Being closely-held or family owned is a common characteristic of a significant number of construction companies. As a result, many share a common dilemma if they don’t have a family member or employee who is capable of, interested in or financially able to take over the company when the founder is ready to retire.
One approach to succession planning that for some time has generally been introduced into this discussion is the employee stock ownership plan (ESOP). An ESOP is a type of employee benefit plan, similar in many ways to a profit-sharing plan. One reason for companies to establish an ESOP is to buy the shares of an owner who wants to retire. 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 (i.e., from a retiring owner).
Sometimes the company makes tax deductible contributions to an ESOP to buy the existing or new shares if cash flow permits, or may have the company or the ESOP borrow from a qualified lender (leveraged ESOP), the funds necessary for the ESOP to purchase the shares, and then make tax deductible contributions to the ESOP in order for the ESOP to service the debt. The stock is held in a suspense account as pledged stock, until paid for. As the loan is repaid or the shares paid for, the shares are released from collateral and allocated to individual employee accounts, based on compensation and the employees become vested in the accounts over a specified period. Either way, the company enjoys tax advantages while helping to deal with the succession issue.
Advantages of an ESOP
In addition to providing a succession plan, an ESOP is intended to motivate employees to work harder toward the company’s success because they are now stakeholders.
There are many tax advantages to an ESOP’s. 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. Once the ESOP owns at least 30% of the company’s shares, the seller can reinvest sales proceeds in other securities within a specified period of time and defer taxes on the gains. This does not hold true for S corporations, however. S corporations have a separate tax advantage because 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 profit.
If the ESOP plan borrows to buy new or existing shares, the company can make contributions to the ESOP in repayment of the debt. In this case both principal and interest are deductible.
Disadvantages of an ESOP
In the construction industry, where cash flow is quite often unpredictable, ESOPs incur considerable costs at the inception of a plan, as well as recurring plan maintenance costs. An independent stock valuation is required annually to determine an established fair market value of the stock in the Plan and the value which to buy back shares of departing employees. These 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 Plan.
Impact on Bonding and Banking
While having a well-designed succession plan in place is a positive factor when being evaluated for bonding or banking, an ESOP Plan can also have a negative impact. If the Company or the ESOP needs to borrow money to meet the ESOP’s financial obligations, that loan will be recorded as a liability on the company’s balance sheet, with an offsetting entry to equity decreasing net worth. Financial covenants related to debt instruments with banks may have to be renegotiated to account for decline in net worth.
Make no mistake — establishing an ESOP is a major undertaking for any construction company. Communication is key in this decision. Be sure to discuss the implications beforehand with your financial advisor, legal counsel and, as mentioned, banker and bonding provider.
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Kathy L. Rendon, CPA, CCIFP
Kathy Rendon has been providing accounting, auditing, consulting and litigation support services to construction contractors and subcontractors for more than 30 years. Many of Kathy’s clients are smaller family-owned enterprises—often subcontractor firms—that include drywall specialists and other material suppliers. She is the ideal person to approach for look-back calculations and guidance through the intricacies of the numerous industry-specific construction accounting methods. Contact Kathy at email@example.com or 714.990.1040.
Frazer LLP has far-ranging experience in the specialized accounting methods for the construction and engineering industries. From tax and accounting compliance and consulting on purchase and sale of real estate, negotiating and tax free exchanges to cost segregation and business valuation, our team can provide you with expert tax, financial, and management advice in any stage of your construction business.