Succession Planning for Professional Services Firms: The ESOP Option
Employee stock ownership plans (ESOP) were traditionally viewed as acquisition vehicles used in transactions involving manufacturing or other capital-intensive businesses; however, more often, ESOPs are being considered and successfully used for the transition of ownership in professional services firms. Due to the aging of the baby boomer generation, professional service firms are seeing partner retirements in clusters. The ESOP structure can provide the manageable, cash efficient method of transitioning ownership that they seek.
Utilizing an ESOP Structure
Traditional exit strategies — for example, a firm merges with competitors or remaining partners buy out exiting partners — can be difficult to finance. The tax benefits of an ESOP can benefit both sellers and continuing employees; thus, they should be considered in appropriate situations for professional firm transactions. Professional firms uniquely match the common profile of an ideal ESOP candidate, which includes the following:
- The owners are looking to exit or sell their interest.
- A capable management team will remain in place.
- The business has debt capacity.
- The business has a consistent and predictable annual cash flow.
- The business has an employee base of critical size.
- The business has the ability to have an employee-owned culture or mindset.
- Third-party or strategic buyers in the market are limited.
- The sellers are motivated by tax advantages.
Because capital investments are not as significant for operations, professional firms typically have light debt loads that make an ESOP transaction more feasible. Although such firms can certainly have “off” years, the cash flow and profitability needed for making ESOP contributions typically do not have the sharp peaks and valleys associated with other industries. A large, highly compensated, highly educated employee base aids in the success of the ESOP, from an understanding of the concept to the amount of wages available to support the necessary plan contributions.
A non–professional services ESOP company commonly operates under a traditional hierarchy: it is headed by a president, followed by vice presidents or departments, then by the front-line employees. Additionally, compensation levels most often follow this top-down approach. Because an ESOP is a defined-contribution plan, contributions benefit more highly compensated employees (within certain limits). In professional firms, such as engineering and accounting firms, a disparity in ESOP ownership and benefits can be significantly narrowed. Although all employees might not be equally compensated, ESOP compensation limits ($275,000 in 2018) in determining plan contributions can effectively equalize partners (and, in some cases, associates) with respect to ESOP benefits.
ESOPs are qualified retirement plans under the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA), subject to the coverage and nondiscrimination rules common to all pension plans. All eligible employees participate in an ESOP plan and share in annual stock and cash contributions based on compensation levels. But it might be necessary to reward new partners (or officers) or to attract new talent in order to grow the practice. Phantom stock plans, or stock appreciation rights (SAR) plans that mirror the terms and growth of the ESOP’s investment in the firm’s stock, can accomplish this goal. Such plans could incorporate a required buy-in of new partners if there is a desire to have capital at risk. Additionally, deferred-compensation plans can be designed to provide incentives to certain partners, as long as such plans comply with IRC section 409A.
Creating an employee-owned culture can be challenging within a partner group that views business decisions and firm financial information as something to be shared only among the equity partners. It is a recommended and common ESOP practice for high-level financial information and firm decisions to be communicated at regular meetings with the entire staff, including nonprofessional employees. New professional firms utilizing an ESOP, however, might not be ready to share financial information with all employees. The only financial information that all ESOP plan participants are required to receive is an annual statement showing allocated ESOP shares and their account value.
Despite the positive attributes of an ESOP structure, the acquisition of a professional firm can be a risky purchase. The highly skilled human talent — where, in large part, the goodwill of a new professional services firm resides — walks in and out of the company doors every day. To make sure the organization’s leaders have an incentive to produce, and thereby increase the ESOP’s stock value, the firm’s profits must be fairly allocated among the leadership team and ESOP owner.
When the ESOP owns all of the entity’s stock, a sharing of the profits is commonly agreed upon between the officers of the firm and the ESOP. For example, in a 100 percent ESOP-owned firm, the ESOP might be entitled to 30 percent of the profits, with the remaining 70 percent being used for compensation of the partners. An ESOP feasibility study is recommended on the front-end of any transaction in order to determine a profit-sharing agreement that provides both a fair market return to the ESOP participants (which, most likely, will include the partners of the former firm who are also officers in the new ESOP entity) and justly rewards the efforts of officers of the newly formed ESOP firm.
It is critical to have an experienced professional licensing attorney review the contractual arrangements between the ESOP and the professional services firm in order to ensure that the contracts work from a licensing perspective for each state in which the firm does business.
ESOP Tax Advantages
Because an ESOP generally can only purchase the stock of an entity taxed as a corporation, professional firms structured as general partnerships, limited liability partnerships, or limited liability companies may need to restructure as either a C corporation or an S corporation.
Professional service corporation shareholders who are selling to an ESOP might be able to take advantage of the IRC section 1042 tax deferral, under which the gain on the sale of stock is deferred if the proceeds from the sale are reinvested in certain stocks and bonds of U.S. corporations. Similar to the tax deferral available to sellers of real estate under IRC section 1031, the sale of stock to an ESOP can defer tax indefinitely, as long as the qualified replacement property purchased within one year of the sale to the ESOP is not sold. Furthermore, the tax deferral becomes permanent upon death, in that the tax basis of the stock or bond owned is then stepped up to current fair market value.
The most significant ESOP tax advantage available is the federal and state income tax exemption of a 100 percent ESOP-owned S corporation. Because an ESOP is considered a retirement plan and is not subject to unrelated business tax, income attributed to the plan’s ownership in an S corporation is tax exempt. Whereas the income allocated to the working officers under a profit-sharing agreement will most likely be taxed as wages to the officers, the profits allocated under the ESOP will accumulate tax free, incurring taxation only when distributed to an ESOP participant upon retirement, termination, disability, or death [and not rolled over to a successor plan or individual retirement account (IRA); plan participants who receive benefits on retirement are eligible to roll the proceeds into an IRA]. It is important to note that many states have begun imposing excise, franchise, or other types of business activity taxes. While ESOPs enjoy a federal income tax exemption, they continue to be subject to these non-income based state taxes.
Under a leveraged ESOP, funds are borrowed to purchase the shares from selling owners, and the shares are released to plan participants as the ESOP pays down the debt. The terms of an ESOP obligation are often 10 to 35 years. With a fixed number of shares purchased, full allocation of the shares to ESOP participants can take as few as 10 years. In any organization, but more importantly in professional firms, providing an ownership stake for future employees who will be charged with growing the ESOP’s stock value and continuing the viability of the firm should be considered. Consequently, creating the ability to have additional shares issued yearly, equal to the value of the firm’s ESOP cash contribution after the initial purchase debt is repaid, could be critical.
If merging with a competing firm makes sense, choosing one structured as an ESOP could be extremely tax efficient. The newly combined entity in the ESOP structure can alleviate the loss of branding and history, making the new entity more acceptable and the transition more seamless for those remaining. Although a non-ESOP competitor (especially one attempting to gain a foothold in the market) might be willing to fund retiring partners’ capital accounts and create incentives for those continuing with the new firm, the cost is frequently a loss of firm culture and autonomy.
The tax shield of an ESOP can be used to acquire additional accounting practices because all the cash received by the firm not used to pay salaries can be used to pay down acquisition debt. As highlighted earlier, the selling partners of the target CPA firm may choose to convert their existing firm into an entity structure that qualifies for IRC section 1042 treatment.
Existing professional service firm ESOPs have advantages over traditional partnership firms in acquiring other firms. Given the tax-exempt status of an ESOP, fewer dollars are needed to make acquisitions; this places less of a burden on cash flow in an acquisition transaction. Merging an organization into an ESOP structure and a phantom stock plan can create new incentives and retirement avenues for the merging partners.
Begin With a Feasibility Study
A feasibility study is usually the first step in the process of determining whether a professional services firm is a good candidate for an ESOP. It projects future cash flow and the firm’s ability to pay down debt that might be incurred in an ESOP transaction. The study also determines if the payroll limits under IRC sections 404 and 415 work, so that certain rules are not violated, and determines the length of time an ESOP acquisition loan will remain outstanding. During the feasibility study, the professional services firm should explore the marketplace for an appropriate ESOP trustee to oversee the contemplated transaction and, on the administrative side, should decide which member of the company’s board of directors will determine the ESOP’s structure.
Although an ESOP is not the least expensive qualified employer plan to implement and manage, it is the only one that provides ERISA protection to plan participants while allowing for acquisition debt to be paid back, in most cases, with pretax dollars and for the sellers to tax defer the sales proceeds.
Keeping you updated on COVID-19 and its impact on businesses and individuals.