Contractors can differ widely in the services they provide. But most construction company owners have one thing in common: someday he or she will want to retire. Also, 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, 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 also can cash out over time, keeping a seat on the ESOP trustee board and, thus, retaining voting rights in management decisions during the transition. In this manner, businesses with an ESOP are often better able to keep valuable and experienced staff on board through management changes. In addition, an ESOP can serve to motivate staff to work harder toward the company’s success — 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. Once the ESOP owns at least 30% of the company’s shares, the seller can reinvest sales proceeds in other securities 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 startup 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 an independently established fair market value.
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 it’s important to note that establishing one isn’t in the best interests of every construction company. But if you’re intrigued by the concept, contact your CPA to discuss it in further detail.