Helping Businesses Transition with an ESOP

By Rich Coffin

Sixty-year-old Toby Phillips (not his real name) started his business a few decades ago out of his garage in Southern California. What initially began as a hobby, turned into a way to make a few extra dollars on the weekends. Soon his hobby rapidly grew into a thriving business.

Toby wasn’t the only one having success in his industry. The competition was fierce, and innovation meant everything. Like most business owners, Toby invested most of his profits where he knew he could reap the highest return on his money – back into his business. He bought equipment, expanded his marketing and traveled the country to show off his products. Toby would put everything into his E-ticket ride into retirement. The plan? Grow and perfect the business and sell to the highest bidder! Surely, they’d be lining up to buy such an amazing business.

A few offers came but they weren’t what Toby needed to ride off into the sunset and certainly not close to what he believed the business was worth. After all, he had his best years of blood, sweat and tears in the business. Meanwhile, his number one competitor sold to a large corporation in a highly strategic acquisition. With much deeper pockets than Toby’s, the competition quickly overshadowed Toby’s business with better distribution, lower prices and greater manufacturing efficiency. Toby’s business soon began to plateau despite the efforts he put forth to stay competitive. The offers to purchase Toby’s business disappeared. It was time for plan B. Sadly, there wasn’t a plan B.

Looking for an Exit Plan

Toby’s story is no anomaly. According to a study done by Exit Planning Institute “The State of Owner Readiness, Greater San Diego, 2017”, of the roughly 6 million privately owned businesses in America, only 20 to 30% of them will transition successfully. Unfortunately, it’s going to get worse. Of those 6 million businesses, two-thirds are currently owned by baby boomers between the age of 54 and 72. The over 75 million members of the baby boom generation, by the sheer size of their demographic, have caused an economic ripple across the nation during each decade of their existence. From healthcare to Social Security, their masses left a wake of destruction behind them. As they enter the retirement phase of their life cycle, they’ve come to be known as the “Silver Tsunami.” Now, Toby has another problem – supply and demand. The supply of businesses like Toby’s is growing as aging owners find themselves tired of being on the hamster wheel or being forced out as a natural result of aging. Half of all businesses fail because of one of the five Ds – Death, Disability, Divorce, Distress and/or Disagreement. Health issues and, in many cases, death will cause a business to go into a fire sale mentality as heirs frantically try to grab onto the life preserver and sell off the assets of the business for pennies on the dollar to the vultures lying in wait.


Will the Silver Tsunami crush you as well? Or can you shape a board (of directors) and ride the wave? To solve the problem of finding a buyer at the right time, offering the right price and under the right conditions for all involved, business owners are looking to sell their business to the people who are most deserving and know best how to run it – the employees. The tool for this is the Employee Stock Ownership Plan or ESOP. Louis Kelso, a political economist, investment banker, a corporate and financial lawyer, created the first ESOP in 1954 when he helped the employees of Peninsula Newspapers Inc., in Palo Alto buy the company from the owners.

In 1974, the Employee Retirement Income Security Act (ERISA) added the ESOP to the IRS code for the first time. An internet search of the acronym ESOP will result in information on the traditional Leveraged ESOP. The Leveraged ESOP is primarily for an owner wanting to exit the business in 12 to 24 months. They should have key people already in place to take the reins and are confident that stepping away will not hinder the growth of their company. How this happens is through the borrowing powers and benefits of an ESOP.  The ESOP is typically limited to borrowing no more than 50% of the business value from a lending institution. As a result, the owner gets half the value of the business up front and takes a promissory note from the ESOP for the remaining 50%. This often presents a significant risk to the business owner since the company is hindered with the liability of paying back the lending institution and simultaneously paying the owner the remaining balance owed. Should the company go into a decline, it could be difficult for the ESOP to fulfill the loan obligations to the bank first and the owner second. This could prevent the owner from obtaining full value from the transfer of the business. That’s a difficult situation for most business owners to accept. That is where Kelly R. Smith Sr. decided to flip the script on an old idea to keep the business owner in control of the business and the buyout.

Leveraged ESOP

Kelly R. Smith Sr., CLU, ChFC, founder of CapitalSmith Financial & Insurance Services (CapitalSmith), began his career in financial services over 43 years ago, qualifying every year, including his rookie year, for Million Dollar Round Table (MDRT). He has 17 years of Court of the Table and 11 years as Top of the Table. After receiving an endorsement by the Los Angeles Association of Deputy District Attorneys to design life and disability programs, he worked as a consultant to the NFL Players Association for Insurance, Finance and Retirement. Kelly then went on to pursue valuable experience in the fields of Mergers and Acquisitions, turnarounds and investment banking. It was during this time he developed his proprietary Offset Strategies™. After meeting economist Louis Kelso, Kelly went on to design his unique version of a Leveraged ESOP.

To address the problem of burdening the business with loan obligations, Kelly discovered that a corporation could issue new stock and transfer, not sell, it to the ESOP. This transaction creates a dollar for dollar deduction that effectively turns profit into Tax Exempt Retained Capital™ (TERC™) that can be used to grow the business, purchase a building, purchase equipment or fund the businessowner’s retirement and exit. Of course, this method takes time, so it wouldn’t be the ideal method for an owner looking to exit in the next year or two. Fortunately for this strategy, the additional time is often what is necessary in order for the businessowner to identify and train internal personnel or recruit from outside the key people necessary to continue the business. Kelly calls his strategy a “Pre-Leveraged ESOP™.” This option allows the business to avoid being burdened by debt. In fact the opposite is true – it frees up capital that would otherwise have been paid in taxes.

After hearing Kelly present on his Pre-Leveraged ESOP™ at a local forum, Toby’s financial advisor arranged for Kelly to meet with him and his client. Kelly met Toby Phillips and heard all about the history of his business and his current situation. Toby would have to either continue running the business or squirrel away enough to one day walk away from it. Kelly considered several options that might help Toby eventually exit his business if the right buyer didn’t appear.

A Real Exit Plan

A pension plan or possibly a deferred compensation plan came to mind but the income taxes on the back end crippled those plans. Additionally, funds allocated to those plans couldn’t be used to grow the business or weather hard times. What made the most sense for Toby’s situation was Kelly’s Pre-Leveraged ESOP™. This strategy would create the buyer for Toby’s business, provide him with a fair market price, substantially reduce his tax liability and redirect those dollars into growing the business or funding his buy-out without restriction on how and when to access those funds. Moreover, Kelly illustrated several other things that Toby hadn’t thought about. What would happen to his employees had he sold to a private equity group or third party? Would they retain their positions? Would the new owner move the company or downsize operations? His employees were like family to Toby and he wanted them taken care of. With the ESOP in place, not only were they able to keep their jobs, they now had an ownership interest in the company they helped build. Employee performance can be surprising when they have skin in the game. Toby noticed that workers became more efficient and more cognizant of what certain actions meant to the success of the company, and ultimately their own success.

Fair market value for Toby’s business was enough to fund Toby’s retirement. What Toby didn’t consider were the capital gains taxes he would have to pay on the sale of his company. Between federal capital gains tax rates and state taxes (California does not have a separate capital gains rate – it’s all ordinary income), Toby was looking at giving up close to 35% in taxes. Suddenly, fair market value wasn’t enough.

What is important to understand though is that the Pre-Leveraged ESOP™ is not a sale of stock to the ESOP. It’s a transfer of newly issued shares of the corporation that slowly divests Toby’s ownership while providing a dollar-for-dollar tax deduction to the company. Before Toby is diluted more than 51%, a final sale of Toby’s personally owned shares of the company are sold to the ESOP. At that point, a 1042 exchange allows Toby access up to 90% of the sale price and defers the capital gains tax for 30 years. Through proper estate planning, the tax due in 30 years is either paid by using investment returns or is eliminated through a step-up in basis at death should that occur before 30 years.

Because the strategy does not require actual money to be paid to the ESOP at the time of transfer, the deduction frees up previously allocated tax dollars that are then used to fund Toby’s buy-out. In Toby’s case, a whole life insurance policy was used as a holding vehicle for those dollars. An analysis done by ATI Capital Group of Colorado, LLC compares the different options for funding an ESOP repurchase obligation. Of all the options, life insurance was the only option to receive an “A” grade by meeting all 11 attributes of a repurchase obligation. The reasons are obvious. If Toby should suffer an untimely death, the death benefit immediately funds any repurchase obligation to the ESOP and allows Toby’s family to not have to worry about the value of the business plummeting with Toby gone. The cash in a dividend paying whole life policy grows tax deferred and distributions done properly are income tax free. Because of the contractual guarantees of the policy, growth is protected, conservative and predictable even during times of market downturns, falling interest rates or geo political unrest. This funding method does not diminish the value of the company. Using the life insurance for the repurchase obligation creates what Kelly has coined as a “Fully Insured Financial Infrastructure™.”

With the unique planning by Kelly and his team, along with the help and collaboration of Toby’s financial advisor, Toby retired seven years later having received full fair market value of his company without the tax burden of an ordinary sale. In this case, implementing the Pre-Leveraged ESOP™ allowed Toby to create enough capital to purchase additional machinery using loans from his whole life insurance policy to the company. This decision, along with the increased productivity from employees with an ownership mentality, created a much more efficient and profitable company. The loans to the life insurance policy were paid back on schedule. Eventually, a third party took notice and made a lucrative offer to the ESOP board of directors to buy the company. The third party bought the shares from the ESOP, providing the employees with a fully vested and very profitable retirement account. Had a third party never come along or the board determined it was not in the best interest of the employees to sell, the plan would still have succeeded. In the end, Toby’s E-Ticket ride into retirement was done using his board (of directors) to surf the silver tsunami and avoid being crushed by it like so many others have.


Rich Coffin is a financial advisor with CapitalSmith Financial & Insurance Services.