ESOPs now Dead Men Walking under Trump’s Tax Plan

For small business owners looking to sell their businesses, leveraged Employee Stock Ownership Plans, or ESOPs, have often been a useful tool. ESOPs allow owners to get liquidity, take care of their employees, and shape the future of their businesses, including the orderly succession of family members to take over as CEOs.

Trump’s new tax plan dramatically reduces the benefits of structuring a business as an ESOP. We expect there to be sharply fewer new ESOPs going forward, with business owners exploring other avenues to gain liquidity from a sale.

How ESOPs work

ESOPs allow a business to become tax free, thus retaining significant additional cash in the business. Imagine a Tennessee manufacturer that employs 120 people with $3 million of pre-tax income on $30 million of sales. If federal taxes are 35%, then a significant portion of that income—roughly $1 million a year—is paid in taxes. An ESOP, paying no taxes, gets to keep that $1 million. Here’s the key: the higher the corporate tax rate, the more benefit there is to being an ESOP.

Now in return for this favorable tax treatment, ESOPs have additional rules they must follow. They are time consuming and expensive to set up. Management actions can sometimes be more constrained, because employees end up owning the company in the manner of a pension plan, and this ownership is governed by the same rules that other pension plans follow.

Nevertheless, for many business owners, and many employees, ESOPs have been a great way for the owners to sell the businesses and for employees to own stock in the company for which they work. That is to say, the tax-driven benefits of setting up and running an ESOP outweigh the costs.

Why the future looks grim for leveraged ESOPs

Leveraged ESOPs are a kind of ESOP that employs bank debt to buy out the owner of a business, and are a favored way for business owners to sell their businesses, particularly for firms for which there are not a lot of buyers, or firms that want to keep management of the business in the family.

Under the current 35% tax rate, the tax-free status of an ESOP provides a lot of incentive for owners to use this structure. Under Trump’s tax proposal, the 15% corporate tax rate cuts the benefits of being an ESOP by over half. Note, that this effect is independent of the various details that will be worked out in the legislation. A sharp drop in corporate tax rates necessarily implies a sharp drop in the benefit of being an ESOP. There will of course still be some companies that will still see a net benefit in adopting an ESOP, but many fewer than in the past.

Yet the 300,000 owners of privately held businesses in the U.S. will continue to sell their businesses when they no longer want to or are able to run them. If ESOPs are no longer as attractive, we predict there will be an increase in traditional sales to competitors, as well as to private equity.

None of this speaks to the law’s impact on existing ESOPs, but clearly corporate acquirers and private equity will get a boost from the new tax laws and new ESOPs will lose a lot of their reason for being.

Andrew Southwell is Managing Director at investment bank Bailey Southwell & Co.