The use of employee stock ownership plans as a tool to transition ownership has a number of attractive benefits that may well be overlooked by accounting firms.
In the recent past, accounting firms might have sold to private equity, according to Lawrence Kaplan, founder and managing partner of CSG Partners, an ESG advisory firm and investment bank, but they're beginning to understand there are other options.
"The use by BDO of an ESOP has sparked interest in the procedure," he said. "BDO sold a minority interest to employees through an ESOP, which led to a tremendous amount of interest. Many that sold to private equity said that if they had understood it better, an ESOP would have been the better route to go." (See "B
"When an accounting firm sells to private equity, it is doing a leveraged buyout, but they can do the same thing through an ESOP, leveraging the company's balance sheets," he explained. "The ESOP is doing a tax-advantaged leveraged buyout of its own accounting firm. The difference when compared to private equity is that when they sell to private equity and receive the proceeds, it's taxable to everyone in the form of capital gain."
Using a leveraged ESOP, shareholders essentially sell equity to an employee trust at a fair market value The transaction is financed through third-party and/or seller debt financing. Eligible employees receive annual share allocations over a period of years, and when they leave the company, their vested stock is sold back to the company at its current value.
Moreover, capital gains can be deferred and possibly eliminated via a Section 1042 rollover if the seller owns the shares for at least three years prior to completing an ESOP transaction. To take full advantage of a 1042 rollover, the company must close its ESOP as a C corporation, since S corporation qualified replacement property is limited to 10% of the sale proceeds, with the remainder subject to capital gains taxes.
"Congress — both Democrats and Republicans — is a big supporter of ESOPs, and it's really starting to take off," said Kaplan. "CPAs jumping from firm to firm can get equity from the firm they're with. If the company performs well, they can make a significant amount of money."
"It's a way for older partners looking for the firm to buy them out to do so in a tax-advantaged way," he continued. "They don't pay tax and they get liquidity at the same time that younger partners get liquidity through participation in the ESOP. Firms are struggling today because they can't get accountants to process their work, and they're looking for ways to attract and retain qualified people who will stay with the firm. At some point, the cost of leaving the firm is not worth it."
A word of caution: In
"Additionally, the IRS has seen promoted arrangements using ESOPs that are potentially abusive," Kaplan said. "For instance, the IRS has seen schemes where a business creates a 'management' S corporation whose stock is wholly owned by an ESOP for the sole purpose of diverting taxable business income to the ESOP. The S corporation purports to provide loans to the business owner in the amount of the business income to avoid taxation of that income. The IRS disagrees with how taxpayers interpret this transaction and emphasizes that these purported loans should be taxable income to the business owners. These transactions also impact whether the ESOP satisfies several tax law requirements, which could result in the management company losing its S corporation status. Over the next year, the IRS will continue to use a range of compliance tools, including education, outreach and additional examinations to address compliance issues associated with ESOPs."
Nevertheless, the use of an ESOP as a transition tool is a perfect solution for many accounting firms, according to Kaplan.
"They have to look to the future and decide which way to go. This is a tool that allows them to be in control of their own destiny," he said.
