Aging baby boomer and business owner Ken Tator had several options when he wanted to cash out a portion of his largest financial asset: KTA-Tator, the Pittsburgh-area business his father started in 1949.
“He looked into financial buyers. He looked into strategic buyers and he encouraged us to look at any other options,” said Daniel Adley, who was chief operating officer.
Adley took him up on the offer, researching whether the employees could buy KTA-Tator, which helps state highway departments and industrial companies select and inspect paint that must withstand exposure to harsh environments. What he discovered was a host of compelling tax reasons – for both Tator and KTA-Tator’s employees – for forming an employee stock ownership plan, or ESOP, to acquire the company.
Just as important, while another type of buyer may have eliminated jobs or moved the company elsewhere, the ESOP meant KTA-Tator’s jobs – currently 240 – would stay put.
“Those are all in jeopardy if you sell to a strategic buyer,” Adley said.
The ESOP acquired 70 percent of the firm from Tator in December 2010 and is scheduled to acquire the remaining 30 percent next year. Any concerns at the time of the employee buyout have been alleviated by what’s happened to their KTA-Tator shares since then. The value has increased nearly 180 percent, according to Adley, who is now CEO.
“We’ve outperformed the market substantially,” he said.
Several Western New York companies have been bought by employees through employee stock plans, including: Ferguson Electric, Harper International, Printing Prep And Gear Motions, The Syracuse-Based Owner Of Oliver Gear.
ESOP advocates say other baby boomer business owners looking to sell should consider doing what Tator did.
“The tax advantages are pretty overwhelming,” said Corey Rosen, co-founder of the National Center for Employee Ownership, an Oakland, Calif., nonprofit that provides assistance to business owners.
“From a financial standpoint, it’s pretty hard to beat an ESOP; and from a legacy standpoint, it’s impossible,” Rosen adds.
Here’s how employee stock ownership plans work. A company owner sells the company to a trust that controls the employee shares. Employees do not purchase shares. Instead, shares are allocated to them based on their pay and length of service. The trustee appointed to oversee the ESOP makes most of the decisions, except on major issues like the sale of the company.
ESOPs are regulated by the IRS and the U.S. Department of Labor. Among other things, the agencies want to make sure the price tag on the ESOP sale reflects fair market value because of the tax benefits sellers and buyers receive.
As long as Tator invested the proceeds from selling his company to an ESOP in qualified U.S. securities, he could delay paying capital gains taxes on gains the sale generated. He can eliminate them entirely if those investments pass into his estate when he dies.
Unlike a homeowner who can only deduct interest payments on a mortgage for tax purposes, the company can deduct principal and interest payments on the loans used to buy the company.
The tax benefit can cut borrowing costs as much as 33 percent, according to Kent State’s Ohio Employee Ownership Center.
Adley said the KTA-Tator ESOP took out two seven-year loans to finance the purchase. One of them has already been paid off and the other is expected to be paid off by next year, when the ESOP purchases Tator’s remaining shares.
The Labor Department also is involved because an ESOP is a tax-qualified employee benefit plan. Like a pension or 401(k) plan, it is covered by federal regulations designed to protect employees.
ESOP shares allocated to employees are put into a separate retirement account and the value of the stock is not taxed until the employee sells it back to the company, usually at retirement. Even then, employees can continue to defer taxes by rolling the proceeds into an IRA. Rosen said ESOP participants typically have 2.5 times more in their retirement accounts than non-ESOP participants have in a 401(k) or other defined contribution plan.
Converting to an S corporation, something KTA-Tator intends to do next year, provides an additional benefit to an ESOP-owned company. S corporations do not pay taxes at the company level but pass the company’s earnings and losses on to shareholders, who report them on their personal income tax returns.
Because the ESOP is a tax-exempt trust, it does not pay taxes on any of the company’s earnings that flow into the ESOP, said Karl Kunkle of Schneider Downs Wealth Management Firm, who specializes in employee benefit plans.
“It frees up a lot of cash flow,” he said.
Rosen said research shows ESOP workers are one-third to one-fourth less likely to be laid off than workers in conventionally owned firms. Employee-owned companies do better on return on equity, profit margins and other financial measures than non-ESOP companies, and they default less often on their loans, he said.
But employee-owned companies are not without their issues. They have to set aside enough cash to repurchase the shares of employees when they retire, and some mature ESOPs struggle with that repurchase obligation, Kunkle said.