According to the National Center for Employee Ownership, about 11,000 companies in the United States have established employee stock ownership plans (ESOPs). The retirement, tax, financing, management and succession planning features of ESOPs can be particularly advantageous in the construction industry. Of the 100 largest U.S. companies that are majority-owned by their employees, 91 have ESOPs, and nearly one-third of those are in construction or related industries.
No single tool is right for every business, but in today’s economy an ESOP should at least be considered by owners who are investigating succession plans for their closely held companies. In addition to providing a tax-advantaged retirement vehicle for the company’s employees, an ESOP can function as a highly effective method for transferring ownership to a new generation, a useful tool for encouraging employee accountability and responsibility, and even an alternative source for company financing.
The ESOP Concept at a GlanceLike 401(k) and profit-sharing plans, ESOPs are tax-qualified retirement plans subject to the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). However, ESOPs differ from other tax-qualified retirement plans in three important ways:
- an ESOP must invest primarily in the company’s stock;
- an ESOP can borrow money to finance the purchase of company stock; and
- an ESOP offers additional special tax advantages not available to other retirement plans.
When a company establishes an ESOP, it sets up a trust into which it contributes newly issued or treasury stock, or cash to buy company stock. Alternatively, the ESOP can borrow money to buy new or existing shares (a “leveraged ESOP”), with the company making cash contributions and paying dividends to the plan to enable the ESOP to repay the loan.
The company’s contributions to the trust are generally tax-deductible within limits, and in many cases the selling owners can avoid capital gains taxes on the transaction. At the same time, shares in the trust are allocated to individual employee accounts, which continue to grow on a tax-free basis until disbursement.
Benefits to Owners Topping the list of important owner benefits is that an ESOP can effectively create a market for the company’s shares where one did not previously exist. This is especially significant these days, when the owner of a construction company who wants to begin transitioning out of the business may find it difficult, if not impossible, to attract qualified buyers.
ESOPs can pay up to the fair market value of the shares, as determined by a qualified independent appraiser. ESOPs also give owners maximum flexibility regarding the size of the transaction and the timing of the sale.
The two most common alternatives to ESOPs—an internal sale to the management team or an internal sale to a new generation of family owners—often pose complications, especially when the buyer lacks adequate capital. In many cases, the owners must finance the sale themselves, which means they remain exposed to the business’ financial risks throughout the transition.
An ESOP can provide added protection and peace of mind because the owner usually does not need to transfer complete control. For most corporate actions, the ESOP trustee, not the participants, votes the shares held by the ESOP. Thus, a properly structured ESOP trust enables the seller to retain control of the business as long as desired.
Additionally, Section 1042 of the Internal Revenue Code allows owners of privately held shares in a C corporation to defer capital gains taxes on the sale of those shares to an ESOP. This rollover treatment allows the seller to roll the proceeds of the sale into qualified replacement property (generally stocks and bonds of domestic operating companies) and defer the gain until the replacement stocks and bonds are sold.
The seller usually can pledge the replacement securities as collateral for a loan and obtain use of the funds in the meantime. Moreover, if the replacement investments are held until the seller’s death, the owner’s heirs benefit from a step up in the cost-basis of the replacement securities, eliminating the tax completely.