Employee stock ownership plans are rewarding for your staff, allow for continuity, and can enhance a firm’s culture and legacy.
Editor’s note: Wintrust Commercial Banking is a sponsor of the 2018 Hot Firm + A/E Industry Awards Conference in Dallas.
Wintrust is excited to be making its first appearance at the Hot Firm + A/E Industry Awards Conference, hosted by Zweig Group, this year in Dallas. Our focus is to bring current ESOP finance information to the engineering profession. Our dedication to both ESOP and AEC firms creates significant advantages for the design industry, and we look forward to sharing our expertise with the conference’s attendees.
When it comes to transitioning a business, a selling shareholder has finite options, including a strategic buyer, private equity, the management team, or an ESOP. None of these options are created equal, so the idea of selling all or a part of your business to an ESOP may make sense for many reasons.
First, because an engineering firm’s primary assets are its employees – not its equipment or facilities – the ESOP alternative is a natural fit for rewarding them. In people-driven businesses, we find that this ownership vehicle serves the surviving company, post-sale, very well through strong accountability and attention to detail in all business aspects. Further, ESOP ownership assists with both recruiting and retaining its employees. There is no other ownership transition alternative that allows for all qualified employees to benefit, without monetary contribution, to ownership of the company. When properly communicated, this benefit has a significant and positive influence on your talent.
Second, in most successful businesses, ownership has created a strong culture, and ownership is not ready or willing to dismantle what it’s built. In fact, with focused attention when transitioning a business to an ESOP, we most commonly see an enhancement of the legacy. Importantly, a driving factor behind maintaining the company’s values lies with the fact that most selling shareholders not only remain active in leading the business they just sold, but oftentimes maintain the same role post-transaction as they held pre-transaction. ESOP ownership allows for consistency, which does not necessarily exist in other ownership transition alternatives.
Finally, ESOP ownership offers significant tax advantages to both the selling shareholders as well as the surviving company. These tax advantages should be well understood before a shareholder commits to a preferred sale path. ESOPs can only take the form of a C-corp or an S-corp. Because in its simplest form an ESOP is a qualified benefit plan, the contributions it makes to the trust, established to house the employees, are tax deductible, thereby reducing taxable income.
A further benefit in a C-corp scenario is offered to the selling shareholders. In the case where at least 30 percent of the company is sold to the ESOP, the selling shareholders have the ability to elect a tax deferral of the capital gains of the transaction. In the case of an S-corp ESOP – assuming a 100 percent sale – the surviving S-corp ESOP is a federal tax exempt entity, and therefore is not subject to federal taxation.
In this scenario, the selling shareholders are not eligible for the election of tax deferral under Section 1042 of the Internal Revenue Code. It is important to note that an S-corp has the ability to convert to a C-corp pre-transaction in order for the selling shareholders to utilize the Section 1042 deferral. However, there are certain restrictions governing the time periods for converting back to an S-corp. Depending on the transactional structure, a selling shareholder may participate in the ESOP and/or receive synthetic equity to further enhance the return to a selling shareholder.
It is important to surround your engineering firms with banking partners who are experts in your industry, and understand the day-to-day challenges business owners face. Wintrust is among a few commercial banks that, on a national basis, brings a dedicated team of professionals to provide financing to both the ESOP and AEC space. Consequently, we remain enthused about bringing ideas and much needed education to a business transition alternative that has long been misunderstood.
We look forward to meeting you in Dallas in September.
James Swabowski is senior vice president; Pat Stoltz is managing director; and Matt Doucet is managing director in the commercial banking group at Wintrust Financial. They can be reached at email@example.com; firstname.lastname@example.org; and email@example.com.