An employee stock ownership plan (ESOP) can be an effective tool for transitioning ownership. Unfortunately, many business owners are unaware of the benefits ESOPs provide. As a result, many owners select alternative methods for transitioning ownership that fail to meet their personal objectives as well as the objectives of the company and its employees. These alternative strategies often result in the company being sold to a third party. In some cases, employees are terminated without cause, and offices and plant operations are consolidated to eliminate redundancies.
Understand Tax Advantages
At a basic level, 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 vehicle for both business owners and sponsoring ESOP companies.
Once the sponsoring company adopts the ESOP trust, the trust can then purchase shares of stock from the business owner using borrowed funds from the company, a bank or the selling shareholder(s).
ESOPs provide two primary tax advantages:
- The first major tax advantage benefits business owners who choose to transition ownership through an ESOP. If an ESOP acquires at least a 30 percent block of stock from the seller(s) and the company is a tax-paying C corporation at the time that the ESOP acquires the stock, the seller(s) may choose to defer paying capital gains taxes on their sale proceeds by electing section 1042 of the Internal Revenue Code.
- The second major tax advantage of an ESOP benefits the sponsoring company. Companies 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 ESOP loan principal and interest, ESOP trusts themselves are tax-exempt entities.
Therefore, if the sponsoring company elects to be taxed as a subchapter S corporation, the ESOP is exempt from paying federal income taxes on whatever percentage of the company it owns. In cases in which the ESOP owns 100 percent of the stock, the company pays no federal income taxes and, in most cases, no state income taxes.
In a nutshell, ESOPs are the most tax-advantaged ownership transition vehicle available to business owners today.
Select a Strong Advisory Team
Selecting a competent and experienced team of advisers that includes fiduciary, financial, legal and administrative professionals is key to maximizing the long-term benefits of an ESOP.
During the ESOP exploration process, a business should perform a feasibility analysis to test various assumptions regarding the value of the company, the size of the transaction, financing options and the expected ESOP benefits delivered to employees over time.
Structure the Transaction
Construction companies must take a number of factors into consideration before implementing an ESOP. Most construction companies have bonding requirements in order to bid certain projects, and in many cases, leveraged ESOP transactions negatively impact the shareholders’ equity. For this reason, a contractor should discuss the transaction with the company’s bonding agent before the transaction to ensure that the appropriate bonding levels are maintained post-transaction.
Other critical factors contractors must consider when exploring an ESOP transaction relate to project and customer mix as well as economic cycles. Most ESOP transactions result in the sponsoring company taking on debt to finance the transaction. As such, customer concentration and economic conditions are important to assess prior to the transaction.
ESOP transaction financing is nonproductive in that it does not enhance the value of the business or provide growth opportunities. A firm’s management team must understand the capital requirements necessary to operate and grow the business going forward.
Create an Ownership Culture
Creating a strong employee ownership culture is critical to ensuring the long-term success of the ESOP. ESOP committees function as internal advocacy groups that help build employee morale and the ownership culture.
Though the only requirement to share financial information is in an annual employee participation statement, ESOP committees often are responsible for sharing important company information, spreading the employee ownership message and functioning as a resource for employees across the company. ESOP committee members are typically nonexecutive employees.
In order for employees to think and act like owners, they must understand what drives the business. In most instances, this boils down to understanding financial metrics and performance.
It is an excellent practice for ESOP companies to share certain financial information with all employees. According to John Case of Inc. magazine, who coined the term “open-book management,” “a company performs best when its people see themselves as partners in the business rather than as hired hands.” The idea is to provide all employees with relevant financial information so that they can make better decisions about their own job functions.
Research by the National Center for Employee Ownership (NCEO) shows that companies that set up an ESOP, on average, increase annual sales, employment and productivity 2.5 percent faster than if they did not have an ESOP.
Plan for the Future
Developing the next generation of management is important to maximize value and preserve any business. Identifying, grooming and transitioning senior management professionals takes many years, so contractors should continually search for and identify future company leaders. The best ESOP companies have competent managers who execute based on a good operating model.
ESOP participants have a mandatory “put” provision that requires the sponsoring company to purchase ESOP shares based on termination, retirement, disability or death. The company’s requirement to meet this obligation is commonly referred to as ESOP repurchase liability.
ESOP repurchase liability is a future claim on cash flow and must be managed alongside other ongoing capital requirements and retirement plan benefit expenses.
The timing for which companies make ESOP account distributions is defined in the ESOP Plan and Trust agreement. Business owners should revisit and reevaluate these distribution policies periodically to ensure that existing policies are appropriate for the ever-changing dynamics of the business in the future.
Take the First Step
One of the great features of an ESOP is the ability to provide business owners with an opportunity to transition ownership over time rather than all at once. Many ESOP transactions are structured as minority interest transactions, whereby 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.
Many privately owned construction companies are exceptional ESOP candidates due to a business owner’s desire to reward long-time, dedicated employees as well as maintain independent operations and perpetuate the legacy of the business.
According to NCEO, approximately 650 construction companies currently have ESOPs. Before business owners select an ESOP as a method for transitioning ownership, they must understand ways to maximize the benefits of an ESOP to ensure the long-term success of the company and its employees.