S-Corporation ESOPs

Even though sellers of stock in S-corporation ESOP transactions are required to pay the capital gains taxes on the sale of their stock to an ESOP (on the price less accumulated basis, of course), the S-corporation ESOP has a significant advantage the C-corporation ESOP does not. Only S-corporations can take advantage of a tax reality that results in the company paying zero federal corporate taxes. How? Because the company is owned by a non-taxpaying shareholder-the ESOP. 

Recall that S-corporations, as business entities, do not pay federal taxes. Rather, any corporate earnings are "passed through" to the company's shareholders in accordance with their ownership, and the shareholders individually pay any taxes due. Remember that the ESOP itself is a tax-exempt trust for the benefit of employees. Any S-corporation shares owned by the ESOP are not subject to taxation (either at the federal or state level). The more S-corporation stock that is owned by the ESOP, the less tax is due and the more cash is available for repayment of the buyout or for corporate growth.  

Many companies have responded to these incentives. The ESOP Association, a Washington, DC-based non-profit organization, estimates that 35 percent of all ESOPs are now S-corporations and 2,000 are 100 percent ESOP-owned. This is a stark comparison to 1998, the first year ESOPs could be shareholders of an S-corporation, when there were no S-corporation ESOPs and only 15 percent of ESOPs in the United States were majority owned by the plan. Clearly, the advantage created by this legislation has had its intended effect of increasing the number of ESOPs.

In a properly structured transaction, an owner could sell stock to an ESOP in a C-corporation and take advantage of the indefinite capital gains tax deferral. Following the sale, the company could then make an S-corporation election and take advantage of the S-corporation ESOP tax reduction.

The tax benefits of an S-corporation ESOP transaction go beyond the benefits to the company and the seller and also help the employees. As a result of the transaction, the company's tax burdens are reduced, enabling the company to pay for stock purchases faster and offer the ability to reinvest in the company at a more rapid rate. This ultimately leads to a company and ESOP that are better positioned to buy another block of stock from or a company that has extra cash to reinvest in the business.

ESOPs and Construction Companies

If ESOPs are so great, why are there not more of them? That's a great question. One important reality facing contractors with an interest in using an ESOP is the effect of leverage and bonding capacity.

Sureties may reduce the bonding capacity for contractors with debt because of the fixed costs associated with debt repayment, the balance sheet accounting for leveraged ESOPs and their seniority of claims. To the extent a contractor commits cash flow for a fixed period of time, the volatility of a given cash flow increases. If a project goes bad, there is less cash flow available to correct the problem in the sureties' eyes. When ESOPs are proposed to sureties, the best results come when only a small portion of free cash flow is being used to finance the ESOP. This means that it will take somewhat longer for a contractor to sell shares to an ESOP than to a third party. If the owner has already decided they want "out," a longer payout ESOP may not be of interest.

Another factor relates to the sureties' focus on net worth ratios. The accounting for leveraged ESOPs hits the right side of a company's balance sheet only by increasing the liabilities and reducing equity. The magnitude of these charges is directly related to the transaction size. Thus, if the ESOP sale is a smaller amount, it is easier for the balance sheet to absorb these changes.

Finally, because banks are "senior" lenders, they typically get a "first priority" on all assets in the event of liquidation. This makes sureties uneasy since they are left only with certain assets once the bank is done securing its repayment.

For those with bonding requirements, there are a couple of considerations for using leveraged ESOPs:

• 1. Use leverage in small amounts, or simply sell stock to the ESOP on a year-to-year basis without any debt.
• 2. If the owner personally guaranties the bonds, the net worth accounting issue can be managed because the reduction in company net worth will be offset by an increase in the owner's personal net worth.

Other attributes that make companies good ESOP candidates-from the perspective of the appraiser, the banker and the surety-are management depth, customer and project concentrations and growth rate.