Employee Stock Ownership Plans (ESOPs) have been on the rise since the Employee Retirement Income Security Act of 1974 (ERISA) set the foundation for the qualified retirement plan concept we encounter today. According to the National Center for Employee Ownership’s (NCEO) 2016 data, plan assets nationwide have reached $1.5 trillion, with 6,500 companies sponsoring ESOPs. 11% of those companies are in the construction industry.
Implementing an ESOP is a complex process and presents companies, management and owners with many questions. Here is an overview of the basic Who, What, When, Where, Why & How of ESOP formation for the construction industry.
Who will sell and who will own the company?
An ESOP invests in company stock and holds that asset in a trust. An ESOP doesn’t always own all company stock – it can own any fraction. Additionally, if there are multiple current owners, each can sell any fraction, or none. ESOP participants are company employees. The employees do not purchase shares with their own funds. Through various possible mechanisms, the company makes contributions to the ESOP, and at that point shares are allocated to the employees annually based on compensation, or a mix of compensation and length of service. Generally, when employees leave the company or reach a certain age, some or all of their shares are repurchased by the ESOP.
Who is getting money?
Current shareholders will receive the proceeds from the sale of their stock to the ESOP; however it is the company that finances the sale. The company can use available cash, external financing, or shareholders can finance the sale themselves with the company taking on a subordinated note payable to the shareholder. That last option may be the only way to get the surety on board for many companies.
Who will be the trustee?
An ESOP trustee, appointed by the company’s board, can be inside the company or it can be a third party. Anyone making decisions about an ESOP is taking on a fiduciary responsibility to act for the exclusive benefit of plan participants. As a result, the best practice is to have a third party discretionary trustee making the decisions about the Plan going forward – one who fully understands the specific complexities of ESOPs. If another path is taken, be sure that everyone involved understands the responsibility and diligence involved.
What is your current leadership structure?
A strong management team is critical, particularly for majority-owned ESOPs. You’ll want to make sure they stay on board. Alternatives to direct ownership such as stock appreciation rights or deferred compensation arrangements can be set up for them, so long as they are reasonable. However, although these agreements do not represent direct ownership, if the company is an S-Corp these types of agreements are “deemed” ownership for certain IRS rules that limit key management and shareholder ownership.
What is your current employee composition?
Companies less than 20 employees in size can set up an ESOP; however it is often much more challenging, and because of certain compliance rules, a few less can be practically impossible for an S-Corp. A good mix of employee ages will make for a more even flow of payments as the participants become eligible to “cash out” of their allocated stock balance.
When did the company start?
Reaching and maintaining a strong financial position and track record of strong earnings is important.The first few years of a new business may be a bit early to consider ESOP formation. ESOP formation and annual compliance can represent a large cost for smaller companies.
Where is your valuation and feasibility study?
As soon as a preliminary decision to implement an ESOP is made, a feasibility study should be performed to get a picture of the possible impact on cash from financing, contributions and repurchases of stock from participants.
You will also need a valuation of the stock, which must be completed by an independent appraiser. The purchase price is where most legal scrutiny occurs for an ESOP. Best practices would have an outside discretionary trustee selecting the appraiser, reviewing the valuation and negotiating the purchase price if appropriate.
Why should certain companies avoid the ESOP route?
According to the NCEO, ESOP start-up fees tend to range from $75K to $200K, with annual compliance ranging from $20K to $30K. The cost for implementing a partial ESOP ownership tends to be considerably less than with 100% ESOP implementation. Either way it’s a sizeable expense if the company and shareholder were not otherwise looking to sell.
ESOP planning, implementation, and maintenance is a huge effort. Even owners and executives involved successful ESOP implementations who are happy they did so usually find that it was much more work than expected.
Maintaining ERISA compliance requires a management team and the proper team of advisors and someone at the company who becomes a de-facto ESOP “expert”. The “lone gun” management style of some contractors works against the employee-centered culture found behind successful ESOPs. Additionally, companies with a short, uneven, or poor track record financially, especially with low or uncertain cash-flow, are not the best ESOP candidates.
Why go the ESOP route?
ESOP owned contractors can be attractive to bond producers and sureties. ESOP-owned Companies have demonstrated they tend to work under a mission of culture. Studies have show that they may be more profitable on average than non-ESOPs. A crucial continuity plan is in place. A 2018 NCEO and ESCA survey of S Corporation ESOPs found that “ESOP participants represented in the survey have more than twice the average total retirement balance of Americans nationally and that those making less than $26,000 a year also have on average more than double the retirement savings compared to similar workers nationally.”
The selling shareholder will have found a viable liquidity/diversification or exit strategy in an ESOP, and there are various tax benefits all around – Seller gain is capital gain, and while the current capital gain rates are attractive, selling shareholders of C-Corp stock can potentially defer or eliminate some or all of the gain by reinvesting proceeds into certain qualified investments. An ESOP’s S-Corp income is not taxed at the federal, or often state, level. Company contributions to the ESOP are in most cases deductible, and contributions to a participant employees’ ESOP accounts represents compensation not taxed until they take a cash out distribution, usually for retirement.
How do I get started?
The professionals at Albin, Randall & Bennett are industry leaders here to help your construction company through the ESOP implementation process and all of your employee benefits plan questions. We are available to assist with understanding the complexities and benefits of ESOP formation. Contact us to discuss a strategy for getting started.