In recent years, a growing number of construction companies have established employee stock ownership plans (ESOPs).1 The interest in an ESOP is often generated by the need for an exit strategy for one or more of the owners of a closely held business, a common scenario in the construction industry. Because private equity buyers are rarely interested in construction companies and because construction companies seem less likely to sell to competitors than companies in other industries, the construction industry seems particularly drawn to ESOPs. In circumstances where the business is not easily sold to a third party and/or the owners have a desire to provide for continuity, an ESOP can be a great solution.
ESOPs provide a tax-advantaged path for an exit strategy, and they can provide liquidity for owners that may not be easy to obtain in a sale to a third party. ESOPs help build an ownership culture and incentivize employees to grow the company. As a related matter, they can be a useful retention tool. The increased cash flow generated by reducing or eliminating taxes can be critical to the sustainability of the company.
There are unique issues that construction companies need to address in implementing an ESOP, particularly with regard to sureties and any new debt that is incurred by the company to complete the ESOP transaction. The following provides a background on ESOPs and an analysis of issues affecting construction companies.
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BACKGROUND
An ESOP is a type of tax-qualified retirement plan that primarily invests in employer stock. Like other retirement plans, the ESOP is governed by the terms of a formal plan and trust documents. The ESOP buys shares from selling shareholders, the company, or some combination of both. In a leveraged transaction, the shareholders typically sell their stock to the ESOP. The ESOP will usually purchase the stock through a combination of seller notes and cash borrowed from the company, which in turn will often borrow money from a bank.
Employees are usually allowed to participate in an ESOP after completing a year of service and will have shares allocated to their account for each year of service they continue to provide. Through additional allocations of stock and increases in share value, employees can accumulate significant tax-favored retirement savings over time. Employees are able to access their retirement savings in an ESOP after they retire (or, with some limitations, terminate their employment) and can generally roll over these funds to another retirement plan or IRA. The company has the flexibility to tailor the ESOP and its distribution policy to the needs of the company and employees through different eligibility, vesting, and distribution options.
There are several tax advantages to an ESOP. One such advantage is that contributions by the company to the ESOP to enable the ESOP to repay the promissory note are tax deductible (up to certain limits); thus, a loan used to finance an ESOP transaction can be repaid with pre-tax dollars. Additionally, a selling shareholder of a C-corporation may be able to elect Internal Revenue Code Section 1042 tax-deferral treatment of the capital gains associated with the sale of his or her shares, subject to certain requirements. Finally, for companies that elect S-corporation status, the ESOP’s share of recognized earnings is ordinarily exempt from income taxes. The goal for most ESOP-owned companies is to eventually become a 100 percent ESOP-owned S-corporation, thereby achieving the best possible tax status.
To start the ESOP process, companies will usually obtain a feasibility study that considers valuation, transaction size, financing, surety program impact, and the expected benefits delivered to employees over time. The ESOP process will also ordinarily consider the long-term goals and related incentives for management, including any management transition issues.
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ISSUES UNIQUE TO CONSTRUCTION COMPANIES
Maintaining Continuity
Many construction companies are closely held companies that do not have a business continuity plan. They may be owned by the founder or a small number of shareholders who are not working for the company. An ESOP can provide continuity by establishing a market for the purchase of shares.
Incentivizing Employees
An ESOP is designed to provide employees with “skin in the game,” thereby incentivizing them to increase the value of the company stock and their beneficial ownership. As the number and value of shares allocated to an employee’s ESOP account grows, employees will see the dollar value of their account grow as well. It is not uncommon for long-term employees to be able to accumulate significant wealth in an ESOP. Given labor shortages in the construction industry, an ESOP can provide an important retention tool and incentive for employees to remain employed with the company and pursue long-term growth. Also, because union employees can be excluded from participating in an ESOP, an ESOP may also reduce employee interest in unionization.
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