After more than a year of whipsaw change brought on by the pandemic, many business owners have decided to retire. A recent survey of business owners conducted by the Wilmington Trust found that the pandemic is behind this rush to retire, adding another unexpected wrinkle to a devastating year.
But what’s the right succession plan? It’s no small consideration for an owner who has spent a career building a business and wants to see that legacy continue.
For many in the construction industry, that answer is increasingly found in an employee stock ownership plan, or ESOP, which allows for continuity in the sale process, and can provide tax savings as well.
An aging industry
Indeed, the construction industry is ripe for a transition to the next generation. The median age of construction workers increased to 42.9 from 2010 to 2020, an increase of 1.3 years. For the economy as a whole, the increase was 0.5 years over the same time frame.
And many owners of construction firms are at an age where they need to consider succession planning. According to the latest survey on ownership transfer and management succession by research firm Future Market Insights, a majority of those surveyed plan to exit their business in the next five years or so. But at the same time, more than 50% reported that they do not have an ownership transfer plan.
The exit strategies usually fall into five categories:
- Liquidate the business
- Sell to an external third party (competitor, private equity, etc.)
- Sell or gift to a family member
- Sell to employees
- Sell or gift to both family and employees
Amid this range of choices, the employee stock ownership plan has increasingly stood out in recent years.
Employees as owners
An ESOP is a qualified employee retirement plan governed by the Employee Retirement Income Security Act (ERISA). ESOPs function to reward employees with an ownership stake in the business that they work for, allowing them to share in the successes of the company while also providing for a tax-advantaged transition plan for owners and the sponsoring ESOP companies.
Once the company adopts the ESOP trust, that trust can purchase shares of stock from the owner using borrowed funds from the company, a bank or the selling shareholder.
An ESOP can provide certain advantages to a selling shareholder, including the continuity of the existing company and tax savings.
Using an ESOP can provide an owner with a structured exit over a longer timeframe, should the owner want to stay involved. This is typically achieved because the owner is not required to sell 100% of the business in the transaction, although an owner can defer tax on the gains made from the sale of an ESOP if the ESOP holds 30% or more of the stock, along with meeting other requirements. By not having to divest fully, an owner can continue to be involved with the business while determining the proper succession plan.
The second advantage is taxes, and it’s not just for the owner.
If the sale of the company is at least 30% of the stock from the seller—and the company is a tax-paying C corporation at the time the ESOP acquires the stock—the seller may defer paying capital gains taxes by electing Section 1042 of the Internal Revenue Code. This can lead to tax savings for the seller.
Another major tax advantage results from the sponsoring company. Businesses can borrow money to fund ESOPs and repay these loans with pretax dollars because both the principal and interest are deductible when repaying an ESOP loan (as opposed to just the interest in a conventional loan). This can be a significant savings on cash flows for the company.
Consider this example: A company, taxed at a 35% tax rate, wants to borrow $1 million. The firm arranges conventional financing at 10% annual interest and makes equal annual principal payments over five years. The following represents the summary of after-tax cash incurred by the company with conventional lending versus ESOP financing.
There is a $350,000 difference between conventional debt lending versus ESOP financing. This makes the ESOP financing less risky to lenders and allows for greater cash flows for the company.
There are some disadvantages to ESOPs as well. One is a result of balance sheet leverage. If a company borrows money and then lends it to the ESOP to enable the ESOP to make a leveraged purchase of company stock, this will hurt the company’s equity position (as liabilities will increase and equity decreases). This reduction could have an impact on the company’s financial leverage and affect both bonding capacity and potential financing with third-party lenders.
Another disadvantage is that the trustee of the ESOP needs to monitor the repurchase obligations of an ESOP. The timing of redemptions will need to be monitored to ensure that there is significant cash or liquid assets available to meet the repurchase requirements needed for the ESOP. The price of which will be determined annually through a formal valuation process. Moreover, if the value of the company does not regularly increase, employees may feel that the ESOP is less attractive for them than other profit-sharing plans.
The last disadvantage is that ESOPs require significant management time and resources. These resources will need to be used to meet rules related to accounting, the Internal Revenue Code and the Department of Labor. Meeting these rules can be burdensome and will require continued annual fees, such as formal valuation and audit requirements that come with implementation of an ESOP.
It is important to note that if a contractor is interested in pursuing an ESOP, that contractor should meet with business advisors including attorneys, lenders, certified public accountants, fiduciaries and other administrative professionals to discuss implementation and perform a feasibility analysis. This analysis will help to test the assumptions that go into an ESOP and what the expected benefits would be for employees and help to determine whether an ESOP is a viable exit strategy.
While ESOPs are not for all contractors, they can be a great succession strategy for the right organization to help transition the business to the next set of leaders. Retirement can be a challenge, but it would make it a lot easier knowing that the owner’s legacy will continue in the company.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.