In recent years, a growing number of construction companies have established employee stock ownership plans (ESOPs). The interest in an ESOP is often generated by the need for an exit strategy for one or more of the owners of a closely held business, a common scenario in the construction industry. In fact, the construction industry, more than most industries, seems particularly drawn to ESOPs. A few reasons for this are that private equity buyers are rarely interested in construction companies and construction companies seem less likely to sell to competitors than companies in other industries. In circumstances where the business is not easily sold to a third party and/or the owners desire to provide for continuity, an ESOP can be a great solution for the owners and the company; they can obtain liquidity, and the company can operate with improved cash flow.

There are some unique issues that construction companies need to address in implementing an ESOP, particularly with regards to sureties and any new debt that is incurred by the company to complete the ESOP transaction. This post provides a brief overview on ESOPs. In future blog posts, we will address key issues relating to ESOPs for construction companies.

Brief Background on ESOPs

An ESOP is a type of tax-qualified retirement plan that primarily invests in employer stock. Like other retirement plans, the ESOP is governed by the terms of a formal plan and trust documents. The ESOP buys shares from selling shareholders, the company, or some combination of both. In a leveraged transaction, the shareholders typically sell their stock to the ESOP. The ESOP will usually purchase the stock through a combination of seller notes and cash borrowed from the company, which in turn will borrow money from a bank.

There are several tax advantages to an ESOP. One such advantage is that repayments of the principal amount of an ESOP loan can be tax deductible. To elaborate, contributions by the company to the ESOP to enable the ESOP to repay the ESOP’s promissory note are tax deductible (up to certain limits); thus, a loan used to finance an ESOP transaction can be repaid with pre-tax dollars. Another advantage is that a selling shareholder of a C-corporation may be able to elect Code Section 1042 tax deferral treatment and defer the capital gains associated with the sale of his or her shares, subject to certain requirements. Finally, the most important tax advantage is that, for companies that elect S-corporation status, the ESOP’s share of recognized earnings is ordinarily exempt from income taxes. The goal for most ESOP-owned companies is to eventually become a 100% ESOP-owned S-corporation, thereby achieving the best possible tax status.

To start the ESOP process, companies will usually obtain a feasibility study that will consider valuation, transaction size, financing, surety program impact, and the expected benefits delivered to employees over time. The ESOP process will also ordinarily consider the long-term goals and related incentives for management, including any management transition issues.