With a growing share of financial advisors nearing retirement, succession planning has become a major challenge for the industry
More than a third of advisors plan to retire within the next decade, yet most lack a defined timeline for transitioning ownership, according to Financial Planning survey data. The problem is compounded by financing concerns, with nearly two-thirds of advisors admitting they do not have a plan for how a succession would be funded.
ESOPs: A Flexible Exit Strategy for RIAs
Employee Stock Ownership Plans (ESOPs) offer RIA owners a flexible, tax-efficient exit strategy that allows them to sell some or all of their shares, defer or eliminate capital gains taxes, and reward employees in the process.
Nick Francia, a private wealth advisor and a partner of the Capital ESOP Group at UBS, highlighted the flexibility of ESOPs, stating that owners can sell anywhere from 1% to 100% of the equity in the company. This flexibility allows owners to tailor their exit strategy to their specific needs and preferences.
In a typical ESOP transaction, employees do not put up their own money. Instead, the company borrows funds to buy shares from the owner, with future earnings used to repay the loan. This process allows shares to be gradually allocated to employees’ retirement accounts.
The 1042 Rollover: A Strategic Tax Shield
One of the biggest draws of ESOPs is the ability to combine them with a Section 1042 rollover, which allows sellers to defer or avoid paying capital gains taxes on the sale of their business. To qualify for this provision, several strict requirements must be met, including the company being a privately held C-corporation and the seller owning the stock for at least three years.
Francia emphasized the importance of reinvesting the full value of the sale into Qualified Replacement Property within a 12-month window to qualify for the 1042 deferral. This requirement presents a practical challenge for sellers, as they must carefully consider the mix of qualified replacement property they purchase to meet the reinvestment criteria.
The Benefits of ESOPs and 1042 Rollovers
Aside from the tax benefits, ESOPs offer RIA owners the opportunity to preserve their firm’s legacy and independence by selling to employees rather than an outside buyer. Additionally, the costs associated with ESOPs are often lower than those of a third-party sale, with transparent costs that are known in advance.
While ESOPs may not be suitable for every RIA, they provide a way to monetize at a fair price while rewarding staff. Rosen emphasized that legacy is often the prime driver behind owners’ decisions to sell to an ESOP, highlighting the importance of preserving the unique culture and independence of the firm.
Limitations and Suitability
Francia noted that an ideal RIA candidate for an ESOP typically needs at least $3 million of EBITDA, 30 or more employees, a strong management team, and minimal existing debt. For firms heavily reliant on the founder and lacking a solid management team, an ESOP may not be a viable option.
Ultimately, while ESOPs are not the right choice for every business, they offer a tax-efficient and legacy-preserving exit strategy for many RIAs. Understanding how ESOPs and 1042 rollovers work is crucial in determining if this approach is suitable for a firm’s succession plan.
