An Employee Stock Ownership Plan (ESOP) is often touted as a tax-savvy succession planning tool for business owners. But an ESOP has many other features that may be attractive to construction companies, including providing a vehicle for saving for retirement, as well as rewarding employees with an ownership stake in the business they are helping to build. In addition to providing tax incentives that can ease the ownership transition process, an ESOP can create a company culture that promotes employee productivity, accountability, loyalty, and engagement.
An ESOP is an employee benefit plan that is similar in some ways to a profit-sharing plan, but is unique among benefit plans in its ability to borrow money. In an ESOP, a company sets up an Employee Stock Ownership Trust, an independent entity that has its own accountants and legal counsel. The company contributes to the trust new shares of its own stock or cash to buy existing shares, or the ESOP borrows cash from an outside lender or the seller to purchase new or existing shares in the company. The company then makes tax-deductible cash contributions to the plan that the trust uses to repay the loan. By selling stock on a gradual basis, owners can initiate a financial transition in their company, while remaining involved in the business for a period of time.
Like 401(k)s, ESOPs are company-sponsored, tax qualified, defined benefit retirement plans. Thus, many of the IRS and Labor Department regulations that govern those plans also govern ESOPs. However, while other defined contribution plans are required to own stock in a broad portfolio companies, an ESOP must be primarily invested in company stock; though limited diversification may be permitted for participants aged 55 and older. Shares in the trust are allocated to individual employee accounts, and all full-time employees over age 21 are generally eligible to participate in the plan. The share allocations may be made on the basis of relative pay, years of service, or another approved formula. Under ESOP rules, employees must be fully vested within three to six years, depending on whether the vesting occurs all at once or gradually. The participating employees are granted voting rights on company decisions, but their rights may be more limited in a private than in a public company.
When an employee leaves the company, the plan either distributes the fair market cash value of the stock at the time of distribution, or permits the employee to sell the distributed stock to the employer at the fair market value. The distributions may occur in a lump sum or installments. Participants have the option of paying tax on the gains at the time of distribution, or they can roll over their distribution into another qualified plan that defers taxation, such as an IRA. However, the income tax share of the distributions is subject to a 10% penalty if the distribution is made before the normal retirement age.
Despite the substantial benefits associated with ESOPs, the plans have some limits and disadvantages. Most significantly, repurchasing the shares of departing employees can be costly for private companies. Construction contractors considering setting up an ESOP should also take into account the potential impact on their leverage and bonding capacity, as a surety may lower the bonding capacity for construction companies with high levels of debt. Contractors with bonding requirements may wish to mitigate the reduction in the company’s net worth by limiting their leverage, or selling stock to the ESOP gradually without taking on debt. Yet having an ESOP can also be an advantage for contractors in the surety underwriting process, because it demonstrates that the company is committed to retaining key employees and to continuing operations after the founding company owners retire or sell their shares.