This Opinion piece appears in the Oct. 27 print edition of Transport Topics. Click here to subscribe today.
By Ronald J. Gilbert
ESOP Services Inc.
and Jim Parham
Transport Capital Partners
With all the news about company bankruptcies, increased government regulations, higher equipment costs and economic uncertainty, some motor-carrier owners are looking for options.
They are asking themselves: “Should I buy another company to get larger and spread the overhead of more regulations?” or “Should I sell? And if so, to whom?”
If selling is the preferred option, owners then find themselves looking for the “perfect buyer.”
The “perfect buyer” usually: (1) is willing to acquire either 100% of the business or a minority interest; (2) does not get involved in the day-to-day operations of the business; (3) pays fair market value; (4) offers flexible terms; (5) offers the seller the option of paying no capital gains tax on the sale; and/or (6) provides some upside participation in the future performance of the business.
The only “near-perfect” buyer that fits these criteria is an Employee Stock Ownership Plan, or ESOP as it is commonly known. While ESOPs are not a traditional method of exiting the trucking industry, they are becoming more common and should be considered.
• How Does It Work?
The ESOP often provides all of the benefits outlined above in great part because of the tremendous tax benefits provided through the U.S. Tax Code. But from the seller’s perspective, the tax benefits only matter if they allow owners to realize their objectives.
Let’s examine the benefits of the ESOP from the seller’s perspective.
The ESOP may purchase any percentage of the company the owner wishes to sell. Sales of 100% are not uncommon. The minimum is normally 30%, but it can be even lower.
The carrier’s board of directors and management team run the company. ESOP trustees, while observant of performance, normally take a “hands-off” approach when it comes to operating a company. Owners that want to stay involved can.
The representations and warranties required by the ESOP will normally be less onerous than those of an outside buyer.
ESOPs normally pay fair market value as determined by an independent valuation firm. “Add-backs” from compensation or other benefits that will not be paid to the owner in the future will increase the sale value.
Many sales to ESOPs involve some seller financing. Warranties may be attached to the seller debt and receive an additional cash payout when the seller debt is repaid based on the company’s performance.
The IRS 1042 “tax-free” rollover allows eligible selling shareholders to defer capital gains taxes on the sale to the ESOP. And at death, under current tax law, the estate receives a “stepped-up” basis and the capital gains tax is extinguished.
A completely ESOP-owned S corporation pays no federal income tax. Income attributable to an ESOP in an S corporation is not subject to federal income tax, and most states mirror this provision. The tax-free income is proportional to the ESOP ownership. C corporations can make tax-deductible contributions to repay ESOP debt. Tax benefits range from a minimum of 40% to more than 80%.
Because of all the tax benefits Congress grants to ESOPs, employees must benefit from an ESOP, and research proves that significant benefits are created. Numerous studies show that employee-built ESOP account balances are two to three times greater than a 401(k) account at retirement. Employees rarely put any of their own money into an ESOP. The funding to pay off the ESOP debt comes from the tax-free or tax-deductible corporate income referred to above.
The company can be perpetuated through the ESOP transaction. There is normally no change in management, employee base or corporate advisers.
The fees associated with an ESOP transaction will be competitive with a transaction made with an outside buyer. Ongoing maintenance fees are slightly higher than fees to maintain with a 401(k) plan.
• What’s the Catch?
The ESOP is a qualified retirement plan under the federal retirement law, known as the Employee Retirement Income Security Act, and subject to oversight by the Internal Revenue Service and the Department of Labor. It is very important to carefully adhere to the rules and procedures established by these agencies in initially setting up the ESOP as well as operating it on an ongoing basis.
Before making the decision to proceed with an ESOP transaction, a careful analysis of the owner’s objectives, along with the company’s situation and the impact of the ESOP, should be undertaken. A “preliminary analysis,” giving a “30,000-foot view” of how a proposed ESOP transaction would impact the company, is strongly recommended. Some firms specializing in ESOP transactions offer this type of analysis on a no-fee basis.
• Sale Process Already Under Way?
Even if a company has already started the sale process, or is planning to start soon, it is still very advisable to take a look at the ESOP option. In fact, going down a “parallel track” and evaluating outside offers and the ESOP can be the ideal path to take. If “an offer that you can’t refuse” emerges from an outside buyer, take it.
But, given all the advantages outlined here, the ESOP frequently emerges as the preferred buyer. Over the years, we’ve also seen instances where the competition offered by the ESOP — including price, terms and conditions — motivated the outside buyer to substantially sweeten the offer.
ESOPs have been around for more than 40 years, and very appropriately have been referred to as “Win-Win-Win.” The advantages to the seller are numerous and compelling. The tax benefits to the company
are unique, and the new ESOP participants have a substantial wealth-building opportunity.
For many owners, rewarding the long-term employees who helped them build the company, while perpetuating the company at the same time, is as important as any other ESOP benefit.
Gilbert is president of Scottsville, Va.-based ESOP Services Inc., which specializes in Employee Stock Ownership Plans for companies in the United States and internationally. Parham is the managing partner at Transport Capital Partners, a trucking and transportation consulting firm that specializes in transportation mergers and acquisitions based in Arlington, Va.