by Mike Mathioudakis, Genesis ESOP Advisors, LLC
Community banks are the very lifeblood of many communities. They serve the banking interests of the businesses and individuals in their respective communities, still offering a personal level of service that the big banks just can’t match.
Community banks have fought long and hard over the years to maintain their independence. However, this has become an increasingly difficult challenge as the big banks just keep getting bigger. The “costs” and the “risks” to keep up continue to rise. Technology has changed the banking industry (and most others) in ways no one could have imagined.
However, there is another major risk that community banks face that is a very real threat to their very existence. That risk is ownership succession.
Studies have shown as baby boomers move into retirement, those who own family businesses are finding that their children are not following in their footsteps and entering the family business like they have in decades past. There are multiple reasons for this, which are beyond the scope of this article. However, the net result of this trend is not. The result is that a far greater percentage of these boomer-owned businesses are being sold to non-family members. This same phenomenon faces many community banks.
- Sell or gift to their children and/or grandchildren
- Sell to bank management
- Sell to a larger (typically not community) bank
- Sell to an Employee Stock Ownership Plan (ESOP)
Each of the first three alternatives face unique challenges. Frequently, the family of the bank’s owner are not coming into the family business as they have in years past. Or, if they are, it’s possible only one of multiple children. Typically, bank management doesn’t have the financial resources to buy-out the majority owners, which eliminates them as potential successor owners. All too frequently, this leaves the majority owner of community banks having only one viable alternative – selling to the dark side – those big banks they have spent their careers steering clear of.
While this goes against the very essence of why community banks exist, in many cases, it’s the only viable option. When this occurs, the community loses its community bank. The bank and its long, proud history in the community is gone.
Is there any other option? Yes, there absolutely is. Employee Stock Ownership Plans (ESOPs) offer a unique and compelling alternative.
ESOPs are a type of qualified retirement plan. The big difference between ESOPs and other retirement plans is that ESOPs primarily (or exclusively) own stock of the employer.
ESOPs have some extraordinary tax advantages to sellers and buyers. An ESOP can allow the owner of a community bank to cash out while completely deferring capital gains tax on the sale.
In the case of the company, the tax code offers some incredible tax benefits. ESOPs can purchase the stock of the bank with pre-tax dollars. Yes, pre-tax dollars. This makes it much cheaper for an ESOP to purchase the bank than if the executive team was to purchase the bank as they would have to purchase it with after-tax dollars. S-Corporation ESOPs have another huge tax advantage as they do not pay any federal income taxes on the income attributable to the ESOP. In other words, an s-corp owned 50% by an ESOP only pays income taxes on half of its income. In the case of a s-corp owned 100% by an ESOP, it pays zero federal income tax.
This results in significant benefits to the seller and buyer. With reduced or even eliminated income taxes, the seller can be paid-off much quicker. The company is also much more financially sound due to its reduced tax burden. From the ESOP’s perspective, it can pay-off the debt used to purchase stock much quicker (due to no taxes) and as it does pay-off the debt, significant benefits accrue to the new employee-owners. This becomes a completely new source of retirement income for all of the bank’s employees. So, those who have helped build the bank can now reap the rewards of ownership in the form of a significantly enhanced retirement.
Tax Savings of an ESOP Transaction – a $10 Million Example
After-Tax Benefits After-Tax Cost
to Seller* to Company*
ESOP Alternative $10,000,000 $7,000,000
Non-ESOP Alternative $7,500,000 $10,000,000
Differential $2,500,000 $3,000,000
Total Tax Savings Using ESOP $5,500,000
* Assumes a 30% company tax rate and a 25% capital gain tax rate (including state taxes)
As this table illustrates, when you consider both the full tax deferral available to a seller under Section 1042 and the tax savings to the company in an ESOP, the tax savings can represent more than half of the total transaction amount. In this example of a $10 million company value, the seller saves $2.5 million of capital gains tax while the company saves $3 million in income tax, resulting in $5.5 million of total tax savings compared to a traditional outright sale.
ESOPs are one of the most powerful and effective business succession strategies available to business owners, including community banks. However, they are widely misunderstood by my most CPAs, Attorneys and Financial Advisors. ESOPs can provide very substantial benefits to the seller through the complete deferral of capital gains tax. ESOPs also provide incredible benefits to the company as it can pay-off the debt with pre-tax dollars. As illustrated above, together these tax benefits can result in tax savings totaling 50% or more of the total transaction value. In addition, ESOPs provide unprecedented and substantial benefits to the bank’s employees, as they end up owning the company. All in all, ESOPs are one of the most attractive and powerful strategies offered in the Internal Revenue Code.
If you would like to discuss ESOPs in more detail, just let us know as we have significant resources both internally and with ESOP firms we partner with.
Questions? Contact your IZALE representative today!