Accounting firms typically have multiple partners, some of whom may want to retire or move on in the near future, and others who want to stay longer.

Partners in accounting practices may plan to effect a buy-sell agreement, or some day sell to a larger competitor. But the hoped-for value may not be realized in a sale to a third party, or owners may ultimately not want their practice to be swallowed up into another firm's culture.

Partners who buy each other out, or have the practice do so, must use after-tax dollars to make the purchase. Similarly, redemptions of stock are not tax deductible. Some accounting firms are turning to another alternative: selling to employees through an employee stock ownership plan. These plans have long been used as a very attractive vehicle for ownership succession planning, and some accounting firms have been involved in consulting on them. But few have considered an ESOP for themselves or even realized that in 40 states an accounting firm could have an ESOP, provided it is a C or an S Corporation, or is willing to convert to one.

One common concern that accounting firms have is that their state laws do not allow accounting firms to have ESOPs. That was the norm some years ago, but today 40 states allow ESOPs for accounting firms. In Virginia and Minnesota, an ESOP can own 100 percent of the firm; in the other 38 states, the plan must own less than controlling interest.

State laws typically require that owners of accounting and other professional firms be members of that profession, but that problem can be resolved by having the trustee or trustees of the ESOP be accountants. ESOPs own stock through an employee benefit trust, not unlike a 401(k) trust, and the trust is run by a trustee or trustees appointed by the board. The trust, not the participants in it, is considered the legal owner of the shares, so having the trustee be an accountant satisfies state rules.

Firms should check with their state accountancy boards to get details. The trustee votes the shares, although companies can voluntarily pass that through to plan participants, and they must let plan participants provide direct voting on recapitalization, reclassification and sale of all or substantially all of the assets.

An ESOP was the route chosen by HLB Tautges Redpath, Ltd., based in St. Paul, Minn. As managing partner Jim Redpath tells the story, back in the early 2000s, when the founders were reaching their late 40s and early 50s, they were thinking about their future. "We didn't know what to do with what we had," he said.

They thought about selling to another, larger firm. "A lot of them wanted to buy us," said Redpath. "But, is this really us?"

They did some research and considered options. In 2003, the firm implemented an ESOP, and today HLB Tautges Redpath is 100-percent employee owned. Jim Redpath and the other partners are still there. They sold their ownership shares to the ESOP in 2003, and now they participate in the firm's growth and profits through the ESOP, just like other employees.

Jim Redpath believes that becoming employee owned has helped the firm do well in the last several years. While revenues for many other accounting practices have been flat or down during the recent period of economic downturn, their business has enjoyed record profits for the past three years in a row.

HLB Tautges Redpath is just one of over 11,000 examples of companies with employee stock ownership plans. Almost unknown until 1974, these plans now cover over 13 million employees in the U.S. There are, however, few accounting firms with ESOPs.

The National Center for Employee Ownership has only been able to identify a total of four CPA firms, including Burr, Pilger, Mayer, a 16 percent ESOP-owned practice that is the largest California-based ESOP accounting firm.

SELLING TO AN ESOP: BENEFITS FOR OWNERS

An ESOP is a type of qualified employee benefit plan and is by far the most tax-favored method of ownership transition. A company sets up a trust to hold company stock. The company (not the employees) funds it out of tax-deductible pretax earnings, either by putting in cash year after year to buy shares or, more commonly, by the trust borrowing money to buy a larger chunk all at once and the company then making tax-deductible contributions to the plan to pay off the loan.

An ESOP allows owners to sell their ownership interests all at once or gradually in installments. In addition, owners have the option to define their role in the business moving forward, by either continuing in a management, board or consulting role. Also, if there is more than one owner, as is generally the case with midsized accounting practices, an ESOP allows just one owner to exit and others to stay on for the time being.

Accounting firms do need to remember that an ESOP is not allowed in an LLC, partnership or sole proprietorship. A company must first convert to S or C Corp status before setting up the plan.

ADVANTAGES, REQUIREMENTS AND OBSTACLES

There are tax and performance advantages to the company with an ESOP, and benefits to the employees. Most important is that ESOPs are the only way that a company can use pre-tax dollars to buy its own shares. In addition, sellers can get a tax deferral for sales to an ESOP in a C Corporation where the ESOP owns at least 30 percent of the stock, and dividends paid on ESOPs shares in a C Corporation can be deductible.

If the company is an S Corp (or converts to one), any profits attributable to the ESOP-owned shares are not subject to federal income tax. Most states follow this provision in their own tax laws. So a 30 percent ESOP pays no tax on 30 percent of its income.

If the company becomes 100 percent ESOP owned (like HLB Tautges Redpath), it pays no federal income taxes. For employees, there is no tax on the contributions when they are made. Instead, ESOP distributions are taxed in the same way other benefit plan distributions are.

Research on ESOP companies has found that employee ownership can improve business performance. A study by Rutgers University in 1998 that looked at corporate performance pre- and post-ESOP found that after the ESOP was in place companies on average had 2.4 percent higher annual sales, a 2.3 percent higher annual growth rate and a 4.5 percent increase in productivity.

For employees, sale to an ESOP protects their jobs, provides them with a significant retirement benefit and can create an even better work environment.

Companies that are employee-owned often use this as a marketing feature, pointing out that their employee-owners will be especially customer focused. And there is an added advantage for accounting practices that may want to find ESOP companies as clients - an ESOP accounting practice can advise its clients based on its own real-life experience. Burr, Pilger, like HLB Tautges Redpath, has set up an active ESOP consulting effort.

ESOPs also come with rules. Shares in the plan are held in individual employee accounts. Contributions are allocated to each participant in the plan based on relative pay up to $245,000 per year or a more level formula. Allocations are subject to vesting over up to six years and are distributed after the employee leaves the firm (up to six years after for termination; but one year for death, disability or retirement). Distributions can be paid in installments over up to five years. There are limits on how much can be put into an ESOP annually, but these are almost never an issue.

What this means is that ESOPs cannot be used to provide ownership to select employees based on merit or other approaches. Like all ERISA plans, ESOPs must be non-discriminatory and operated for the benefit of plan participants. The sale price of the shares is also not a negotiation, but is instead set by at least an annual independent outside appraisal.

Aside from issues over whether these rules are acceptable to the owners, ESOPs also are costly to install (about $60,000 to $100,000 typically, but a fraction of that annually) and must be paid for out of corporate profits. Firms without profits will have a hard time making an ESOP work.

Before creating a plan, owners need to get educated about their options and find advisors with substantial specific expertise in the field.

Corey Rosen is a senior staff member at the National Center for Employee Ownership.

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