Exploring the Many Facets of an ESOP

Most construction company owners want to retire someday, and just about every contractor is looking for ways to improve employee engagement and retention. One ambitious and somewhat complex way to do it all is by offering an employee stock ownership plan (ESOP)

Establish a trust

An ESOP is a type of employee benefit plan, similar in many ways to a profit-sharing plan. To set up an ESOP, a company establishes a trust fund and contributes either new shares of its own stock or money to buy existing shares. The shares in the trust are then allocated to individual employee accounts (based on compensation or a formula that considers tenure), and the employees become vested in the accounts over a specified period of service years.

One reason for companies to establish an ESOP is to buy the shares of an owner who wants to retire. In many closely held or family-owned businesses, including construction companies, there isn’t a family or staff member who’s capable of or interested in taking over when the founder is ready to leave. In such cases, the company can make tax-deductible contributions to an ESOP to buy the owner’s shares or have the ESOP borrow money to buy shares. Either way, the company enjoys tax advantages while helping to deal with the succession issue.

A retiring owner who’s cashing out over time or has lost money to the ESOP will often keep a seat on the company board and retain voting rights during the transition. In this manner, businesses with an ESOP are often better able to keep valuable and experienced staff on board through ownership changes. In addition, an ESOP can serve to motivate staff because they’re part owners.

Think about taxes

The tax advantages of ESOPs are considerable. All contributions to the plan are tax-deductible, including shares of stock, cash contributions (whether they’re used to buy stock or to build up a cash reserve) and any payments made to repay loans taken out by the ESOP.

In addition, in C corporations, sellers are eligible for a tax deferral. If certain conditions are met (say the seller has held stock for at least three years and the ESOP owns at least 30% of shares), the seller can reinvest sales proceeds in qualified replacement property (generally, domestic stocks and bonds) and defer taxes on the gains as long as the rollover is executed within a specified time.

In S corporations, the percentage of ownership held by an ESOP is tax-exempt at the federal and usually at the state level as well. When an ESOP holds 30% of an S corporation’s stock, 30% of profits are tax-exempt. When the ESOP holds all of the S corporation’s stock, there’s no income tax owed on any of the company’s profits.

Last, ESOPs are allowed to borrow. When the plan does so to buy new or existing shares, the company can then make tax-deductible contributions to the ESOP in repayment. In such a case, both principal and interest are deductible.

Assess the risks

ESOPs incur considerable start-up and maintenance costs that can run into tens of thousands of dollars, even for small businesses. Midsize to larger companies may face even higher expenses based on the complexity of the arrangement.

A greater potential risk is the pool of money needed to buy back shares of departing employees at fair market value. If the ESOP can’t do so, the company (as plan sponsor) must buy the shares.

So the company or ESOP must maintain enough liquid assets to repurchase the shares of employees who leave. If the stock price appreciates substantially, doing so can be a tall order for contractors, who commonly face cash-flow dilemmas associated with the unpredictable nature of construction projects and backlog.

An ESOP can also substantially affect your bonding capacity. So be sure to consider these risks with your surety representative before creating an ESOP.

Discuss in detail

Yes, ESOPs are a many-faceted thing. And establishing one isn’t in the best interests of every construction company. But if you’re intrigued by the concept, contact us for further details.

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