Engineering Inc - July/August 2018 - 16

ESOPS AND THE ENGINEERING INDUSTRY

ESOPs are tax-qualified retirement plans that invest primarily
in the sponsoring company's stock. Because it buys anywhere
from 1 to 100 percent of the firm's stock, an ESOP creates a
market for the shares of departing owners. In certain circumstances, the sellers can defer or even avoid capital gains taxes
from the sale. ESOPs are also the only type of retirement plan
that can borrow money to finance purchases of company stock
for the benefit of employees. Finally, ESOPs provide retirement
benefits to employees and an ownership stake in the company
where they work.
The engineering industry has a long tradition of employee
ownership.
"The industry has a highly educated employee base who
understand the benefits of ownership," says Chris Staloch,
managing director of Chartwell Financial
Advisory in Minneapolis. "A lot of engineering firms are already owned 20 to 30 percent
by their employees."
According to Robert Massengill, managing director of Pilot Hill Advisors in Summit,
New Jersey, approximately 300 A/E firms have
partial or 100 percent ESOPs. Additionally,
Massengill says, many of the largest employeeowned companies are A/E firms, including
Jacobs, Parsons, HDR, Black & Veatch, Burns
& McDonnell, CDM Smith and STV.
"The ESOP model works very well for HDR
because our employees know their work
impacts their personal success as well as that of the firm," says
Rex Fisher, HDR senior vice president and director of corporate relations. "Our employee-owners are truly working for
themselves and for each other. Employee-ownership is also very
attractive to recruits."
About 80 percent of ESOP firms have fewer than 500
employees, and 39 percent have fewer than 100 employees.
In a typical ESOP transaction, the firm sets up an ESOP
trust, which is a defined contribution plan regulated under the
Employee Retirement Income Security Act of 1974 (ERISA).
The firm borrows money from a bank, investors and/or the
selling shareholder(s) and then lends it to the ESOP on a longterm loan that is typically 10-30 years in length. The ESOP
uses the funds to pay the shareholders for some or all of
their equity.
Initially, the shares are held in suspense. Each year, the
company makes a contribution to the ESOP, which uses those

funds to pay down the loan. As the loan is paid back, the ESOP
releases a portion of the suspense shares, allocating them to
employees' retirement accounts, generally in proportion to their
annual compensation.
When employees leave the firm, the company or ESOP buys
back their shares on a predetermined schedule.
SIGNIFICANT TAX ADVANTAGES

ESOPs enjoy substantial tax benefits, both for the sellers and
the buyers, because Congress has been determined over the
years to promote and expand employee ownership.
"There is a lot of bipartisan support for ESOPs," says
Staloch. "In fact, there have been a number of bills introduced
in Congress in recent years that would provide additional
incentives for companies and shareholders to adopt an ESOP
as part of the ownership structure."
The primary tax advantage for the seller to
an ESOP is the ability to utilize Section 1042
of the Internal Revenue Code, which allows
for the rollover of proceeds from the sale of
stock to an ESOP on a tax-deferred basis.
Under Section 1042, the firm must be a
C corporation at the time of the sale to the
ESOP and the ESOP must own at least 30
percent of the voting shares immediately
after the sale. Additionally, the seller cannot
receive stock as compensation and must reinvest the proceeds from the sale in a qualified
replacement property (QRP), such as corporate bonds or blue-chip equities.
If those requirements are met, the seller can defer the tax on
the capital gain realized from the sale until they sell the QRP.
The tax deferral on any QRP that has not been sold becomes
permanent upon the death of the shareholder, given the step
up in basis that would occur at that time.
For the buyers, combining a 100 percent ESOP with an S
corporation can create a tax-free entity. As an S corporation,
the firm pays no federal and, in most cases, no state income
taxes at the corporate level, passing the income tax liability
through to the shareholders. Furthermore the ESOP, as the sole
shareholder, does not pay income tax.
Contributions made by the firm to the ESOP are tax
deductible as long as they do not exceed the statutory limits.
This includes contributions made to the ESOP to repay the
loan between the ESOP and the firm-which means both the
interest and principal payment are tax deductible-as well as

Approximately
300
A/E firms
have partial
or 100 percent
ESOPs

"The most successful ESOPs are very transparent.
The leadership communicates constantly about the ESOP,
what it is and how it benefits the employees."
CHRIS STALOCH
CHARTWELL FINANCIAL ADVISORY

ENGINEERING INC.

JULY / AUGUST 2018

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