Employee stock ownership plans are a valuable exit strategy for construction owners looking to receive a fair price for a business that will continue under a new generation of leaders.
The problem is construction businesses are often challenging to sell outright, often limiting the exit strategies available to owners. There’s certainly value in construction businesses, but the risks contractors take and the legacy relationships that owners hold make it challenging to transfer their businesses. While there are exceptions — and you do see some strategic acquisitions, management team buyouts, and mergers — these are somewhat rare. Keeping a variety of options open is always a good idea. That’s where an employee stock ownership plan (ESOP) can make a difference both for the outgoing owners and the next generation of leaders. Most construction owners will benefit from understanding where the ESOP option fits in the universe of succession plans.
How does an ESOP work?
An ESOP is a specialized form of qualified retirement plan. Just like a 401(k) or profit-sharing plan, it’s designed to provide retirement income to plan participants. The difference with an ESOP is that it serves a dual purpose of transitioning the ownership of the business to a new generation of leaders. This strategy works best for businesses with a strong company culture and a next generation of employee-leaders who are ready and willing to step into executive roles.
When creating an ESOP, the current owners of the company sell all or part of their interests to the plan, and the employees become the plan participants. Owners aren’t required to sell all of their ownership interest to the ESOP — at setup, there’s no minimum percentage of company stock an ESOP is required to own, but most ESOPs own somewhere between 30 and 100%. An ESOP-owned company is organized as either a C or S corporation. In order to fund the purchase of the ownership interests, the company will usually take on debt. Frequently, the executives who are selling their shares into the ESOP initially receive promises to pay over time rather than an immediate cash payment.
When creating an ESOP, the current owners of the company sell all or part of their interests to the plan.
In most instances, the selling shareholders stay on for a period of time as they transition to the next generation of leadership. It’s not a “quick out” for someone who’s looking to retire imminently. It’s a means of transferring ownership of a healthy business over time to a group of employees who are ready to take on executive responsibilities in a manner that helps them grow into their new roles.
How do you structure an ESOP?
The key thing to remember about the creation of an ESOP is that you’re essentially selling your business to a new entity that you’re creating. The new entity is an ESOP trust that’s created to hold the shares of the company for the benefit of the employee owners. The ESOP trust is subject to IRS and Department of Labor (DOL) regulations and reporting requirements. Many of the due diligence and valuation considerations that would apply in any business sale will apply when setting up this plan. The ESOP will need to have an independent trustee to represent the ESOP trust’s interests, as well as a plan auditor and recordkeeper to make sure that it stays in compliance with qualified retirement plan rules. The owners and the ESOP will both need valuation experts, legal counsel, and tax and accounting experts to identify and manage any unique concerns that arise as part of the transaction. The business may need to line up a lender to support any debt it will take on to fund the ESOP at the outset should the owners wish to receive some cash out upon the sale, even though they will be carrying some of the debt themselves.
The process begins with an initial assessment of value. The current owners need to get a third-party assessment to understand the potential worth of the business on the market, generally in the form of a range of values. With that range of values in hand, they conduct a feasibility and repurchase liability study essentially modeling the transaction and future financials of the company and of the ESOP trust. Do the cash flows of the business support the transaction? When participants are ready to retire, will the ESOP have the money necessary to buy them out? Once it seems likely that an ESOP will be a good fit, the parties move forward with assembling the team of professionals necessary to create the ESOP and execute the sale of the business. The parties, with the trustee, negotiate over the valuation of the business and with the lender over the terms of financing. When the terms are finalized, the ESOP trust is formed, and it purchases the stock from the owners.
Selling to an ESOP is a negotiated transaction, and the selling shareholders need to recognize that sale to an ESOP has an unusual wrinkle. As trustee of a retirement plan, an ESOP trustee has a fiduciary responsibility under federal retirement laws and is subject to review by the DOL. It doesn’t happen often, but if the parties agree to a valuation that the DOL finds unsupported by the facts of the transaction, the government can restructure the pricing and even claw back a portion of the proceeds paid to selling shareholders.
Once the transaction is complete and the plan is established, it will be subject to ongoing federal recordkeeping and reporting requirements, including the regular filing of a Form 5500 Annual Return/Report of Employee Benefit Plan.
What are the tax benefits of an ESOP?
There are significant tax benefits associated with ESOPs — for certain selling shareholders, the company and employees.
If the company is a C corporation and at least 30% of the company stock is sold to the ESOP, selling shareholders may take advantage of a special tax deferral known as “1042 treatment.” If certain criteria are met — most notably reinvesting the proceeds in qualified replacement securities and holding those securities for at least three years — the selling shareholder can defer recognition of any gain on the sale to the ESOP. This can be a big advantage to a selling shareholder who’s looking to diversify without prematurely recognizing a taxable gain.
For an S corporation owned by an ESOP, the tax benefits are substantial. As a pass-through entity, any income earned by the S corporation passes through to its owners. Where the owner is an ESOP — a nontaxable entity — the company doesn’t pay tax on the ESOP’s proportionate share of income. This treatment provides a significant benefit to ESOP participants both in terms of cash flow and value retention.
Finally, an ESOP provides one of the few opportunities to transfer the value of ownership to employees without creating an immediate tax impact. Because the value transferred to employees is done through a qualified retirement plan, any amount accrued is tax-deferred. When an employee leaves the company, they can take their account as taxable cash or as a nontaxable rollover to another qualified plan or an IRA.
Ins and outs of ESOPS
Few exit strategies offer the kinds of benefits that an ESOP does, but it takes a certain type of business to succeed in an ESOP structure. You need a business with a strong culture and a group of employee leaders that are ready and able to step into executive roles and keep the company moving forward. If you’ve got that team in place, a successful ESOP offers tax advantages for the business and the retiring executives that few other exit strategies can match. For many construction businesses, an ESOP is a way for retiring executives to get fair market value for their business, as opposed to the book value they would likely recover if they wound up selling assets.
Few exit strategies offer the kinds of benefits that an ESOP does, but it takes a certain type of business to succeed in an ESOP structure.
In some cases, though, the ESOP may not be the best option. If a construction business is focused in a sector of the industry that would command a premium at sale, the fiduciary responsibilities imposed on an ESOP might result in a lower payout. If the retiring owner/executives are looking to be out in less than two years, it’s highly unlikely that the proper transition necessary to support an ESOP could be completed. And perhaps most importantly, if the business doesn’t have a strong culture and a next generation of suitable leaders, those looking to step away are taking a substantial risk that a failure of the business could have a devastating financial impact on their retirement.
To learn more about how an ESOP might fit into the future of your construction business, please contact Plante Moran.