When planning an exit, business owners typically consider three primary paths: selling to a strategic buyer (such as a larger competitor), selling to financial buyers (like private equity firms or family offices), or pursuing a related-party transaction, such as a management buyout or gifting the business to family. One often overlooked related-party option is selling to an Employee Stock Ownership Plan (ESOP). Under the right circumstances, an ESOP can be an ideal exit strategy. For some owners, it offers a chance to unlock significant liquidity, reduce taxes on the sale, preserve the company’s legacy, and retain a stake in the business’s future success.

Before diving into the mechanics of an ESOP, it's important to first understand the benefits this structure can provide to both the business owner and the company.

Benefits of an ESOP Transaction

From a personal point of view, it's common for entrepreneurs to experience regret after exiting their business, as the company often provided them with a strong sense of purpose and, in many cases, identity. The abrupt shift to post-exit life can be jarring for some. Selling to an ESOP can be done in stages and offers a more gradual transition, allowing owners to ease into life beyond the business.

From a business perspective, an ESOP can provide attractive structural advantages and significant tax benefits for owners. Many business owners choose to sell a portion of their shares initially, remain involved in the business, and share in its future growth through warrants received at closing. In some cases, a minority stake in a larger, ESOP-owned company can ultimately be more valuable than full ownership of a smaller, non-ESOP business.

ESOP Mechanics

While ESOPs can take many forms, the most common structure involves the establishment of an ERISA-compliant retirement plan. The company then secures financing from an ESOP lender, and the plan uses those funds to purchase some or all of the owner's shares.

Over time, shares are allocated to eligible employees as employee compensation. As vested employees leave or retire, the ESOP provides liquidity by repurchasing their shares.

This structure can be mutually beneficial for both the company and its employees. Studies have shown that most ESOP-owned companies often experience faster growth than their non-ESOP counterparts, as employee ownership fosters greater alignment with the company's goals and mission. Employee Stock Ownership Plan (ESOP) transactions are also associated with higher employee retention, increased productivity, and improved morale.

ESOP vs. a Third-Party Sale

Selling to a strategic buyer or private equity firm often comes with significant challenges such as price renegotiations, earn-outs tied to tough performance targets, escrow holdbacks for reps and warranties, and restrictive post-sale non-compete agreements. For many owners, these risks and conditions can feel burdensome.

In contrast, an ESOP can help an owner maintain one of their top priorities: control. Unlike a private equity sale, it doesn’t introduce a new boss, and unlike a strategic buyer, it’s less likely to compromise the company’s legacy or long-term vision.

Another attractive aspect of an ESOP transaction is that, compared to other exit strategies, it is always structured as a stock sale of the owner's shares, which qualifies for favorable capital gains tax treatment. Because certain ESOP sales allow the seller to defer or even eliminate capital gains taxes under Section 1042, it’s important to compare the economics of an ESOP sale against more traditional exit options.

For example, if a business owner sells for $10 million in cash, a traditional sale might yield $8 million after federal and state taxes, whereas a 1042-compliant ESOP sale could preserve the full $10 million.

Given Section 1042 reinvestment restrictions, it’s reasonable to assume a lower rate of return on the sale proceeds under the ESOP with 1042 versus an ESOP with no 1042. Assuming a lower annual return of 6.2%, the 1042 ESOP seller could accumulate $33.1 million over 20 years outpacing the $30.0 million a non-1042 ESOP seller might achieve. However, after 30 years the higher return rate of the ESOP w/o 1042 catches up, resulting in breakeven.

The key takeaway here is that the benefit of a 1042 deferral can be less profound for younger entrepreneurs.

By contrast, most third-party buyers prefer asset sales - particularly in strategic or private equity deals - which can be far less tax-efficient for sellers. For C corporation owners, asset sales often trigger double taxation: once at the corporate level on the sale of assets, and again when proceeds are distributed as dividends or during liquidation. Asset sales often have significant depreciation recapture for asset and real estate heavy businesses. In the prior example, it would require an asset sale price of $11.98 million to match the after-tax proceeds of a $10 million ESOP stock sale without a Section 1042 rollover.

It is important to note that the ESOP retirement plan will ultimately not pay more than “fair market value” for the shares. While this can streamline the closing process, it may rule out the potential for a premium offer from a strategic or private equity buyer. Owners should carefully evaluate the trade-offs between an ESOP and third-party sale options.

One effective approach is to run a dual-track process - conducting an ESOP feasibility study to establish a pricing floor, while simultaneously testing the market for third-party interest. In fact, many third-party sales that fall through ultimately transition into successful ESOP transactions.

Compared to other exit strategies, the ESOP process is generally seen as less disruptive to daily operations and offers a more collaborative, less contentious experience for all parties involved.

Tax Considerations and Structural Benefits of an ESOP

When considering a transition to an ESOP-owned structure, the company’s organizational framework should be carefully assessed from a tax standpoint.

ESOP-owned companies structured as S corporations enjoy significant tax advantages, as the ESOP’s share of earnings is tax-exempt. This allows the company to retain more cash, accelerate debt repayment, and reinvest in growth without the need to make annual shareholder distributions for tax purposes, as typical S corps do.

While not tax-exempt, like S corps, C corporation ESOPs can deduct dividends paid to the ESOP and allow sellers to defer capital gains taxes through a Section 1042 rollover. This deferral strategy can be a powerful planning tool depending on the owner's circumstances.

Section 1042 Rollovers to Mitigate Capital Gains Taxes

If the requirements of Section 1042 are met, business owners may be able to avoid some or even eliminate all capital gains taxes on the sale of their business. A 1042 rollover allows the proceeds from a business sale to be reinvested into Qualified Replacement Property (QRP). The QRP assumes the cost basis of the original business shares, deferring any taxable gain until the QRP is sold. If the QRP is held for the remainder of the owner’s life, it receives a step-up in basis upon inheritance by a spouse or heirs, effectively eliminating the capital gains tax altogether.

Section 1042 rollovers come with specific requirements that must be met for the strategy to be effective. Qualified Replacement Property (QRP) is limited to stocks, preferred stocks, bonds, and convertible bonds of U.S. operating companies. Investments such as mutual funds, government bonds, tax-exempt bonds, and ETFs generally do not qualify, which can complicate efforts to maintain a diversified portfolio.

It should also be noted that because Section 1042 reinvestment choices are somewhat limited, it may be prudent to use more conservative return assumptions in personal financial planning projections.

Additionally, QRP must be purchased within a specific window - between 3 months before and 12 months after the liquidity event - and the business shares being sold must have been held for at least 3 years. Because many ESOP sale structures include a seller's note paid over time, reinvesting the full amount needed to defer capital gains can be difficult. There are also several compliance steps required to complete a 1042 rollover, including a statement of election attached to the owner’s tax return, a statement of consent from the ESOP company, and a statement of purchase for the QRP that should be notarized within 30 days of purchase.

All Equity QRP Investment Management

One strategy to manage QRP is for the owner to construct a diversified portfolio of high quality U.S. large-cap stocks designed to approximate the performance of the S&P 500 or a similar index. This approach requires confirming that each stock qualifies as a U.S. operating company at the time of purchase. Nonetheless, corporate actions such as mergers, spinoffs, or acquisitions may trigger taxable events. That said, the impact of these events can be mitigated through broad diversification across a large equity-based QRP portfolio.

Over time, income needs can be met through taxable dividends from stock holdings or by strategically reducing overweight positions. While overweighting high dividend paying stocks can provide more consistent income within an all equity portfolio, it may also lead to concentrated exposure in sectors like utilities and financials. When constructing an all equity QRP portfolio, careful attention should be paid to sector allocation. Simply mirroring the current sector weights of the S&P 500 or other indices can potentially lead to underperformance, as historically overrepresented sectors - such as tech in the late 1990s or financials in 2008 - have experienced sharp mean reversions.

Incorporating Bonds Into QRP Wealth Management

While an all equity portfolio may be suitable for investors with a long time horizon, many will prefer to include fixed income for diversification purposes and to reduce volatility. Incorporating bonds into a QRP portfolio, however, presents challenges as bonds become taxable upon maturity. Older investors might consider long-dated bonds with maturities beyond their life expectancy or use preferred securities, but this introduces additional volatility due to duration risk.

Furthermore, credit risk becomes harder to manage with longer maturities, and the limited universe of long-dated bond issuers can lead to concentrated exposure in certain industries. To mitigate these issues, investors with sizable IRAs or old 401(k) accounts may choose to allocate fixed income in those accounts instead, achieving broader diversification and reduced overall portfolio volatility without affecting the QRP strategy.

With a 1042 rollover, there may be a tendency to implement a portfolio that has the primary aim of purchasing QRP, but investors should remain focused on building a portfolio aligned with their long-term needs, goals, and overall financial plan.

Mitigating Section 1042 Installment Sale Issues

Several strategies are available to help manage the lack of upfront proceeds from a sale. One approach is to use external capital to purchase the QRP, as the IRS does not focus on the source of funds used for the QRP purchase. More commonly though, sellers will use the cash available at closing to purchase long-dated floating rate notes (FRNs) - often called “ESOP bonds” - with maturities of 30 to 40 years. Note holders then typically borrow against them to purchase an amount equal to the full business sale value to achieve maximum capital gain deferral. Given that FRNs have regular interest rate resets and a put feature, FRNs tend to have stable pricing and are typically marginable for up to 80%–90% of their value.

Because the FRN market is relatively illiquid and the number of issuers is limited, assembling a diversified portfolio can take time. For this reason, it’s advisable to begin purchasing FRNs early within the 15-month window surrounding the sale’s closing. Additionally, FRNs are typically low-yielding securities, often producing returns below the Secured Overnight Financing Rate (SOFR). As a result, there is usually a negative spread between the income generated by the FRNs and the interest cost of borrowing against them.

Incorporating Floating Rate Notes Into Wealth Management

There are several strategies an owner can use to incorporate floating rate notes as Qualified Replacement Property to optimize the wealth management of their sale proceeds. In a full cash ESOP sale, the owner could allocate the entire QRP to FRNs, then borrow against them to construct a diversified portfolio of stocks and bonds. If the ESOP sale is to be completed in stages over time, the owner could take a similar approach using FRNs for the initial QRP, borrowing against them, and using excess margin to invest in a diversified portfolio. As future sale payments are received, the owner could choose to either reduce the margin balance or further diversify the portfolio. The most effective strategy will depend on factors such as current margin interest rates, FRN yields, fees, and a thorough evaluation of the risks.

Partial 1042 Rollovers

It’s important to note that owners are not required to roll over the entire sale proceeds under Section 1042. They can choose to allocate a portion of the proceeds into QRP investments and invest the remaining amount in a diversified portfolio. While a partial 1042 rollover would incur some capital gains taxes, it offers greater flexibility in investment choices and allows for better risk mitigation on the non-1042 portion.

When a 1042 Rollover Isn’t a Good Idea

The 1042 rollover strategy isn’t suitable for every owner. Those who participate in the minimum 30% sale required to qualify for 1042 tax treatment are prohibited from receiving ESOP share distributions into their retirement accounts. If the benefits of receiving these distributions as an employee outweigh the tax savings from a 1042 rollover, it might be more advantageous to forgo the rollover. For instance, owners with a high cost basis relative to the sale price may not gain as much from deferring capital gains

Tax policy and future expectations of tax rates significantly influence the appeal of ESOPs and 1042 rollovers. If you anticipate being in a higher capital gains tax bracket or believe capital gains rates will rise, forgoing the 1042 rollover and paying taxes upfront might make sense. Prior to the implementation of the 2017 Tax Cuts and Jobs Act (TCJA), many business owners could reduce their taxes by deducting their state tax burden from a business sale on their federal tax returns. However, the TCJA capped state and local tax (SALT) deductions at $10,000, eliminating these savings. Future decisions regarding the SALT deduction cap - whether it expires or is extended after 2025 - will affect the attractiveness of using 1042 rollovers to mitigate taxes.

In addition, only C corporation owners are eligible to execute a 1042 rollover, so owners of other entity types must weigh the potential tax benefits against the implications of converting to a C corp and managing the associated tax consequences of operating under that structure. Post-closing, ESOPs are generally more advantageous under an S corp structure, as a wholly ESOP-owned S corp effectively pays no federal income tax.

One strategy is for the company to convert to a C corp before the sale to take advantage of the 1042 rollover, then later transition to an S corp. However, if the company began as an S corp and switches to a C corp, it must remain a C corp for at least five years before converting back. Despite this, the C corp structure may still offer benefits in the interim as C corp ESOP companies can deduct both debt principal payments and dividends, which can help offset corporate taxes. A company in this situation could accelerate debt repayments during its time as a C corp, reducing its tax liability, and then convert to an S corp once eligible, emerging with a stronger balance sheet.

Some C corp businesses may qualify for a $10 million capital gain exemption under Section 1202 (Qualified Small Business Stock). In such cases, selling to a strategic or financial buyer may be more attractive than pursuing an ESOP transaction.

QRP Portfolios and Financial Planning Projections

Owners should work with their financial planner to run financial projections incorporating various portfolio allocations scenarios around investing expected post-exit proceeds. This analysis should also account for other assets, liabilities, income sources, and expected expenses to determine the probability of success of their retirement projections.

For example, the probability of success for a 55-year couple that sells their business for $9 million with income needs of $300,000/year, stocks and bonds of $2,000,000, and no debt would be ~97%. This scenario assumes they invest the $9 million in a moderately aggressive portfolio of 70% stocks and 30% cash/bonds, and they would have between $16M and $79M at age 95. If the same couple were to invest $9 million of QRP proceeds and $2 million of outside funds in a moderate portfolio of 55% stocks and 45% cash/bonds, they would have fewer portfolio assets, i.e. between $10M and $39M in assets at age 95 as shown below.

Estate Planning Impact of ESOPs

From an estate planning perspective, selling to an ESOP offers several strategic advantages. ESOP transactions often have a higher likelihood of closing compared to third-party or private equity sales, helping ensure liquidity is available to cover future estate tax obligations. For families with substantial net worth and potential estate tax exposure, an ESOP can provide a way to generate liquidity without relinquishing control of the family business. For example, a partial sale to an ESOP can free up cash while allowing the family to retain majority ownership and continue running the company. In the event of an unexpected passing, the ESOP can also serve as a ready buyer for shares at fair market value - potentially protecting heirs from having to sell their interests at a discount.

ESOP and Family Business Estate Planning

ESOPs can also be an effective solution in situations where one adult child is involved in the business and expected to take over, while another is not. In these cases, the first generation may wish to equalize inheritances by creating liquidity through a partial ESOP sale. Sale proceeds could be designated in the estate plan for the second generation siblings not involved in the business, while the remaining company shares could be gifted over time to the siblings working in the business.

Equalizing an inheritance through a partial ESOP sale

Without thoughtful planning - especially if the first generation’s assets are mostly illiquid - attempting to equalize inheritances could lead to conflict, particularly between heirs involved in the business and those who are not.

When gifting non-ESOP shares to the next generation, the first generation could use estate planning tools such as Grantor Retained Annuity Trusts (GRATs), sales to Intentionally Defective Grantor Trusts (IDGTs), or other advanced trust structures. Many of these strategies focus on minimizing the taxable value of the transferred assets, which can sometimes lead to scrutiny or disputes with tax authorities. However, the annual third-party valuation required by an ESOP offers a consistent, well-documented reference point, which can help minimize the risk of valuation disputes.

For families facing potential estate tax exposure and planning to gift shares to the next generation, doing so shortly after an ESOP transaction can be particularly advantageous. Because ESOP companies are typically highly leveraged following a sale, post-transaction valuations are often temporarily depressed, enabling business owners to use less of their lifetime gift exemption when transferring shares. Moreover, with many ESOP sales structured in stages, there may be opportunities to apply minority interest discounts when gifting non-controlling shares. However, since the ESOP provides a built-in market for shares, the applicable discount may be smaller than in private company transfers.

Charitable Giving and ESOPs

Charitable giving planning can be thoughtfully integrated with an ESOP sale in several ways. For example, owners might donate specific QRP positions to charity if those holdings become too concentrated in their portfolio.

Another strategy may be to combine a 1042 rollover with a contribution to a Charitable Remainder Trust (CRT), providing a charitable deduction while also generating income through annuity payments. Alternatively, shares can be donated to a CRT before the ESOP transaction, with the ESOP later purchasing the donated shares from the trust.

When ESOPs Aren’t a Good Idea

Owners and founders should be mindful when an ESOP isn’t a viable exit planning strategy. Companies that are unprofitable, already heavily leveraged, or have volatile earnings may struggle to support the debt obligations associated with an ESOP. However, even underperforming businesses might still appeal to strategic buyers. Additionally, the upfront and ongoing costs of establishing and maintaining an ESOP can be significant. These include transaction-related fees for legal counsel (ESOP attorney, trustee attorney, lender attorney) as well as recurring expenses such as trustee oversight and annual valuations. For smaller businesses or those with limited earnings, these costs may outweigh the potential benefits.

In some cases, a company's demographics may make an ESOP less viable. For example, the typical morale and retention boost associated with an ESOP may not apply if the company has a high proportion of younger employees who are likely to leave anyway. Additionally, for certain companies, it may be challenging to reward key managers or transfer concentrated shares to family members under the structure of an ESOP.

That said, business owners have several exit options to consider - strategic sales, financial buyers, related-party transfers, and ESOPs. Under the right circumstances, an ESOP can be an ideal solution, offering liquidity, potential tax advantages, legacy preservation, and the opportunity to stay involved in the company's future.

David Flores Wilson, CFP®, CFA, CM&AA, CEPA is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.

ESOP Financial Planning Considerations for Business Owners