Increasingly, closely held business owners are turning to employee stock ownership plans to create liquidity from their businesses. This is due partly to the changing M&A landscape after the recession, partly to the aging of baby boomer business owners and partly to recently improved designs for transactions involving employee stock ownership plans.

An ESOP is a qualified retirement trust used as a tool of corporate finance that generates tax deductions and exclusions for corporations, and enables a shareholder to sell all or a portion of his closely held stock in a tax-­advantaged manner.

Employee stock ownership plans offer owners of closely held businesses a more flexible business succession tool than a third-party sale and often create a market for the owner's stock that might not otherwise be available. As a type of qualified retirement plan, ESOPs also create equity incentives for management and employees.

In a typical ESOP transaction, the corporation borrows money with a combination of senior debt and seller financing, known as the "outside loan." The corporation relends the borrowed money to an ESOP trust, known as the "inside loan," and the trust then purchases stock from the selling shareholder. Where sellers hold subordinated debt in their own company, they often elect to receive warrants. Thus the seller receives up-front cash, a stream of income and upside growth potential on the stock in the company.

From a tax perspective, selling shareholders like a sale to an ESOP, since they can structure the transaction to permanently avoid paying capital gains taxes (if they are a C corporation at the time of the sale), and the company also gets large income tax deductions for the repayment of both principal and interest on the acquisition costs.

If the post-transaction company is an S corporation in a 100% ESOP buyout, the company is permanently exempt from income taxes, freeing up significant extra cash flow, since the shareholder is a qualified retirement plan.

The sellers can now diversify their investments from the cash received, yet they continue to have operational control of the company.

Employees like ESOPs because they receive equity without paying current income taxes or investing any capital. Since an ESOP is a qualified retirement plan, the accounts in the ESOP grow tax deferred and when eventually cashed out can be rolled over tax-free to an IRA. It is also common to couple an ESOP with a management incentive plan (using stock appreciation rights) to reward and retain key management.

An ESOP is a friendly financial buyer created for the sole purpose of buying a shareholder's stock. The seller will dictate the amount of stock he or she wants to sell and the cash he or she wants to receive at closing. If senior debt does not provide enough up-front liquidity, investment and mezzanine debt can be brought in.

The most typical ESOP candidates are long-term businesses with consistent earnings. Often, when there are limited cash options from strategic or financial buyers, the ESOP creates the only available market. An ESOP can also be used as a tax-­efficient way for one shareholder to buy out another.

Since an ESOP allows for a gradual transition, it gives the seller time to develop a capable successful management team while he or she receives up-front liquidity.

The ESOP transaction has many similarities to a typical M&A transaction. The corporation has legal, accounting, valuation and investment bankers on its side. An independent buy side is created with a trustee representing the employees, with its own legal counsel and independent financial adviser who will need to issue a fairness opinion.

ESOPs have significant tax and nontax benefits.

Clients must do a careful review of their alternatives before they decide to sell to an ESOP. The ESOP study process involves corporate and tax-planning work often utilizing a qualified ESOP adviser who identifies the value of the company and presents the client with alternative structures to sell to the ESOP.

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Jeffrey S. Kahn and Marc R. Baluda are shareholders of Greenberg Traurig LLP. Kahn focuses on employee benefits and the design, implementation and operation of ESOPs. Baluda focuses on transactions and financings involving midmarket and emerging-growth companies seeking liquidity, including ESOP transactions.