Construction Business Owner, April 2007 

Successful entrepreneurs know that it takes time and planning to maximize the value of their companies' stock when they are ready to move on. Developing an exit strategy is not an easy process, but it is a process that can unfold gradually. It takes time to position a company's financial health, identify successor management and decide how and to whom you will sell your business when you are ready to leave.

Part of the transition planning process is deciding on which transition method makes sense for you, from a financial, corporate and employee perspective. There are many options, each with its own benefits and limitations. Some of you may choose to sell the company to an outside buyer, cashing out completely and walking away from the business in one clean transaction. For family-owned businesses, you may opt to "gift" your ownership interests to a relative. Some owners simply wind down the business and turn out the lights.

But, there is another alternative that you might not have considered-an "internal" sale that can be structured using an employee stock ownership plan or ESOP. In the right circumstances, the ESOP is the most controlled and tax-efficient buyout technique available.

How can a business like yours harness the power of ESOPs to accomplish liquidity and business succession goals? Much of the information that follows applies to privately-held companies across industries. But there are several issues unique to construction companies to consider before implementing an ESOP. 

ESOPs Defined

ESOPs are widely misunderstood by business owners and financial professionals alike. By definition, ESOP is simply an acronym for an "employee stock ownership plan" (not stock option plan). ESOPs are company-sponsored, tax-qualified, retirement benefit plans. They are a type of defined contribution plan, much like profit sharing and 401(k) plans, so many of the rules that govern those plans also govern ESOPs. There is, however, an important difference. While other defined contribution plans are required to own stock in many (mostly publicly-owned) companies, an ESOP is required to own one stock in its portfolio, the stock of the company. In addition to being required to own only company stock, the ESOP is also allowed to borrow money to purchase shares of that stock. These defining characteristics (ownership of company stock and the ability to borrow) are the cornerstones of the ESOP's ability to provide a mechanism for a sale of the company that does not require an outside buyer.

Ownership and Control in an ESOP Company

ESOPs afford business owners the ability to sell part or all of their stock at a fair price. They offer liquidity that business owners desire, but in essence, they keep the companies owned by the people that helped create them. In addition, because of the way stock is held in an ESOP, a certain degree of control can also be maintained.

The name "ESOP" suggests that employees own the stock directly, yet this is not true.  The assumption that employees own the stock in these plans is perhaps the biggest misperception of ESOPs. Whether a company has 50 or 5,000 employees, stock purchased by an ESOP is held by a single shareholder-the Employee Stock Ownership Trust. Employees earn a beneficial right to receive stock over time, but never own the shares directly. This is true for the Home Depot ESOP as it is for a small, private contractor. As part of the transaction process, an ESOP trust is created (to purchase and hold the stock), and trustees are named by the board of directors of the company. It is very common for companies to hire an independent trustee to approve the purchase of stock from a seller and then to appoint an inside trustee for ongoing administration of the plan.

This strategy effectively allows owners to begin a financial transition in their business by selling stock on a gradual basis, while remaining involved in their companies for a period.

This is why we say that the ESOP is a "controlled" buyer of stock. First, by establishing an ESOP, the company creates an internal buyer for company stock without having to search for a third party buyer. Second, the exact percentage of stock being sold is determined by the seller and will be a function of the company's ability to pay for the stock while the business continues to operate. And finally, maintaining control of the ESOP shares can be accomplished by selecting a prudent, independent trustee, who provides an impartial perspective on the transaction. 

The Tax Efficiency of ESOPs

The ESOP is an economical buyer of company stock because tax deductions are available for the transaction costs related to buying the stock-even when the money is borrowed to make the purchase. This is quite different from an inside sale to management or an outside sale to a third party where the costs of the transaction are paid with after-tax cash. 

The following table illustrates this difference. The example assumes a purchase price for stock of $2.7 million. The illustration shows a typical commercial loan (where the interest expense is tax deductible but the principal repayments are not) and a loan used in an ESOP transaction (where both interest and principal are tax deductible).

You can see that if a non-ESOP buyer paid $2.7 million for your business, that buyer would be required to generate $3.0 million in profits (do we need to know over what period of time the profits should be generated?) to recover the transaction costs. The ESOP sale (sale to whom, the ESOP?  Is the ESOP business then sold-this is a little confusing to me, but perhaps the heading with help explain this), however, requires only $2.1 million of profits to pay for the same stock. This means that the ESOP can either finance a larger buyout (buyout of what, the same business?) with the same cash flow, or use less cash for the same buyout.

Assuming a loan amount of $2.7 million, the company spends $945,000 less in cash in the ESOP transaction to repay the same debt. This is $945,000 that is available for working capital and growth. This is also $945,000 the company would not have available in a sale to a non-ESOP buyer. There are limits on the available deductions in any given year for an ESOP (similar to the limits for other defined contribution benefit plans). But regardless of the repayment terms on the loan used for the ESOP transaction, the deductions are available for each payment.

To expand on the notion of the ESOP being the most "tax efficient" transaction, here are two other transaction realities. First, sellers in certain ESOP transactions are permitted to defer indefinitely the payment of capital gains taxes on the stock sale if certain conditions are met. Sell your stock and keep all the proceeds? Let's use the $2.7 million transaction illustrated above and assume a basis in the stock of $100,000. (What does basis mean?) The company borrows the funds and the loan proceeds are used to purchase the stock. As long as the ESOP owns at least 30 percent of the company stock (one of the requirements) then the seller is eligible to defer as much as $390,000 in taxes by taking the proceeds and re-investing them in the market. 

This technique is similar to a "1031 property exchange," (might need to define 1031 property exchange) but in an ESOP sale, the seller has twelve months to use the sale proceeds to purchase qualifying U.S. stocks or bonds. Section 1042 of the Internal Revenue Code defines qualified replacement property (QRP). As long as the proceeds are invested in QRP, the seller defers capital gains tax. One of the other requirements of this deferral is that the ESOP company must be a C-corporation, so S-corporation sellers will not be entitled to the same deferral. (But S-corporation owners should not feel left out, as there is a dramatic tax advantage provided for these companies as well, described below.)

In our example, the $2.7 million ESOP transaction created tax savings for both the seller and the company, as much as $1,335,000, thus supporting the claim that the ESOP is tax efficient.