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Is an ESOP a viable exit strategy for your construction company?

September 20, 2023 Article 7 min read
Michael Krucker Shane Brown

Employee stock ownership plans offer tax benefits and other advantages. They can be a valuable succession planning tool for construction companies and a viable exit strategy for owners, but ESOPs aren’t a fit for every construction firm. We explain.

Construction workers on frame of house.Succession planning is critical for construction companies; owners looking at their exit strategy have several choices. Finding a buyer for the business is one option, but construction companies can be challenging to sell outright. That’s not to say there isn’t value in construction businesses; there is — often, significant value. But legacy relationships, bonding, personal guarantees, and other factors can make a sale challenging. Strategic acquisitions, management team buyouts, and mergers are options for some owners, but these are rare.

An employee stock ownership plan (ESOP) is an often-overlooked exit strategy. ESOPs can have significant tax and other benefits for the owner, the company, and employees. Construction owners considering an exit should understand how an ESOP might fit into their overall succession planning.

What is an employee stock ownership plan, and how does it work?

An ESOP is a specialized form of qualified retirement plan. Similar to a 401(k) or profit-sharing plan, an ESOP is designed to provide retirement income to plan participants. What distinguishes an ESOP from other retirement plans, however, is that it serves the added purpose of transitioning ownership of the business to its future leaders.

In an ESOP plan, the company’s current owner sells all or part of their business interest to the plan, and the company’s current employees become the plan participants. The outgoing owner isn’t required to sell their entire stake to the ESOP. There’s no minimum percentage of company stock an ESOP must own at the time the ESOP is established. However, most construction owners typically set up their ESOP to hold somewhere between 30 and 100%. It’s also common for owners to sell their interest over time through a series of smaller transactions.

ESOPs for construction companies: What makes a good fit?

An ESOP strategy works best for construction businesses with a strong company culture and motivated employees with the expertise and willingness to step into executive roles.

In most instances, the current owner — the selling shareholder — stays on for an agreed-upon period to help ensure a smooth transition to the new leadership. For this reason, an ESOP isn’t a “quick out” for an owner who wants to retire immediately. Instead, an ESOP is a way to transfer ownership of a healthy business over time to a group of employees ready to take on executive responsibilities in a way that allows them to grow into their new roles.

That said, an ESOP may not be the best succession planning tool for every construction business or the right exit strategy for every owner. If a construction business is focused on a sector of the industry that would command a premium at sale, the fiduciary responsibilities imposed on the ESOP might result in a lower payout. If the retiring owner is looking to be out in less than two years, it’s doubtful that the transition involved in an ESOP could be completed. Perhaps most importantly, if the business doesn’t have a strong culture and suitable future leaders, the owners looking to step away are taking a substantial risk — a business failure could have a devastating financial impact on their retirement.

Structuring an ESOP

When you as a construction owner create an ESOP, you’re essentially selling your business to a new entity. The new entity — organized as either a C or S corporation — is an ESOP trust that holds the company shares for the benefit of the employee-owners. Since an ESOP is a qualified retirement plan, the ESOP is required to benefit a broad base of employees. While certain parts of a company’s employee population can be excluded, as is often the case for a company’s collectively bargained workforce, the ESOP should be viewed as a broad-based plan rather than one targeting key employees. Once established, the ESOP trust is subject to IRS and U.S. Department of Labor (DOL) regulations and reporting requirements.

The company will usually take on debt to fund the employees’ purchase of the outgoing owners’ interests. The business may need to line up a lender at the outset if the owners wish to receive some cash out upon the sale. The owners selling their shares to the ESOP frequently forego an immediate full cash payment and agree to carry some of the debt themselves.

Steps to creating a construction company ESOP

Many of the same due diligence and valuation considerations in the sale of any business also apply when setting up an ESOP. The owners and the ESOP need to build their advisory team — valuation experts, legal counsel, and tax and accounting specialists — to manage the process and identify and address concerns arising during the transaction.

The process begins with an initial assessment of value, with the current owners securing a third-party evaluation to understand the potential worth of the business on the market, usually in the form of a range. With this value range in hand, current owners and their expert team conduct a feasibility and repurchase liability study to model the transaction and future financials of the company and the ESOP trust. The study addresses questions such as: Do the business’s cash flows support the transaction? What is the right mix of outside debt, seller debt, and cash? When participants are ready to retire, will the ESOP have the money necessary to buy them out?

Once it’s determined that an ESOP is a good fit, the parties can move forward. The ESOP will need to have a trustee to represent the ESOP trust’s interests, as well as a plan auditor and recordkeeper to ensure it complies with qualified retirement plan rules. It’s best practice — and strongly recommended — that the company hire an outside trustee who’s genuinely independent and experienced with ESOPs.

The parties, including the trustee, negotiate the valuation of the business and, with the lender, the financing. Once terms are finalized, the ESOP trust can be formed, and it then purchases the stock from the owners, effectively executing the sale of the business.

Once the plan is established, it’s subject to ongoing federal recordkeeping and reporting requirements, including the regular filing of a Form 5500 Annual Return/Report of Employee Benefit Plan.

A unique ESOP exit strategy consideration

Selling ownership interests to an ESOP is a negotiated transaction that can have an unusual wrinkle. Because an ESOP is a type of retirement plan, the ESOP trustee has a fiduciary responsibility under federal retirement laws, and the transaction 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 transaction’s facts, the government can restructure the pricing and even claw back a portion of the proceeds paid to selling shareholders.

ESOPs, 1042 tax deferral, and other tax benefits

Employee stock ownership plans can provide significant tax benefits for certain selling shareholders, the company, and employees. If the company is a C corporation and at least 30% of company stock is sold to the ESOP, selling shareholders can take advantage of a special tax deferral known as 1042 treatment. If specific criteria are met — 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. Where available, 1042 treatment can be a significant advantage to a selling shareholder who wants to diversify without prematurely recognizing a taxable gain.

Currently, 1042 treatment isn’t available for ESOP transactions involving S corporations, but the law was changed in early 2023 to extend a limited opportunity for this treatment to transactions occurring after 2027. 

Despite 1042 treatment being currently unavailable to selling S corporation owners, the tax benefits for an S corporation ESOP are substantial. The S corporation passes any income earned to its owners as a pass-through entity. When the S corporation owner is an ESOP — a nontaxable entity — the company doesn’t pay tax on the ESOP’s proportionate share of income, providing a significant benefit to plan 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. Any amount accrued is tax-deferred because the value transferred to employees occurs through a qualified retirement plan. When an employee leaves the company, they can take their account as taxable cash or as a nontaxable cash rollover to another qualified plan or an IRA.

Final thoughts on succession planning and ESOPs in construction 

Few exit strategies offer the benefits an ESOP does, but it takes a specific type of business to succeed in an ESOP structure. A strong culture, an owner willing to shepherd the transition, and a group of employee leaders who are ready and able to step into executive roles and keep the company moving forward — are all critical success factors. 

If you’ve got that team in place, a successful ESOP offers tax advantages for the business, employees, and owners that few other exit strategies can match. For many construction businesses, an ESOP is a way for exiting owners to get fair market value for their business instead of the book value they would likely receive if they wound up selling assets. 

Is an ESOP right for your business? Consider your current situation, retirement plans, and your business’s leadership talent before deciding whether to make an ESOP part of your construction company’s succession plan.

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