Over the next twenty years retiring baby boomers will be exiting the workforce in droves, a phenomenon often described as the “silver tsunami.” Baby-boomers own 66% of all businesses with employees in the U.S., and their retirement will cause the transfer of trillions of dollars in business assets. The open question is – to whom?
Some have predicted that these businesses will be gobbled up by private equity firms. But private equity may not be available to many small business owners, and even where it is, the private equity model – which seeks to purchase equity in a business and sell that equity at a 100% profit within three to five years – may not achieve many of the business owner’s core concerns. Given that private equity investors are looking to sell the business in a short time period, they cannot commit to core values, such as retaining the business’ identity, reputation or fulfillment of a community need. For small business owners who’ve devoted the majority of their working life to their company, and whose legacy is at stake, private equity might be an unsettling prospect. Fortunately, there exists an alternative that may help ensure the business’ long-term viability: selling to the employees as an employee-owned business.
Forming an employee-owned business can provide a succession plan that addresses many concerns of small business owners. For one, by opting to sell their business to their employees, who usually live in the community, business owners can help ensure that their business will remain rooted in the community. Second, selling a business to employees can actually help provide the business with a competitive advantage when compared with investor-owned firms operating within the same marketplace – for instance studies have indicated that workers are more productive in worker owned firms. Most importantly, selling to employees may provide an exit possibility for the great number of business owners who plan to fund retirement through a business sale but are unable to identify a potential buyer.
But while there are many potential benefits of employee-ownership conversions, perhaps the most striking and yet underutilized advantage has to do with taxes. Specifically, an underutilized provision ion the tax code – Section 1042 – enables business owners to defer all capital gains taxes when they sell their company to an eligible worker cooperative. For business owners on the verge of retirement, the prospect of both preserving their business’ legacy while simultaneously decreasing the tax burden from the sale of their business should be quite alluring. And Section 1042 can also allow the business owner to plan his or her exit, slowly over a period of years, or quickly under the appropriate circumstances. Here’s how it works:
Section 1042 allows business owners who have had an ownership stake in a company for three or more years to sell their companies to an eligible worker cooperative, and take the proceeds from the sale free of taxation. While only owners of C Corporations are eligible to take advantage of Section 1042, S corporations can easily elect C-status. So long as the owners have held an ownership stake in the business for more than three years, they will be eligible to sell their business under 1042. And, a recent IRS ruling suggests LLC owners can do the same.
To take advantage of Section 1042’s tax deferral, the business owner must take the proceeds from the sale and invest it in “qualified replacement property,” which includes stocks, bonds and other debt instruments of domestic corporations. So long as the business owner holds onto the replacement property, he or she will not be required to pay any tax on the proceeds from the sale. Thus the business owner could take some portion of the proceeds from the sale and create an investment portfolio, or add corporate bonds and individual stocks to his or her investment portfolio. The business owner would then only be required to pay the applicable tax rate on dividend or interest income from the property – typically the ordinary income tax rate for bonds and other debt instruments, and 15% for dividends – but no taxation on the property itself.
For the selling business owner, this could mean great savings, and may provide a great advantage over other modes of sale, such as an asset sale, or a non-1042 equity sale. For instance, if the business is taxed as a C corporation and sold as a collection of assets, the proceeds from the sale would be subject to double taxation – first at the applicable corporate tax rate, and then at the dividends tax rate when the company disburses the sales proceeds to the selling owner. This could potentially lead to a situation in which over half of the proceeds from the sale are taken as taxes. By contrast, using 1042 the selling owner can put off the capital gains taxes. Thus, even in situations in which an external buyer would offer more money for the purchase price, the selling business owner might end up receiving a lot less than he or she would under a 1042 sale. Further, even if the business is not taxed as a C Corporation, such as most LLCs or S Corporations, or if it is sold through a non-1042 equity sale, as in the private equity model, the proceeds of the sale would still be taxed at the long-term capital gains rate or higher.
A further benefit of 1042 cooperative conversions is that they enable the business owner to plan and execute the succession of his or her business over a period of years. Under Section 1042 once 30% of the business equity is transferred to the worker cooperative, the transaction that achieves the 30% transfer and all subsequent transfers to the worker cooperative, are eligible for tax deferral. A selling business owner, or owners, could thus transfer the initial 30% of stock to the worker cooperative, work with financial advisors to invest the proceeds, and gradually transfer the remainder of the business to the worker cooperative. This can be a huge benefit for the many small business owners that wish to sell their business as a partial source of retirement income because it can provide them the opportunity to ensure that their employees are properly-trained and prepared to manage the business in a manner consistent with the business’ identity and practices. And for businesses where the value of the business is deeply tied to the owner, it can allow the owner to expose the business’ customer base and clientele to the new management structure, thereby disentangling the value of the business from the owner.
For more about employee-ownership conversions, including a legal analysis of Section 1042, stay on the lookout for GC3, SELC and Project Equity’s forthcoming Legal Conversion Guide, which will be accessible at this site.
William Lisa is a graduating law student at Berkeley Law and an intern at the East Bay Community Law Center’s GC3 Clinic. He plans to work with companies creating employee share ownership plans (ESOPs) after graduating from law school.