fully analyze the after-tax proceeds of an ESOP stock sale versus a third-party sale. The ESOP transaction price may look less appealing at first glance, but once the long-term tax benefits of selling to and operating an ESOP are taken into account, the ESOP may be the clear winner.
Whether you go with an ESOP or a third-party sale, your goal should be to boost the value of your company stock. You can do this in many ways by understanding the business drivers that impact your trucking company value. For example, heavy emphasis is usually placed on the business’s earnings before interest, taxes, depreciation, and amortization (EBITDA). You can boost the value of your stock by adding more revenue, reducing costs, or becoming more efficient. If a key metric is an emphasis on risk, you can manage risks by shoring up internal control deficiencies, lowering turnover rates, or keeping tighter control over unbilled revenue.
Making the Right Decision for Your Business
Whether you are prepared to sell your business today or plan to work for a few more years, establishing a carefully considered succession plan is important. An ESOP may not be the exit structure that works for your trucking company, but it is one you should consider.
KSM’s ESOP Services Group can help determine the fair market value for your transportation business and can assist in evaluating the exit strategy structure that best meets your goals for your company, employees, and family. As a leader in the transportation industry, we have helped trucking companies of all sizes develop their succession plans and identify their business’s value. Contact a KSM advisor to discuss your options or complete this form.
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