For retirement-minded contractors, ESOPs are worth considering
For some construction company owners ready to retire, selling their business to outsiders or passing it down to relatives seems the easiest and fastest way out the door. There is another option, however, that is growing in popularity: selling the business to employees by means of an employee stock option plan (ESOP). Although not appropriate for every construction company, an ESOP carries several inherent advantages, including the ability to change ownership gradually or all at once. It also allows owners to retain a share of the company—even a majority share—if they wish.
While they function to reward long-time employees with an ownership stake in the business they helped build, ESOPs also offer the most tax advantages in an ownership-transition vehicle available to business owners. Yet only about 11 percent of construction companies had ESOPs in 2016, according to research by the National Center for Employee Ownership (NCEO). Further research by NCEO shows that companies that set up an ESOP tend to increase annual sales, employment and productivity an average of 2.5 percent.
An ESOP is a qualified employee retirement plan governed by the Employee Retirement Income Security Act (ERISA). ESOPs function as a tax-advantaged ownership transition plan for owners and sponsoring ESOP companies. Once the sponsoring company adopts the ESOP trust, the trust can then purchase shares of stock from the owner using borrowed funds from the company, a bank or the selling shareholders.
ESOPs provide two primary tax advantages
The first major advantage benefits business owners: If an ESOP acquires at least a 30 percent block of stock from the seller—and the company is a tax-paying C corporation at the time the ESOP acquires the stock—the seller may choose to defer paying capital gains taxes on sale proceeds by electing section 1042 of the Internal Revenue Code.
The second major tax advantage of an ESOP benefits the sponsoring company. Businesses can borrow money to fund ESOPs and repay these loans with pretax dollars, effectively making the cost of the entire transaction tax deductible.
In addition to the deductibility of the ESOP loan principal and interest, ESOP trusts themselves are tax-exempt entities.
Among other advantages, an ESOP can be an effective tool for increasing cash flow and net worth. A contractor can reduce corporate income taxes as well as increase cash flow and net worth by electing to be taxed as an S corporation. Using this approach, a company may drastically reduce or even eliminate its federal tax liability. The cash flow impact can be dramatic. If the contribution to the ESOP is made in lieu of cash contributions to a profit sharing plan, the cash flow savings are even more significant. This has obvious advantages to contractors, as the savings serves to free up additional cash and capital to finance their projects, and consequently improve their surety program.
For surety agents, ESOPs often are appealing because they provide an ownership-transfer vehicle that ensures continuity. They also provide an incentive plan to retain key employees and have the potential to enhance the financial wherewithal of the contractor.
Downside of an ESOP
However, there are some disadvantages to ESOPs as well. If a company borrows money and then lends it to the ESOP to enable the ESOP to make a leveraged purchase of company stock, accounting regulations require that the loan be recorded as a liability on the company’s balance sheet, and a like amount debited to the equity account. The net effect is a reduction of the company’s net worth by the amount of the bank debt. This reduction could affect the company’s financial leverage, which in turn affects bonding and financing.
Additionally, the trustees of the ESOP will need to monitor the repurchase obligations of the ESOP. The company will need a formal annual valuation. The timing of redemptions will need to be monitored in order to ensure that there is significant cash available. Ideally, the ESOP will maintain a portion of the fund in liquid investments in order to provide liquidity for retiring or terminating employees.
Moreover, if the value of the company does not increase, the employees may feel that the ESOP is less attractive than a profit sharing plan.
Timing and implementation
The timing for making ESOP account distributions is defined in the ESOP plan and trust agreement. Business owners should revisit and re-evaluate these distribution policies regularly to ensure existing policies are appropriate for the ever-changing dynamics of the business.
Implementation of an ESOP requires significant management time and resources and it can complicate financial accounting. The ESOP also follows complicated Department of Labor rules, making it necessary for the company and the ESOP to employ professionals with significant ESOP experience.
To help their ESOP remain successful, company leaders usually establish an ESOP committee that functions as an internal advocacy group. This can help build employee morale and promote a culture of ownership. By law, the only requirement for sharing financial information is in an annual employee participating statement. However, most ESOP committees share ownership information on a fairly regular basis, while also functioning as a resource for employees across the company. ESOP committee members can be non-executive employees.
For retirement-minded owners, ESOPs provide a way to leave the business gradually. Many ESOP transactions are structured as minority interest transactions, where the ESOP acquires less than a 50 percent block of stock of the company. Minority interest ESOP transactions provide business owners with an opportunity to create liquidity and still control the company.
Contractors interested in pursuing an ESOP should visit with their certified public accountant regarding the tax and accounting implications. Other advisers should include fiduciaries, lenders, attorneys and administrative professionals. During the ESOP exploration process, a contractor should perform a feasibility analysis to test various assumptions regarding the value of the company, size of the transaction, financing options and the expected ESOP benefits delivered to employees over time.
ESOPs aren’t for all contractors. Considerations include the company’s debt, revenues and net profits, cash reserves, company benefits, total assets, potential for future growth, and the like. But for those contracting companies that are suitable, an ESOP offers a good way for owners to transition out of the company on their own schedule, while also giving valued employees a stake in the company.
Published In: August 2017 Texas Contractor.