How ESOPs, 1042 rollovers are shaping RIA succession plans

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.

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The problem is compounded by financing concerns. Nearly two-thirds of advisors say they do not have a plan for how a succession would be funded, leaving many RIA owners feeling boxed in between selling to a large private equity-backed aggregator or hoping a junior partner can eventually afford a buyout.

An often overlooked alternative is gaining traction: pairing an Employee Stock Ownership Plan with a Section 1042 rollover. Advocates say the approach can give owners more control over their exits, help preserve firm culture and, in some cases, result in higher net proceeds than a third-party sale. Still, experts caution that the strategy is not a fit for every owner or firm.

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What is an ESOP for an RIA?

An Employee Stock Ownership Plan (ESOP) is a flexible, tax-efficient exit strategy that lets owners of privately held businesses sell some or all of their shares, defer — or even 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, said that ESOPs offer greater flexibility than many other options because the owner is effectively “creating a buyer” in the form of a trust.

“Theoretically, I can sell anywhere from 1% to 100% of the equity in the company,” Francia said. “If it makes sense for me to do a minority transaction to allow me to take some chips off the table … but I’m not prepared mentally to sell 100% of my company, I could do a 30%, a 40%, a 49% transaction. That’s a minority transaction. 

“If I’m ready to sell 100% of my company, and I want to start that transition, then I could sell 100% of the company, right? So I have the flexibility. Unlike private equity, where it’s uncommon that private equity wants to take a minority interest in a business, with an ESOP I can do that very easily.”

In a typical ESOP transaction, employees don’t put up their own money. Instead, the company borrows funds and uses future earnings to buy shares of the company from the owner. The company usually takes out a bank loan and passes the money to an ESOP trust to pay the seller/owner at closing. Because the bank loan often covers only part of the price, the seller typically finances the rest through a note that the company repays over time. As the company makes tax-deductible payments to the ESOP, shares are gradually released and allocated to employees’ retirement accounts.

The 1042 rollover: A strategic tax shield

ESOPs offer many benefits, but one of the biggest draws is the ability to combine them with a Section 1042 rollover. Under this provision of the Internal Revenue Code, a seller can defer, or, with proper planning, permanently avoid paying capital gains taxes on the sale of their business.

To qualify, the transaction must meet several strict requirements. The company must be a privately held C-corporation, the seller must have owned the stock for at least three years and the ESOP trust must own at least 30% of the firm’s equity after the sale.

The seller must also reinvest the full value of the sale into Qualified Replacement Property, which includes the debt or equity of U.S. operating companies, within a 12-month window. That requirement can create a practical challenge: reinvesting enough to qualify for the tax break without locking up all of the seller’s money.

Consider an RIA owner who sells their firm to an ESOP for $100 million. At closing, the owner receives $40 million in cash, with the remaining $60 million structured as a seller note to be paid over time. Even though the owner is only receiving $40 million initially, they must still reinvest the full amount of the sale to qualify for the 1042 deferral.

“If you have $40 million and you have to buy $100 million within 12 months, how do you do it?” Francia said. “You have to do it in a manner that’s going to allow you to have liquidity, because the tax incentive is wonderful. You’re saving almost $37 million in taxes. But even if you’re saving $37 million in taxes, you’re not going to do it at the expense of losing access to all of your capital.”

That forces sellers to think carefully about the mix of qualified replacement property they buy. Because sellers typically do not have enough cash on hand to reinvest the full amount, leverage is almost always part of the equation. “You have $40 million, you need to get to $100 million,” he said. “The only way to do that is to borrow.”

One common approach, he said, involves using a security known as an ESOP bond, also called a floating-rate note. The instrument was created in the early 1990s specifically for sellers to ESOPs who wanted to defer capital gains taxes while maintaining access to their capital. These bonds are designed to be conservative investments that banks are comfortable lending against, often up to 90% of their value.

In a simplified example, a seller might invest $10 million into a Section 1042 account and use that investment as collateral for a $90 million loan from a lender such as UBS. Together, the $10 million investment and the loan allow the seller to purchase $100 million of qualified replacement property in the form of ESOP bonds.

That structure leaves the seller with $30 million of unencumbered cash, which can be used freely. As the company repays the seller note over time, those proceeds restore additional liquidity. In the end, the seller has deferred or potentially avoided capital gains taxes while retaining access to roughly 90% of their capital.

“The trade-off,” he said, “is either structuring it this way or taking the $100 million, paying the IRS $37 million, and having access to $63 million.”

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The benefits: Legacy, liquidity and net proceeds

Taxes aren’t the only considerations for RIA owners using ESOP and 1042. Corey Rosen, founder of the National Center for Employee Ownership (NCEO), said that “legacy matters” to owners and that selling to an outside buyer “may not preserve that.” By selling to the employees, the founder ensures the firm’s “unique culture” and “independence” remain intact.

Rosen, who as a senate staffer in the late 1970s drafted the legislative language for tax incentives that eventually became Section 1042, said that across the thousands of business owners he has talked to over his career, “almost everyone” says that legacy is the “prime driver” behind their decision to sell to an ESOP.

Financially, while ESOPs present unique costs, experts say they are often lower than the “invisible” costs of a third-party sale.

“Every form of selling a business has costs, so the question is about whether an ESOP is more expensive,” said Loren Rodgers, executive director of the NCEO. “The blessing and curse of ESOPs is that the costs are transparent in advance, while many of the costs of a third-party sale — business brokers, investment banking dues, legal due diligence, audits, etc. — are invisible, buried in transaction terms, or simply arise well after the sale process has started.”

According to Rosen, only about 15% of sellers would actually net more money by selling to an outside buyer once all taxes and fees are accounted for.

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Limitations and suitability

Despite the high tax efficiency and legacy benefits, an ESOP is not a universal fit. Francia said that an ideal RIA candidate typically needs “at least $3 million of EBITDA, 30 or more employees, a strong management team and not a lot of existing debt on the balance sheet.”

And if the founder is the sole driver of the business and the firm would “collapse” without them, Francia warned that an “ESOP is 100% off the table.”

For the right firm, however, the strategy offers a way to monetize at a fair price while rewarding the staff.

“An ESOP is not the right choice for a lot of businesses, but it is the right choice for many who don’t do it because they don’t understand how it works,” Rosen said.