2023 was another strong year for many contractors. Overall, the U.S. economy grew at a 3.3% annualized rate in the fourth quarter of 2023, as recently reported by the Department of Commerce. It’s possible the U.S. may have achieved the “soft landing” we have been hoping for. What does this mean for contractors in 2024? According to survey results from the Associated General Contractors of America, the 2024 outlook of construction contractors is mixed. The ability to recruit and retain qualified workers continues to be a challenge, along with ongoing impacts of higher costs and interest rates.
The factors above may make 2024 financial performance difficult to predict, but difficulty in forecasting future financial performance is a recurring theme in recent years. Meanwhile, many owners need to address succession planning in the near term. Every construction company and its owners are eventually faced with succession issues. Owners who ignore succession planning until an unexpected event forces the issue may face fewer options, little time to react, and a reduced company value.
However, proper planning can help create peace of mind and increase the chances of a smooth ownership transition, which could help retain wealth and financial security regardless of the economic environment or uncertainty.
An employee stock ownership plan (ESOP) is one of many succession strategies available. While an ESOP isn’t the right fit for every business, it may be an attractive option for many companies.
What’s an ESOP?
An ESOP is a qualified defined contribution plan, governed by the Employee Retirement Income Security Act of 1974. While similar to a 401(k) plan in many ways, the primary difference is that an ESOP is designed to invest primarily in stock of the sponsor company. An ESOP also has a special exception under the law that allows the plan to borrow money to fund the purchase of employer securities.
According to the National Center for Employee Ownership (NCEO), there are now approximately 6,500 ESOPs in the U.S.1 covering more than 14 million employees. Nearly 4,000 of these ESOPs are 100% ESOP-owned.
An important characteristic of ESOPs is their ability to borrow money to purchase company stock, referred to as a leveraged ESOP. This is similar to a traditional leveraged or management buyout but with significant tax advantages and greater employee participation in future growth. The ESOP can purchase any percentage of the company’s stock. Due to significant potential tax savings, many companies are choosing to become 100% ESOP-owned. This can be accomplished in a single transaction or a series of smaller transactions.
One common misconception is that once an owner sells his or her stock to the ESOP, employees become legal stockholders. In fact, the ESOP trust is the legal stockholder; employees simply have a beneficial interest in the value of the shares allocated to their retirement account. This is an important legal distinction that allows the ESOP trustee to vote the shares in most situations.
Company Legacy
Owners of closely held companies often wish to retain the company name and history, protect employees, and help preserve the communities in which they operate. The thought of selling the construction company to an outsider often conjures images of layoffs, undue oversight, a new management team, and possibly a new name above the door. For many owners, this isn’t a palatable option.
An ESOP can help address these concerns while providing a viable means of creating stockholder liquidity over time. When considering an ESOP transaction, it’s important to remember that selling stockholders can continue to manage the company, even if 100% of the stock is sold to the ESOP.
Stockholder Benefits
Not only can the ESOP pay fair market value for the owner’s stock, but the sale transaction can also be structured to create tax advantages for the seller. In general, the ESOP purchases stock instead of company assets. A seller who has held their stock longer than one year can take advantage of long-term capital gains rates. In addition, a seller financing all or part of the purchase price has the option to take installment treatment on the portion of the transaction financed with a seller note, allowing the seller to pay capital gains tax over a period of time as the seller note is repaid.
If the seller is taking back a seller note, they may be provided with detachable warrants as an interest rate enhancement for financing all or a portion of the ESOP transaction. The warrants are considered part of the overall financing package and are taken into consideration in the overall rate of return on the seller note, including the cash payments of interest. Warrants give the seller the right to purchase a certain number of company shares at a future date (usually after the seller note is repaid). In general, the exercise price equals the post-transaction ESOP price, and the put or call price is based on the company’s most recent ESOP appraisal. Detachable warrants have the benefit of easing the interest burden on the company, while providing the selling stockholders with potential upside in the company depending upon future company performance.
Another tax planning strategy is covered under Internal Revenue Code Section 1042. This allows owners meeting certain qualifications to sell their stock in a tax-deferred or potentially tax-free transaction. To take advantage of §1042, the company must be a C corporation at the time of the sale transaction and the ESOP must own at least 30% of the employer stock after the transaction’s completion. The taxpayer also must have held the securities for at least three years prior to the sale.
Effective for sales after December 31, 2027, S corporation shareholders can defer 10% of their gain on their sale to the ESOP. This change was implemented as part of the Setting Every Community Up for Retirement Enhancement (SECURE) 2.0 Act of 2022.
To achieve gain deferral, the selling stockholder is required to reinvest in qualified replacement property (QRP) within 12 months of the sale date. QRP is essentially stocks or bonds of domestic operating companies. Mutual funds, municipal bonds, and certain other investments aren’t considered qualifying property. The tax basis in the company stock sold carries over to the QRP. The deferred gain is realized only when the QRP is sold. However, if the selling stockholder holds the QRP until death, the QRP will become part of the stockholder’s estate. At that time, the QRP will receive a step-up in basis (in years where the estate tax is in effect), resulting in income tax avoidance.
Certain strategies allow the stockholder to invest in QRP and retain the tax deferral while retaining access to most of the sale proceeds. Due to historically low long-term capital gains rates, §1042 gain deferral hasn’t been widely used in recent years. However, this strategy may be more appealing for taxpayers in certain high income tax rate states.
Company Savings
The selling stockholder certainly isn’t the only one to reap the tax advantages of an ESOP transaction. The company can realize substantial tax savings as well. Because a leveraged ESOP company can deduct principal payments on debt used to purchase company stock (subject to certain tax deduction limits), a significant portion of the transaction can be repaid with company tax savings.
There are even greater benefits for ESOPs taxed as S corps. The portion of the company’s earnings attributable to the ESOP is exempt from federal and most state income tax (except in certain states that don’t recognize S corp status). When an S corp is 100% owned by an ESOP, the potential for savings is even greater. In this case, the company no longer pays federal or, in general, most state income taxes because the ESOP is a tax-exempt retirement plan. The company can retain this cash to pay off acquisition debt, support company growth, or even fund acquisitions. This tax-advantaged structure can make a leveraged transaction more palatable to key stakeholders, such as sureties. The additional cash from the tax savings may allow the company to deleverage more quickly than in other leveraged transactions.
Employee Incentives
In a tight labor market, it can be tough for construction companies to recruit and retain skilled labor. ESOPs can be an attractive addition to an employee’s overall compensation and benefits package. ESOPs can provide significant retirement benefits to long-term employees of construction companies. In general, any employee who is at least 21 years old and has one year of service with the company is eligible to participate. According to the NCEO, employees at ESOP companies have 2.2 times greater retirement accounts2 than employees at companies without an ESOP, and 20% more financial assets overall compared to non-ESOP companies.
As the company makes annual contributions to the plan, the ESOP uses those contributions to make payments on the ESOP loan. These loan payments trigger the release of shares, which are then allocated to eligible participants. The shares are typically allocated pro rata based on each employee’s eligible compensation compared to the total compensation of all other eligible participants (within certain IRS limits). For example, a participant earning $50,000 per year will receive twice as many shares as a participant earning $25,000 per year.
Participants who receive allocations of shares become vested in that benefit over time. To become vested in their account, participants usually must have three to six years of service with the company. Because an ESOP is a type of qualified retirement plan, there are special rules regarding when participants are entitled to receive a distribution of their account balance. In most cases, employees receive a distribution of cash equal to the value of their account instead of stock. With a leveraged ESOP, it’s critical that the plan is designed to delay significant cash distributions until the ESOP debt is repaid. In the early years, this allows the company to retain operating cash flow to service debt rather than pay benefits to terminated participants.
Key members of management will usually participate in the ESOP along with other employees. However, to retain key management and help ensure their goals and objectives are properly aligned with the ESOP’s, it’s often important to provide additional equity incentives, such as incentive stock options or stock appreciation rights. Extending these incentives to the management team is a key element to the success of the ESOP transition and the company’s future performance. Such incentives, when taken into consideration with the total compensation package, must be considered reasonable by the ESOP trustee.
The ESOP Solution
An ESOP can be a powerful succession planning tool for certain construction company owners. It may not be the ideal strategy in all situations, but for stockholders looking to implement a permanent succession plan, preserve company legacy, and reward employees, an ESOP may be just the solution they’re seeking. It is critical to coordinate with key stakeholders such as the senior lender and surety throughout the ESOP implementation process to ensure the structure will be successful.
ESOPs are inherently complex, but an experienced professional can help business owners assess whether an ESOP is the right tool to help them accomplish their goals and objectives. If you have questions or need assistance, please reach out to a professional at FORVIS.