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 5 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 govcon 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 govcon’s 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 govcons 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. The 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% 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% of eligible compensation.
- In the case of govcons 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.
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