ESOPs and Key Concerns for Construction Contractors
An employee stock ownership plan (ESOP) can not only offer retirement benefits and company ownership stake to employees, but it can also act as a significant estate planning tool for business owners, especially those hoping to address challenges like lack of liquidity and providing for children outside the business. Spurred in part by the “silver tsunami” of baby boomers approaching retirement, contractors have demonstrated more interest in establishing ESOPs in the last several years.
What is an ESOP?
ESOPs are tax-qualified retirement plans that invest primarily in the sponsoring company’s own stock instead of stocks, bonds and mutual funds. These plans offer a range of benefits to the owners of closely held companies and to their employees. ESOPs are subject to the same rules and restrictions as qualified plans, including contribution limits and minimum coverage requirements.
Since ESOPs invest in company stock, they create a market for the shares of departing owners. By selling to an ESOP, owners are able, under certain circumstances, to defer and even avoid capital gains taxes arising from the sale. And because ESOPs can also borrow money for investment purposes, which is unique among retirement plans, ESOPs offer financing options to facilitate purchases from departing owners.
Typically, companies make tax-deductible cash contributions to the ESOP, which uses the funds to acquire stock from the current owners. This doesn’t necessarily mean giving up control, though. The owners’ shares are held in a trust, and the trustees vote on the shares. An ESOP’s earnings are also tax-deferred: Participants don’t recognize taxable income until they receive benefits — in the form of stock or cash — when they leave the company, die or become disabled.
Key considerations for contractors
There are several indicators for whether a privately held business might be a good candidate for an ESOP. Below are just a few considerations for owners of construction companies:
Selling-owner prerogatives. It’s important for business owners to consider their objectives in establishing an ESOP. While tax incentives encourage companies to use ESOPs, owners should also consider the timeframe it may take to establish an ESOP and perform a cost-benefit analysis. Those businesses with strong successor management teams often make good candidates for ESOPs.
Corporate structure. ESOPs are available for both C corporations and S corporations. C corporations can recognize the Section 1042 rollover, which is a powerful tax incentive. Section 1042 allows certain shareholders of closely-held C corporations the ability to sell their stock to an ESOP and defer – and possibly avoid altogether – federal taxes on any capital gain arising from the sale.
Profitability. Establishing and maintaining an ESOP can be a complicated and costly process. Designing a plan, performing a feasibility study and implementing an ESOP all pose significant costs to business owners upfront. After an ESOP is established, maintaining the plan can still represent a large cost. Ongoing administration and oversight of the plan is required, which includes maintaining the details of each participant’s plan, keeping the plan current and accounting for policy changes and conducting the required annual valuation of the business. For these reasons, ESOPs are typically a better strategy for businesses that are more profitable.
Maturity and cyclicality of earnings. Highly cyclical and competitive industries are generally not good ESOP candidates. The ability to fulfill the repurchase obligation is dependent upon a business’s earnings. In leveraged ESOPs, where money is borrowed to finance the purchase of the sponsoring company’s stock, paying down debt can become difficult in periods of contraction.
Employee demographics and depth. Ideally, a good rule of thumb is for ESOP-owned companies to have at least 80-90 employees with a wide disbursement in age among employees. This helps not only even out cash flow, but also spreads out some of the repurchase obligation. It also helps ensure the company will not suffer from a loss of key employees. It’s vital that exiting owners transfer key relationships and operational knowledge on to their successors. Having a higher number of employees can also hedge against Section 409(p) testing failures.
Bonding requirements. ESOP debt is typically viewed negatively by bonding companies, because bonding lines are determined by tangible measures like working capital and net worth. To comply with the Employee Retirement Income Security Act of 1974 (ERISA), it’s important for plan sponsors to understand the bonding requirements and ensure the bond they purchase satisfies them.
Company culture and homogeneity. Construction firms are often driven by entrepreneurs that thrive in a high-risk, high-reward atmosphere. ESOPs spread ownership across the company, stripping away in some cases the entrepreneurial focus that drives most contractors. Sometimes, owners experience productivity increases driven by employees who are more highly motivated because they stand to directly gain from improved company performance. Alternatively, no one individual in the company has as much to lose or gain.
Retirement and estate planning benefits
If a large portion of your wealth is tied up in a closely held business, lack of liquidity can create challenges as you approach retirement. An ESOP may provide an alternative solution to selling the business that can help fund your retirement and provide for your family.
By selling some or all of your shares to an ESOP, you convert your shares into liquid assets. If the ESOP owns 30 percent or more of the company’s outstanding common stock immediately after the sale, and certain other requirements are met, you can defer or even eliminate capital gains taxes by reinvesting the proceeds in qualified replacement property (QRP) within one year.
QRP provides a source of retirement income and allows you to defer your gain until you sell or otherwise dispose of the QRP. From an estate planning perspective, a simple but effective strategy is to hold the QRP for life. Your heirs receive a stepped-up basis in the assets, eliminating capital gains permanently. If estate taxes are a concern, you can remove QRP from your estate, without triggering capital gains, by giving it to your children or other family members. These gifts may be subject to gift and generation-skipping transfer taxes, but you can minimize those taxes using traditional estate planning tools.
ESOPs can offer significant benefits, but they aren’t without their disadvantages. Every business situation is unique, and a careful analysis is necessary to determine if an ESOP is right for your business.
For more information on ESOPs or to learn more about services for the construction industry, please contact Scott Brandt, Audit Partner and Construction Industry Group Leader, at firstname.lastname@example.org or 314.983.1211.