How an ESOP can preserve a business and a legacy

After more than a year of whipsaw change brought on by the pandemic, many business owners have decided to retire, according to a recent survey of business owners conducted by Wilmington Trust--adding another unexpected wrinkle to a devastating year.

But what’s the right succession plan? It’s no small consideration for an owner who has spent a career building a business and wants to see that legacy continue.

For many in the construction industry, that answer is increasingly found in the employee stock ownership plan, or ESOP, which allows for continuity in the business post-sale, and can provide tax savings as well.

An aging industry

Indeed, the construction industry is ripe for a transition to the next generation. The median age of construction workers increased 1.3 years to 42.9 from 2010 to 2020. For the economy as a whole, this increase was 0.5 years over the same time frame.

And many owners of construction businesses are at an age where they need to consider succession planning. According to the latest survey by Future Market Insights, a research firm on ownership transfer and management succession, a majority of those surveyed plan to exit their business in the next five years or so. But at the same time, more than 50% reported that they do not have an ownership transfer plan, the survey found.

The exit strategies usually fall into five categories:

• Liquidate the business
• Sell to an external third party (competitor, private equity, etc.)
• Sell or gift to a family member
• Sell to employees
• Sell or gift to both family and employees

Amid this range of choices, the ESOP has increasingly stood out in recent years.

Employees as owners

An ESOP is a qualified employee retirement plan governed by the Employee Retirement Income Security Act of 1974 (ERISA). ESOPs function to reward employees with an ownership stake in the business that they work for, allowing them to share in the successes of the company while also providing a tax-advantaged transition plan for owners and the sponsoring ESOP companies.

Once the company adopts the ESOP trust, that trust can purchase shares of stock from the owner using borrowed funds from the company, a bank or the selling shareholder.

Advantages

An ESOP can provide certain advantages to a selling shareholder, including the continuity of the existing company and tax savings.

Using an ESOP can provide an owner with a structured exit over a longer time frame, should the owner want to stay involved. This is typically achieved because the owner is not required to sell 100% of the business in the transaction, although an owner can defer tax on the gains made from the sale of an ESOP if the ESOP holds 30% or more of the stock, along with meeting other requirements. By not having to divest fully, an owner can continue to be involved with the business while determining the proper succession plan.

The second advantage is taxes, and not just for the owner.

If the sale of the company involves at least 30% of the company stock—and the company is a C corporation at the time the ESOP acquires the stock—the seller may defer paying capital gains taxes under section 1042 of the Internal Revenue Code, which can lead to tax savings.

The company itself can also enjoy a major tax advantage. A business can borrow money to fund an ESOP, and the value of the interest and principal leads to tax deductions over time as shares are contributed to the ESOP. This tax savings in turn can lead to improved cash flow.

Disadvantages

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, the company’s liabilities will increase and its equity will decrease. This shift could have an impact on the company’s financial leverage and add complexity to both bonding capacity and potential financing with third-party lenders.

Another disadvantage is that the company needs to monitor the repurchase obligations of an ESOP. The timing of redemptions will need to be monitored to ensure availability of significant cash or liquid assets to meet the repurchase requirements, which will be determined annually through a formal valuation process. Moreover, if the value of the company does not regularly increase, employees may feel that the ESOP is less attractive than other profit sharing plans.

The last disadvantage is that ESOPs require significant management time and resources to comply with rules and regulations for financial statements, tax reporting and the Department of Labor. Compliance can be burdensome and will require annual fees to pay for services such as formal valuation and auditing.

The takeaway

Any business owner interested in pursuing an ESOP should meet with advisors to discuss implementation and perform a feasibility analysis. This analysis should test the assumptions that go into an ESOP, calculate the expected benefits for employees and determine whether an ESOP is a viable exit strategy for the owner.

While ESOPs are not ideal for all owners, for some they can be a great strategy to help transition the business to the next set of leaders. Retirement can be a challenge, but leaving a strong company as a legacy can make it a lot easier.”