While employee stock ownership plans (ESOPs) function to reward employees with an ownership stake in the business they helped build, they can also offer tax advantages as an ownership-transition vehicle. Yet only about 11 percent of construction companies had ESOPs in 2016, according to research by the National Center for Employee Ownership. Further research shows that companies that set up an ESOP tend to increase annual sales, employment and productivity an average of 2.5 percent.

When Do Participants Receive Benefits? 
Because an ESOP is a qualified retirement plan, it will generally make distributions to participants in a manner similar to other retirement plans. Ultimately, the ESOP plan provisions dictate the specifics of how and when distributions occur. Events usually leading to distributions include death, disability, termination of employment and retirement. 

Distributions may occur in a lump sum or installments and may commence within certain time frames of these events happening. Participants are generally taxed at the time of distribution, but can elect to roll over their distribution into another qualified plan, which defers taxation until a distribution is received from that rollover plan. 

In addition, although an ESOP participant’s account consists mainly of employer stock, the plan will generally either distribute the cash value of that stock at the time of distribution or, if stock is distributed, include an option whereby the employee can immediately sell the stock to the employer. This policy exists so the employees are not left holding employer stock that may not be easily converted into cash in an outside market.

Are ESOPs Risky for Employees? 
An ESOP does have to remain primarily invested in employer securities to qualify as an ESOP and receive the associated benefits. Most individuals are more familiar with 401(k) plans, which generally allow employees to choose among an array of diversified investment options. In reality, though, employees at ESOP companies often end up with larger retirement account balances. 

Because most ESOP companies usually offer the ESOP in addition to other retirement plans, employees often receive the ESOP account on top of other diversified accounts. In addition, most ESOP companies contribute more as a percentage of pay to employees’ ESOP accounts than non-ESOP companies do to employees’ 401(k) accounts. 

Department of Labor research also shows that ESOPs have higher rates of return and are less volatile than 401(k) plans. Moreover, ESOPs generally cover more employees because they provide benefits to employees without the employee having to elect into the plan, whereas employers typically only contribute to 401(k) accounts if the employee elects to participate in the plan first, and not all do. 

And lastly, diversification rules exist that require the ESOP to provide participants who are at least age 55 and have been in the plan for at least 10 years the option to diversify 25 percent of their accounts over a period of five years. In the final year of this diversification window, participants must be allowed to diversify up to 50 percent of their account balance if they so elect.

Tax Advantages for the Company
When an owner sells to an ESOP, the company has a new retirement plan that requires regular and continuous contributions. Those contributions are tax-deductible employee benefit expenses. Most ESOP transactions are structured so financing is obtained by the company (either from an outside creditor or the seller) when the stock is purchased.

The debt brings cash into the company, which is then loaned to the ESOP to purchase stock from the company or selling shareholders. The payments the ESOP makes on that debt in effect become tax-deductible to the company because the company funds the ESOP’s debt payments with its regular and continuous contributions to the ESOP. 

In addition, a C corporation may receive a tax deduction for dividends paid to an ESOP. 

An S corporation can receive even more favorable tax treatment because the ESOP is not taxed on its share of the S corporation. And because the S corporation is generally not taxed at the entity level, company earnings allocable to ESOP ownership escape current taxation.

In addition to providing tax incentives, an ESOP helps create a culture that promotes productivity, responsibility, loyalty and participation of employees.

Costs to the Company
The benefits of an ESOP do come with a cost to the company, but in most cases, the benefits far outweigh the costs. Costs incurred in the initial year of the ESOP will include: 
  • an independent appraisal to support the stock price at which the transaction is entered; 
  • accounting and legal services related to advising on ESOP effects and terms; 
  • preparing and effecting documents; and 
  • operating and administrating the plan. 
The initial costs depend on the company size, the industry, the availability of information for valuation purposes and the financing structure, among other factors. 

After the initial year, ongoing annual costs include fees for an annual valuation, audit fees if the plan has 100 or more participants, administration costs (which usually include a flat fee plus a charge per participant in the plan) and tax return preparation fees. 

Timing and Implementation
Contractors interested in pursuing an ESOP should consult with their tax advisor regarding the tax and accounting implications. Other advisers should include fiduciaries, lenders, attorneys and administrative professionals. During the ESOP exploration process, a contractor should perform a feasibility analysis to test various assumptions regarding the value of the company, size of the transaction, financing options and the expected ESOP benefits delivered to employees over time.

ESOPs aren’t for all contractors. Considerations include the company’s debt, revenues and net profits, cash reserves, company benefits, total assets, potential for future growth, and the like. But for contracting companies that are suitable, an ESOP offers a good way for owners to transition out of the company on their own schedule, while also giving valued employees a stake in the company. 

Anne Bushman is senior manager and Denise Bendele is a partner with RSM US LLP. For more information, visit rsmus.com.