By Kevin McPhillips
The new year is traditionally the season of planning, popularly expressed in New Year’s resolutions. For businesses, the planning has higher stakes, a course for future success for the next year or so. But what about the endgame?
Based on research out of the Rutgers School of Management and Labor Relations, less than 56% of business owners over 55 have a succession plan. This is no small number. The Exit Planning Institute projects there will be more than 4 million companies changing hands over the next eight to10 years as baby boomers age into retirement. The U.S. Labor Department estimates that as many as 30% of these may simply go out of business, creating a real economic challenge.
The sale of a business or merging it with another are traditional routes that accounting practitioners eye when contemplating an exit. But some owners may need some time to get the willpower to hand over the business they built to strangers. Some may never be ready. For those who are ready, know that there are alternatives. One is a transition via employee ownership, or more specifically, employee stock ownership plans (ESOPs). The ESOP has been a part of the Employee Retirement Income Security Act (ERISA) since 1974, although very few understand its capabilities.
In brief, the following is how an ESOP generally works. A business owner (or owners) can sell some or all of their business to their employees (20%, 40%, 100%, or any percentage that works), but the employees pay nothing. Rather, the business takes a loan from a traditional source such as a bank to pay the owner the fair market value. The selling shareholder(s) can opt to take back some paper at a desirable interest rate and diversify their own holdings for an agreed upon period of time.
The federal government and the state of Pennsylvania both exempt from tax the future profits from whatever portion is now owned by the employees (whose shares are held in a trust). To repeat that: the business will pay no tax on a portion of some or all of its profits. The cash saved is then used to pay down the debt, and once that is paid the business has substantial additional cash to grow. It should not be surprising that ESOP businesses are as much as 12% more profitable year-over-year on average than businesses not owned by employees.
ESOPs tend to work best in businesses that have 20-25 or more employees. So, what about Main Street businesses such as cafés, hardware stores, and the numerous service companies that make up the vast majority of businesses in the U.S. economy? For them, there is a relatively new alternative: the employee ownership trust (EOT).
Just like an ESOP, a business owner can sell some or all of the shares to the employees for an agreed upon amount. The shares of the business are held in a trust, and the profits of the business belong to the employees in a way designed by the selling owners and the employees. The owners reap value from their years of work and the employees now profit from their daily efforts. Although relatively new in the United States, EOTs have been common in the United Kingdom for generations. The large U.K. department store, John Lewis & Partners, has been employee owned for over 100 years!
Today, more than 300 businesses in Pennsylvania are all or partly employee owned. They include Sheetz, Wawa, Dansko Shoes, Joy Cone, among others across all 67 counties in Pennsylvania. And the number grows every month. Pennsylvania is second in the nation, behind only California (with three times the population) in new employee-owned companies. Yet very few have been aware of this remarkable program. That is changing.
Bipartisan legislation has been introduced to create an Office of Employee Ownership in the Pennsylvania Department of Community and Economic Development. With it, the Employee Ownership Program Assistance Act will provide meaningful funding in the form of grants, loans, and loan guarantees to businesses interested in converting to employee ownership. This will be game-changing for Pennsylvania businesses designing their succession plans.
Not only can this benefit small CPA firms as the proprietors reach retirement age, it also is a great practice opportunity for the CPA community. It is important for professionals to understand these options so they can confidently add to their clients’ transition options and can help them access funds if they choose this route. The Pennsylvania Center for Employee Ownership, a 501(c)(3) volunteer nonprofit organization, can help. We raise awareness about this remarkable program and direct interested parties to informative resources. You can learn more by visiting www.OwnershipPennsylvania.org.
Kevin McPhillips is executive director and CEO of the Pennsylvania Center for Employee Ownership (PaCEO) in Havertown, Pa. He can be reached at firstname.lastname@example.org.
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