Contractors often struggle to find suitable buyers for their companies when they’re ready to retire or otherwise move on. That may be why many construction businesses implement employee stock ownership plans (ESOPs). These plans offer a gradual exit strategy and other benefits that can pay off for owners and employees. Of course, they’re not without potential drawbacks.
Nuts and bolts
An ESOP is a type of qualified retirement plan that allows employees to invest solely or mainly in their employer’s stock. Businesses that satisfy the IRS requirements and have stock (ownership shares) can sponsor an ESOP. In other words, the plans are available only to companies structured as C or S corporations.
Under an “unleveraged” ESOP, the business owner sells all or part of the company to a trust that holds the stock for plan participants (employee-owners). Contributions can be new shares of company stock or cash to buy existing shares. As a succession planning strategy, many owners sell their shares over long periods by making annual contributions to the trust.
Alternatively, under a “leveraged” ESOP, the plan obtains outside financing to buy shares at a sale price set by an independent appraiser. The company then contributes enough cash annually to cover the principal and interest payments.
In either case, shares are typically allocated to participants’ accounts according to a formula, often based on each employee’s compensation. Staff members usually become eligible after a year of employment; legally, they must attain eligibility after two years of service.
An ESOP needs to include a vesting schedule that establishes what percentage of an account balance each participant is entitled to receive following events such as termination, retirement, disability or death. Payouts can be installments or lump sums in stock or cash.
Positive attributes
On the positive side, a properly structured and carefully administered ESOP offers a way to preserve your legacy. When selling to a third party, you forfeit your construction company’s brand and reputation. And if you sell to a private equity firm, you might find the business doesn’t even exist a few years down the road.
Your employees, on the other hand, will more likely maintain the company name, uphold its reputation and continue to grow the business. Indeed, an ESOP gives participants “more skin in the game,” which typically boosts engagement and productivity.
The tax benefits are notable, too. For example, C corporations that sell at least 30% of their shares to an ESOP can defer capital gains taxes by reinvesting the proceeds into “qualified replacement property” — generally, securities issued by domestic operating corporations. (Additional details and requirements apply.) S corporations that are wholly owned by an ESOP aren’t subject to federal income taxes at all.
Because ESOP contributions are made pretax, participants won’t incur tax liability until they receive distributions. And they can even defer those taxes if they roll over distributions into a qualified retirement account.
Risks to consider
However, as mentioned, ESOPs do present risks. For starters, they can put a substantial strain on cash flow. The National Center for Employee Ownership has estimated the cost of setting up a plan based on periodic cash or stock contributions at “under $100,000,” but setup costs can vary. The same organization has also estimated that, for most closely held companies, ESOP transaction costs tend to run between $150,000 and $400,000. Remember, though, that selling the business to a third party likely comes with hefty legal, accounting and brokerage costs, as well as other fees — without the ESOP tax perks.
In addition, when selling shares to an ESOP, you might have to settle for a lower sales price. Under the Employee Retirement Income Security Act (ERISA), an ESOP can’t pay more than fair market value for shares. A third party might pay more — especially if your construction business specializes in a lucrative industry sector.
Finally, ESOPs bring administrative hassles. Retirement plans are subject to ERISA, so they must comply with various federal rules and regulations. There may be state-specific requirements, too.
Team effort
As you can see, any contractor pondering an ESOP has much to consider. If you decide to explore the strategy, be sure to involve your leadership team and professional advisors. Please feel free to contact our firm for help understanding the accounting, tax planning and financial management aspects of these plans.
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