Business owners planning for retirement generally contemplate either the sale of the business to a third party or a transferof ownership to family members, but another option may be to sell the business to company employees. There are several techniques and issues to consider when planning this type of sale.
Initial Transfers. The sale of a business to its employees often starts with purchases of minority interests (stock or limited liability company (“LLC”) membership interests), sometimes through installment payments. For the selling owner, maintaining voting control until the sale is completed is important and can be ensured by barring minority interests from being transferred to outside parties or by only transferring nonvoting interests. Employees should file an Internal Revenue Code Section 83(b) election (within 30 days of the purchase), so that capital gains treatment is available for a future sale of the business interests.
Financing and Redemption. Employees often do not have sufficient cash to purchase the entire business. An alternative to a bank loan or seller financing is the redemption by the company of the remaining equity interests not previously sold or transferred to employees. Capital gains treatment can be obtained for a corporation under Code Section 302, which essentially requires a complete termination of interest. Distributions from Subchapter S corporations or limited liability companies taxed as a partnership have different tax attributes, and the accumulated earnings may have already been taxed.
ESOPs. Another technique to sell equity interests to employees is to create an employee stock ownership plan (an “ESOP”), which can purchase stock using bank loans. The yearly contributions to an ESOP are deductible as retirement plan contributions, with the loan to the ESOP repaid from the yearly plan contributions. For a “C” Corporation, there is a tax deferral technique if the owner rolls over the sale proceeds into qualified U.S. domestic corporation replacement securities and if at least 30% of the company stock is sold to the ESOP. If the owner holds the new qualified domestic corporation securities until death, a stepped-up basis under Code Section 1014 could eliminate the capital gains tax upon a sale of the replacement domestic corporation securities.
Securities Law Issues. The sale of equity interests to employees also involves an analysis of federal and state securities law registration exemptions and general securities law requirements. All securities transactions require adequate disclosure of material facts to avoid securities anti-fraud claims. Illinois has a securities law exemption for the sale of stock within the state of Illinois if the sale is to less than 35 purchasers. Illinois also exempts sales solely to existing shareholders. For federal securities law purposes, U.S. Securities and Exchange Commission (“SEC”) Rule 506 provides an exemption for sales that are limited to not more than 35 persons who are not accredited investors, but who have enough sophistication to understand the investment they are making. SEC Rule 701 provides an exemption for sales solely to employees.
Conclusion. The sale of the equity interests to employees is a natural way to transfer the ownership of a company to persons who are knowledgeable about its operations and capable of running the business. The successful implementation of this type of transaction requires an evaluation of financing techniques, tax and securities law issues, and methods to maintain control until all of the equity interests have been sold.