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Government Contractors

ESOPs Gain in Popularity

By: John Carpenter, Principal

Many private company business owners are taking a closer look at Employee Stock Option Plans (“ESOPs”) as a tool for either an exit strategy or a way to “take money off the table” through a sale of a portion of their company stock holdings. ESOPs were a less popular diversification strategy during the 2000s when government spending was on the rise, especially within the Department of Defense (“DoD”) and many companies could sell for attractive multiples with large, upfront cash components. The combination of flat to declining DoD budgets leading to less attractive market multiples, and capital gains tax rates that approach 30 percent when factoring in federal, state, and net investment taxes, more business owners are taking a hard look at ESOPs as a diversification strategy.

An ESOP can be an excellent way for business owners to satisfy certain objectives:

  • The ESOP establishes a retirement program for employees in the company and provides an incentive for them to help increase the value of the company’s stock. This incentive can produce very positive benefits for the company’s bottom line profits, but it requires careful communication and process management with employees. Many studies have shown that on average, ESOP companies tend to be more profitable than their non-ESOP counterparts. Some of the most successful ESOP companies in the past have been government contractors, including SAIC, DynCorp, Camber Corp, and others.
  • The fair value of the company stock is established through a valuation performed by an outside valuation firm. Annual stock valuations must be performed each year that the ESOP is in effect. If the ESOP plan has over 100 participants, then the ESOP plan financial statements must be audited by an outside auditor (same as any other defined contribution plan).
  • Constructing the company valuation assumptions is an area that deserves considerable thought. Valuation assumptions must remain fairly consistent over time. ESOP companies usually strive to not show wide swings in stock price from year to year since that creates unease within the workforce. But neither can the company “manage” its earnings to insure a nice, steady upward stock price trend.
  • Owners may sell as much or as little company stock as they choose. The ESOP must purchase company shares at the valuation price.
  • If the company does not have the cash to purchase the owner’s stock, the ESOP is allowed to borrow the funds necessary to complete the transaction.
  • Some banks have specialty lending units who cater to making loans to ESOP companies. A lender’s underwriting will certainly focus on the company’s ability to generate sufficient profits to repay the ESOP loan, but specialty lenders are well versed in understanding how ESOP tax advantages are factored into the underwriting.
  • Annual contributions to the ESOP Trust (which can include contributions used to repay an ESOP loan that was taken out to repurchase shares) are fully deductible for tax purposes AND are an allowable cost under Federal Acquisition Regulation (“FAR”) Cost Principles. Thus, to the extent that a government contractor has cost-reimbursable contracts and has room in its fringe rate, the government will reimburse for all ESOP contributions.
  • A majority owner of the company owner does not have to relinquish control of the company.
  • Stock sales to the ESOP can be done repeatedly. Thus, it is acceptable for one owner to sell their shares to the ESOP at the outset, causing other owners to possibly sell part of their shares a few years later; and then perhaps make another sale to the ESOP several years after that. It is quite common that owners use the ESOP as a vehicle for a staged sale of stock over a period of years.

Some of the greatest advantages of an ESOP are the tax advantages:

  • If the company is a C corporation at the time of a stock sale, and if 30 percent or more of the company’s outstanding stock has been sold to the ESOP at the completion of the transaction, and the proceeds are reinvested in qualified replacement securities (“QRS”) within twelve months from the date of sale, the selling shareholder can defer payment of the capital gains tax on the sale of privately-held stock to the ESOP. The mechanism for accomplishing this is somewhat complex, but with proper planning the selling shareholder can avoid ever paying capital gains taxes on the stock sale and retain their ability to diversify investments as they choose.
  • If the company is an S corporation at the time of stock sale or thereafter, the ESOP creates a “tax shield” for part or all of the company’s earnings, depending upon the percentage of stock held by the ESOP. This shield results from a provision of the Tax Code which exempts taxable income, which flows to the ESOP Trust from the S corporation. Thus, for example, in the case of an S corporation that is 100 percent owned by its ESOP, the company’s earnings will be entirely tax exempt. Only a few states do not recognize ESOPs, thus earnings are exempt from all federal tax and all state tax (except that which is potentially owed to those few states who do not recognize ESOPs).
  • In the ideal situation, the company would be a C corporation at the time of each stock sale (in order to allow the selling shareholder to avoid capital gains tax on each sale), and it would be an S corporation at all other times. This is somewhat easier said than done. IRS allows an S corporation to convert to C corporation at any time. But once a conversion to C corporation has been filed, the company has to wait five years before converting back to S corporation. Through proper planning, it is sometimes possible to minimize income taxes during the five-year C corporation period and shield all taxes once the S election is again effective.

There are a number of administrative matters which require careful planning and should not be rushed. The valuation assumptions that will be used, the way that employee stock is repurchased upon retirement or termination, and planning for employees over age 55 who are permitted to diversify their holdings into other marketable securities are but a few of the momentous decisions which must be considered before an ESOP is put in place. With careful planning and execution, ESOPs can yield tremendous financial benefits for owners and long-term benefits for the employee-owners of the company.

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