No Need To Envy Tax-Inversion Takeovers: Better Tax Deal Awaits

Watching big pharmaceutical companies and other major U.S. corporations line up to make foreign acquisitions that will bring them a low-tax haven as headquarters, a middle market CEO/owner/entrepreneur could easily become jealous. Are you feeling stuck with an effective tax rate of 25%, 30% or even 35%?

For the likes of AbbVie (ABBV), Walgreen (WAG), Medtronic (MDT) and possibly Pfizer (PFE), the tax inversion deals could add billions of dollars to after-tax profit over a period of years.

The good news is an even better tax strategy is available to middle market companies. It doesn’t require a move outside the U.S. or even away from your current headquarters city. And unlike the much-publicized tax inversions, this one isn’t a tax-tail-wagging-the-business-dog, but rather a move that has already helped thousands of U.S. companies make their operations more productive and profitable and to end up paying far lower taxes.

The strategy is called an Employee Stock Ownership Plan, or ESOP, and I’ve committed my professional life to spreading the format because I believe it’s good for owners, good for employees and their families, and good for the U.S. economy. It preserves jobs and builds retirement wealth while rewarding the owners who built the business.

The tax advantages of partial or entire employee ownership also mean a company can often support more debt than in a private equity transaction, and that can help a company founder not only craft an exit strategy but also preserve his or her legacy as an entrepreneur.

Here’s a one-two summary of the tax savings:

1. Sell 30% or more of your business to a C-Corporation ESOP and you can defer personal taxes on the proceeds by reinvesting in qualifying equities. You heard me right: no capital gains taxes. As a founder, if it’s time for you and other investors to start diversifying, say you sell 30% for $30 million. If you sold under those terms to another buyer, your federal capital gains, state and other taxes could reach 25% or more, or $7.5 million. But selling to an ESOP and reinvesting in stocks – you and your advisor can craft a portfolio to meet your growth and income needs – you avoid those taxes.

2. If your company is a pass-through vehicle, or S-Corporation, an ESOP can become a valid shareholder and it doesn’t pay federal income taxes. That shelters the ESOP’s share – it can range from 5% to 100% ownership – from income taxes until employee owners withdraw funds in retirement or depart the company and are bought out. That increases your after-tax cash flow now.

Skeptical? Read some case studies:

–S&C Electric, a $700 million-a-year maker of equipment for utilities, where an ESOP lived up to the founder’s exacting wishes for his legacy and also rewarded his heirs.

–Central States Manufacturing, where a wildly successful ESOP made Aaron King the millionaire truck driver.

–SmithBucklin, a $100 million-a-year association management firm, where an ESOP is but one element of a high functioning, employee-focused culture.

–National Van Lines, a $100 million moving firm, where employees became the fourth generation of family ownership.

These companies got a lot more than a lower tax rate out of their ESOPs, and in fact operating gains often loom larger in employee ownership considerations. ESOP-owned companies, regardless if the stake is a minority one of 100%, tend to enjoy a productivity boost as employees act like owners. Waste is reduced. There is a self-policing nature to ESOP workforces, so that friction between management and employees also lessens. And good ideas bubble up in greater number. I’ve observed this happen at companies I’ve advised, and it’s also backed up by significant employee ownership research.

Also, despite what you may have heard, employee ownership doesn’t mean that workers manage the company. Normal and customary governance prevails. And many founder/CEOs sell a minority stake to employees and keep right on managing the company.