Harvey M. Katz ()
Owners of closely held businesses, where one but not all of the owner’s children are involved in the operation of the business, face unique business succession issues. The problem has little to do with the business itself but rather to do with minimizing the possibility of fights among the owner’s children. This problem can be avoided by selling part of the company to an Employee Stock Ownership Plan (ESOP), and gifting the cash realized in the sale to the uninvolved children.
The business owner’s dilemma is succinctly stated by the following question: How does one: 1) leave the business to the “involved” child; 2) equalize the value of each child’s inheritance; and 3) minimize the possibility of significant disagreements among the owner and the children? If the owner has sufficient liquidity outside the value of the business, the problem is easily solved by leaving or gifting cash or other assets—equal to the value of the business—to the uninvolved children. For example, if the business is valued at $12 million, he or she would require $24 million in other assets to equalize the uninvolved children. Typically, few closely held business owners have sufficient liquidity to equalize their uninvolved children, as it is typical for a business owner to have 75 percent or more of his or her net worth tied up in the business.
Solutions That Do Not Work
As a result, many business owners simply give equal numbers of shares to the involved and the uninvolved children. Unfortunately this alternative is highly likely to result in future disagreements among the children, a result that virtually every parent wants to avoid.
The reason for these disagreements is obvious. Every involved child is likely to believe that he or she is entitled to fair compensation for his or her day-to-day contribution to the growth of the business. There is a tendency for these children to take higher salaries or bonuses resulting in reduced payouts/distributions to the uninvolved children. Uninvolved children, on the other hand, generally want to realize current income on their shares, in the form of dividends, and in many cases vociferously press their concerns with their involved sibling.
This concern can be particularly acute when the uninvolved children control the majority of the ownership of the company. In the previous example, the uninvolved shareholders would control two-thirds of the shares, possessing a super majority with the ability to appoint the company’s board of directors. Traditionally this problem is addressed by granting non-voting shares to the uninvolved children or through a shareholders’ agreement. However, this alternative only transfers the control of the business from the uninvolved to the involved children. It does not change the dynamics between siblings with fundamentally divergent interests. While the relationship among some siblings is strong enough so as to avoid all-out war, the potential for an unfavorable result militates against this structure.
Of course there are other ways to ameliorate potential problems created by placing children in the position of having divergent interests. For example, mechanisms can be imbedded in the corporate governance structure to require mediation or arbitration of disputes, or to require a buy-out of the uninvolved shareholder in the event of more serious disagreements. If real estate is part of the business but owned by an entity other than the operating corporation, the real estate can be gifted to the uninvolved children. While still potentially adverse to the interest of the involved child, it is not directly impacted by the operation of the business. Again, these solutions do not address the fundamental concern that parents have in avoiding arrangements that are likely to engender disagreements among their children.
ESOPs: a Better Solution
A more effective solution to this problem, in many instances, is the ESOP. The ESOP solution differs from the others noted because it provides a mechanism to monetize the interests of the uninvolved shareholders. Once the transaction occurs, the owner will have cash which can be used to equalize values to the uninvolved children. Simply put, the ESOP is a flexible, tax-favored mechanism to eliminate the ownership of the uninvolved children. Those children never receive stock in the family business, and therefore there is no opportunity for disagreements over its future direction.
By way of example: there is one involved and two uninvolved children and a business valued at $12 million. Two-thirds or $8 million of shares would be sold to the ESOP. In order to purchase the shares, the ESOP would borrow that amount from the company. The company, in turn, would borrow from a lender, such as a bank, a mezzanine lender or the selling shareholder him or herself. After the transaction, the business owner would remain in control of the business as its one-third owner, with the ESOP owning the remainder of the shares.
How an ESOP Works
The ESOP itself is a broad-based employee benefit plan similar to a 401(k) plan or a profit-sharing plan except that funds are invested almost exclusively in employer stock, and employee contributions are generally not permitted. In general, employee participation is universal among full-time, non-union employees after one year of employment. The critical difference between an ESOP and other retirement plans is that an ESOP is permitted to borrow funds to purchase company stock. The loan is generally structured as a two-step process. First the company borrows from a lender, either a bank, mezzanine lender or from the selling shareholder. The funds obtained through the loan are immediately lent to the ESOP by the company.
The loan taken out by the company is generally repaid over five to seven years. The repayment period for the company loan to ESOP can be repaid over a longer or shorter period. Each year the company makes fully tax-deductible contributions to the ESOP. In turn, the ESOP uses those company contributions to repay the loan. The company uses the loan payments it receives to repay the “outside” lender. As a result, the entire purchase is made with pre-tax dollars. Initially, the ESOP trustee holds all of the shares in escrow, as security for repayment of the loan. As principal is re-paid on the loan, equivalent amounts of stock are released from escrow and allocated to participant accounts.
While participants have bookkeeping accounts in the ESOP, they never actually receive direct ownership of the company shares, as those shares are repurchased by the company or the ESOP upon termination of employment. Participants do not have the right to see company financials or to participate in management. With very limited exceptions, no participant has a right to vote the company shares held in his or her ESOP account or to direct the management of the company. The interests of the participants are represented by a trustee who has a fiduciary obligation to act in their best interests.
The ESOP itself stands in the position of a shareholder but as in the previous example, the company will continue to be operated by existing management and the remaining one-third non-ESOP owner of the business is in effective control of the business. In general, the trustee of the ESOP is consulted only when the major corporate event such as an acquisition, sale of company’s assets or merger is under consideration.
Other ESOP Advantages
Because the debt placed on the company in connection with an ESOP transaction lowers its value, there is an opportunity to minimize the value of the shares gifted to the involved child for gift/estate tax purposes. By timing the gift to the involved children to immediately follow the sale to the ESOP, a lower value can be utilized for gift and estate tax purposes.
Immediately after the transaction, the lower “post transaction” value is assigned to the shares. For example, using the facts in the previous example, the value of the shares sold to the ESOP is $8 million (based upon sale of two-thirds of the company with a fair market value of $12 million). However, the company borrows $8 million in connection with the ESOP transaction so that it can lend that amount to the ESOP to purchase the shares. When valuing the company on a post-transaction basis and all things being equal, the value of the entire company is only $4 million. Arguably, the gift of one-third of a $4 million company is less than $1.5 million.
In addition, many traditional estate planning techniques, such as a gift or a sale to grantor retained annuity trust (GRAT) or use of family limited partnerships (FLPs), can be utilized in conjunction with the transfer of the shares or other property to the children. For those owners who are charitably inclined, charitable lead trusts (CLTs) and charitable remainder trusts (CRTs) are available. While a discussion of these techniques, either alone or in combination with an ESOP is beyond the scope of this article, their availability opens the door to an array of tax-saving opportunities.
Prior Gifts Not Fatal
Sometimes one is faced with a situation where shares have already been gifted to uninvolved children. In such case, those children can, and would probably prefer to, monetize their shares by selling them to an ESOP. Depending on the debt capacity of the company and the willingness of the uninvolved children to finance the transaction, there is a lot of flexibility to sell those shares in increments. This solution is particularly effective if disagreements begin to arise between involved and uninvolved children. Sale to an ESOP in these situations will nip those disagreements in the bud.
In the final analysis, control of the business can be passed or gifted to the involved child, and the interests in the business earmarked for uninvolved children can be converted to cash. The ESOP becomes the “friendly” shareholder that rarely becomes involved in the operations of the company. The cash received by the owner is used to make gifts or bequests to the uninvolved children and they never become owners of the company. As a consequence, the business owner avoids creation of a dynamic in which two groups of children possess divergent interests.
Harvey M. Katz is a partner and co-chair of Fox Rothschild’s employee benefits and compensation practice. He can be reached at email@example.com.