ESOPs as a Business Succession Tool For Small or Mid-Sized Construction/Engineering Firms

By Harvey Katz

Many engineering and construction firm owners will be retiring in large numbers in the coming years. Those whose children don’t want the family business face a dilemma. With more “baby-boomer” sellers than buyers, buyers are likely to be highly selective and very parsimonious.

Employee Stock Ownership Plans (ESOPs) are a viable business succession alternative. In concept, sale to an ESOP is simple. Instead of selling to a third party, the owner sells to a trust established and operated by the firm for the benefit of its employees. To finance the purchase, the ESOP borrows from a bank or the business owner himself. The shares of the business are collateral for the loan. As the business operates, it makes contributions to the ESOP until the loan is repaid. Otherwise, the ESOP operates like a 401(k) or profit sharing plan, except that it invests in employer stock. While ESOPs cover all full-time, non-union employees, they never directly own company shares, have access to the company's finances or have a say in day-to-day decisions. Nevertheless, ESOPs are powerful productivity incentives, as employees view themselves as part owners. There are substantial tax incentives to owners who sell to ESOPs and companies that operate as ESOPs. Usually, the owner can avoid payment of capital gains tax otherwise payable upon the sale of the business. In addition, both principal and interest on the loan to purchase the company are repaid with pre-tax dollars. More importantly, once the ESOP acquires 100 percent of the firm, it can elect Subchapter S status, allowing it to pass through profits to its tax-exempt ESOP shareholder and operate as a tax-free company.  

Another more practical advantage is that unlike a third-party buyer, an ESOP will rarely back out at the eleventh hour. Sale to an ESOP also requires much less disruption of business and the owner can sell shares gradually, relinquishing control at a time of his or her choosing. Third parties usually demand complete control from day one. Additionally, any additional cost of structuring a sale to an ESOP is easily outstripped by the tax savings. ESOPs are also useful if only some of the owner’s children want to participate in the business. Giving stock to children who don’t participate in the business is likely to cause strife among siblings. The ESOP can purchase the stock of non-participating children for cash. Here's when to consider an ESOP:

  • Firm is worth $2 million, or with profits of $400,000 a year;
  • Firm has a recent history of profitability and/or strong prospects of future profitability;
  • There are two to three individuals capable of assuming a lead management role in the next five years;
  • Firm is a corporation or capable of being converted into one.

Other helpful, but not essential, factors:

  • Current owners want to gradually transition out;
  • Owners want to reward employees for their service;
  • Employees are likely to be incentivized by ownership in the company.

Harvey Katz is co-chair of Fox Rothschild’s Employee Benefits & Compensation Practice. For more information, please contact him at 212.878.7976 or [email protected].

Have an idea for a guest blog for Construction Today? Contact [email protected] or [email protected].

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