Is an ESOP your best exit strategy

Many executives who own government contracting firms expect that when they are ready to retire, they will sell the firm and the proceeds from that sale will provide a significant part of the resources that will support them in retirement.

Sadly, too few of these owner/executives realize that planning for the sale needs to start years in advance.

One liquidity option available to those who begin planning early is an employee stock ownership plan, or ESOP. This valuable succession planning tool provides a flexible and broad based plan with five key advantages that facilitate retirement planning for govcon executives.

What is an ESOP?

An ESOP is a tax-qualified defined contribution retirement plan designed to invest primarily in the stock of the sponsoring employer. A leveraged ESOP transaction provides liquidity to business owners by way of outside financing. At inception, a lender provides a loan to the company often with guarantees of repayment from the company and the selling stockholder that is used to finance an initial purchase of company stock by the ESOP from the selling stockholder(s).

Each year, the company makes tax-deductible employee benefit contributions to the plan that are used to repay the loan and/or buy additional shares. The shares held in the plan are then allocated to employees over time based on a formula that may include compensation and/or years of service (years of service typically determines vesting and compensation determines allocation). An independent appraiser performs a valuation on the company every year. Individuals who are vested in the plan and who leave the company at retirement or termination of employment can sell their shares back to the employer or the ESOP.

So, how can an ESOP help government-contractor owners plan and execute an effective exit strategy?

1. The market is always there

One of the most critical mistakes that business owners make is selling at the wrong time. When attempting to sell to a strategically aligned business or a private equity firm, short-term fluctuations in the firm’s growth and profits can have a significant impact on both the pool of interested buyers and the amount they are willing to pay.

Venturing into the public market through an IPO carries similar risks and has the added burden of extensive costs associated with regulatory compliance. In addition, to valuation fluctuations, many government contractors simply are not able to identify any interested buyers for a variety of reasons (contract concentration, less interesting customer base, size, set-aside contracts, etc.), These companies can use an ESOP to create a buyer.

Once an ESOP has been created, owners have the benefit of knowing that there is always a market for their shares as long as they are not sold for above fair market value or for more than adequate consideration. Department of Labor and IRS rules require an annual independent valuation of the firm, which helps to manage some of the risk associated with short-term fluctuations in growth and profits as well as shifts in the economy.

2. ESOPs offer a wide variety of tax benefits

To date, Congress has shown a willingness to support employee ownership of businesses through ESOPs by creating significant tax benefits for companies that implement them. The benefits will vary depending on whether the business is organized as an S- or a C-corporation, but an ESOP can deliver valuable tax advantages for either entity.

With a C-corp ESOP, owners can sell stock to the plan and defer or potentially eliminate the payment of capital gains tax on the sale of any gain by following certain requirements in the Internal Revenue Code.

S-corp earnings that flow into an ESOP are not subject to federal taxes because of the plan’s status. Therefore, a 100 percent owned S Corp ESOP pays no federal (and generally no state income tax), which allows a faster repayment of the ESOP loan.

When the initial stock purchased is financed by a loan, both interest and principal payments on that debt are typically deductible up to 25 percent of eligible compensation.

In the case of government contractors that have cost-plus contracts, the principal and interest are allowable expenses and may be included in direct expenses or costs.

All stock purchases by the ESOP result in long-term capital gain treatment to the seller (sometimes deferred), often providing a significant tax rate advantage over other exit strategies that may be treated as asset sales.

3. Employee ownership can improve performance and here is why:

Studies have repeatedly shown that companies with ESOPs outperform similar companies that do not offer employee ownership plans. In one of the most comprehensive studies to-date, two Rutgers professors determined that businesses with ESOPs perform 2.3 percent to 2.4 percent higher than comparable non-ESOP businesses when it comes to sales, employment and sales per employee.

A study released in July of 2012 indicated that employment at S-corporations owned by ESOPs increased over 60 percent between 2001 and 2011, compared with roughly no change in total private nonfarm employment in the United States during the same period. The surveys point to improved levels of employee commitment at businesses that offer employee ownership plans such as ESOPs. For an owner looking to maximize the value of his or her business at retirement, an additional 2 percent annual growth in sales can have a significant impact.

4. ESOPs provide flexibility

ESOP transactions can be designed in many different ways depending on the goals of the selling shareholders in the transaction. This includes the ability to execute a sale of a minority interest in your company and maintain a controlling position, while still being able to take advantage of many of the tax benefits associated with ESOPs. Selling C-corp shareholders may be eligible to obtain all of the tax benefits of creating an ESOP with an initial sale of 30 percent of the business to the plan under IRC §1042 to defer the taxes on the sale of the stock, and many of the tax benefits even when selling less than 30 percent and foregoing the 1042 tax deferred sale).

At that level, founders who built the business can retain control and continue to consider other exit strategies while the main benefit of an ESOP to the owner is improving liquidity and providing an attractive benefit to current and perspective employees. As time goes on, the owner can choose to sell additional shares to the ESOP if it fits his or her needs.

If the ESOP owns at least 30 percent of the outstanding shares and the company is a C Corporation, the selling owner may be able to defer taxes on the gain realized from the sale. To take advantage of this “1042 exchange” tax treatment, the selling owner must use the sale proceeds to purchase qualified replacement property (QRP) consisting of stocks, bonds or notes of domestic corporations within one year of the date of the sale of stock to the ESOP. The QRP takes on the cost basis of the stock sold to the ESOP.

5. ESOPs can protect against four of the five common mistakes sellers make

In addition to the positive things that ESOPs bring to the retirement planning table, the process of creating and maintaining a plan helps owner/executives to avoid four of the five most common mistakes that sellers make. Here’s how:

• Bad Timing: ESOPs help to protect against bad timing by providing a ready market for your stock in a closely held business at any time in the business cycle.
• Failure to Plan in Advance: An ESOP is not a quick solution for retirement. Planning and implementation take time, but when done properly an ESOP can reduce some of the risk associated with planning your exit. Selling to an ESOP is generally quicker and much less painful than a third-party sale. The level of diligence is less time consuming and the transactions can be closed in a shorter time frame and with a higher degree of confidence.
• Poor Tax Planning: The tax treatment of ESOPs provides significant advantages and flexibility when compared to many other exit strategies.
  Failure to Perform a Valuation: By rule, an ESOP requires that your business be valued by an independent valuation expert at the time of the transaction and on an annual basis thereafter.
• Inexperienced Advisors: This is the one mistake that an ESOP won’t automatically prevent. However, if you ask potential advisors about their experiences creating and managing ESOPs, you should be able to evaluate whether they have the knowledge to deliver the service that you need.

Finally, one of the huge advantages for government contractors is that ESOP costs are allowable expenses under the FAR for those contractors with cost-plus contracts. Therefore, the contributions used to repay stock acquisition debt are allowed to be included in a company’s indirect rates. This is a significant benefit for contractors and should not be overlooked.

For any exit strategy to be successful, you need to start early and work with a team of talented advisors that you trust. When you start planning, be sure to ask if an ESOP might be a good option for you. Although an ESOP plan offers many benefits, it may not be right for every business.