Understanding the misconceptions about ESOPs
Construction is a highly cyclical industry, but that doesn’t mean employee stock ownership plans (ESOPs) aren’t a viable option for a contracting firm. According to ESOP Association statistics, of the approximately 10,000 U.S. companies that currently have ESOPs, almost a quarter of these are in the construction and engineering fields.
Even so, many contractors often hold misconceptions regarding ESOPs.
When planning for retirement, contractors often choose ESOPs to pass on their businesses and protect their hard-earned wealth. These plans can provide a helpful alternative to more common exit strategies like transfers or sales, in which owners face a difficult search for viable buyers.
What Is an ESOP?
Simply put, an ESOP provides broad stock ownership interest to employees through a defined contribution employee benefit plan. After adopting an ESOP, a company establishes a trust to hold the company’s stock. The trust acquires stock through contributions or leveraged transactions with borrowed money from the company, the selling shareholder or a financial institution. In a leveraged transaction, the company repays the loan through plan contributions. While this obligation does not appear as a liability on the company’s financial statement, a contra equity account is recorded as a reduction to the company’s equity.
Allowable contributions to the plan are tax deductible, and employees pay no tax on the contributions or shares allocated to their accounts until they sell their stock.
If a private company is a C corporation with 30 percent or more of its stock owned by an ESOP, owners selling their businesses to the plan can defer taxation on their gains by reinvesting the proceeds in securities of other qualifying companies. With S corporations, earnings attributable to an ESOP aren’t taxable—meaning an S corporation fully owned by an ESOP pays no federal income tax.
What Are the Advantages?
An ESOP is a flexible succession tool that owners control. It’s valuable for both the positive impact it has on employees and the tax benefits it provides to both the seller and the company.
Employees can participate at virtually no personal cost—all contributions come from the company. These contributions typically exceed those of a traditional retirement plan and can be based on additional qualifications, such as years of service. An ESOP can create a greater sense of loyalty to the company, leading to more dedicated, hard-working employees who stay with the company longer.
Despite what contractors may think, owners can still retain a leading role in their companies under ESOPs. Acting as ongoing trustees, they can vote all the shares on most issues, and they don’t have to disclose to employees more than they would with standard retirement statements. They can also determine how much of their companies they want to sell to the ESOP.
The sale of company stock to an ESOP funds the owner’s exit, but it also provides a number of tax benefits. Their size and scope depend on the company’s structure, but they can range from deferred taxes on capital gains for the selling shareholder to exempt federal income tax for an S corporation’s company earnings.
An ESOP transition can leave a company’s existing employees and management in place, ensuring a more seamless continuation of the business. A company’s performance may rank higher when compared to its competitors due to the business’s uninterrupted activity, as well as the aforementioned company tax benefits and increased sense of ownership at the employee level.
What Are the Challenges?
An ESOP’s unique nature poses several challenges to you, the business owner. Embracing an ownership culture with your employees can be the first major difficulty. When deciding how much financial information to share, remember that more transparency usually reinforces the type of dedicated culture you’re trying to achieve.
An ESOP is a serious, long-term commitment. It takes several years for most ESOPs to become financially meaningful to employees, and if another entity makes a serious acquisition proposal for your company, you’re legally obligated to consider it and act in the best interest of ESOP participants. You can’t dismiss the bid out of hand like in a closely-held company.
The most significant challenge to an ESOP is deciding how to manage the substantial debt from a leveraged transaction—especially in a volatile industry like construction. The cost of establishing and administering the plan could be overwhelming for smaller companies. Since seller financing is usually a considerable component of funding a leveraged ESOP transaction, you won’t receive all the cash up front. If there is a bank involved for either operating debt or part of the transaction debt, the seller note will almost always be subordinate to the bank. Furthermore, many sureties may be unfamiliar with ESOPs, impacting your relationship with them.
Working with ESOP specialists and ensuring proper communication with bonding companies, banks and other professional advisors are essential to a successful transaction.
Is an ESOP Right for Your Company?
Your personal goals and your company’s financial health determine whether or not an ESOP is right for you. While some contractors see passing on the company as their only option, others face a more complex choice. Selling for financial reasons is not the sole motivation of many business owners who go down the ESOP path. Owners want to receive a fair selling price, but leaving a legacy and sharing ownership with employees are primary factors that go into the decision-making process.
Because of the costs associated with starting and administering an ESOP, the best candidates are often companies with at least 20 employees and $5 million of revenue.
