Typically built and led by a small number of founding principals, most privately owned Architecture & Engineering firms eventually reach a point where their leaders need to think about succession planning. This could be triggered by routine retirement strategy, merger and acquisition activity, or any number of personal reasons. Employee Stock Ownership Plans (ESOPs) can help facilitate succession planning while offering special advantages for owners and employees of architecture and engineering firms, including significant tax incentives. Learn more about the benefits of an ESOP and discover why you should consider one for your A&E firm.
What is an ESOP?
An Employee Stock Ownership Plan (ESOP) is a special kind of retirement vehicle that makes it possible for employees to earn an ownership stake in a company. The concept of employee stock ownership has a long and interesting origin story that reaches back as far as the 1920s. Many companies that are still big names today, such as Pillsbury, Proctor & Gamble, and Sears, developed successful early prototypes, even though the proper ESOP name had not yet been applied to these largely experimental and localized programs. The modern form of the ESOP first appeared in 1956 when an attorney for a San Francisco newspaper envisioned linking the idea to IRS policy on behalf of two founders in their 80s who wanted to retire without having to put the company up for sale.
The 1974 Employee Retirement Income Security Act (ERISA) established the outlines of the ESOP as it exists today. Many uses for the ESOP structure have developed over the years as legislation has continued to evolve, but succession planning is still the primary application. ESOPs have made it possible for generations of employees to acquire ownership stakes that would otherwise have been financially out of reach.
Why Should A&E Firms Consider an ESOP?
ESOP transactions can be beneficial to architecture and engineering firms for a variety of compelling reasons. Succession planning is certainly at the top of the list because a properly structured ESOP can make company stock ownership affordable for employees who may not have the personal financial resources to acquire an equity stake on their own. Here are seven significant Employee Stock Ownership Plan considerations for A&E firms:
- Allows for significant post-sale control by existing leadership. Typically, the existing principals continue leading the now ESOP controlled firm until the ESOP fully pays off the purchase price of the firm.
- Preserves company knowledge and goodwill with people who know the business.
- Provides a safe exit option for individual owners desiring early retirement as no.
- Alternative exit strategy option to private equity taking over, or selling to a competitor.
- Strong retention incentive for key employees and top performers who are now owners of the firm.
- Incentivizes the training and development of the next generation of managers to assume leadership of the company
- Considerable tax incentives for ESOPs that benefit the existing owners at sale, and the new employee owners going forward.
For A&E firms, when properly structured, an ESOP can be a profitable alternative to less desirable M&A transactions that may put buyer or third-party interests ahead of those of the firm’s principals, the employees or the firm itself.
What are the Cultural Advantages of ESOPs for A&E Firms?
A&E industry trends for 2023 and beyond continue to include intense competition for top talent, especially when it comes to younger workers entering the profession out of college. In addition to the emerging importance of culture, there is a persistent “work from anywhere” expectation lingering from the COVID-19 pandemic that continues to impact the labor market. These factors are forcing A&E firms to bring innovation to their hiring practices and older work models that once dominated the professional services office environment.
Employee Stock Option Plans give owners, especially in small to mid-sized firms, an opportunity to build engagement and loyalty among workers at all levels, but especially with emerging leaders. The A&E industry is notorious for talent poaching, particularly where employees have experience or relationships with marquee clients who may be attractive to competitors. An ESOP can significantly increase the “switching cost” for key employees who are anchored by an ownership stake in the long-term health and success of the firm.
Employee ownership can significantly enhance your firm’s brand, both as a supplier and as a preferred employer. Clients may perceive employee owners as more committed to delivering value and be more likely to bring you repeat business. Prospective employees may find an employee-owned company more attractive as a long-term career home. Your current top performers may be more inclined to stay with the firm when there is a real prospect of earning a meaningful ownership stake. Engagement, defined as an employee’s willingness to invest discretionary effort in the goals of the firm, also tends to increase in employee-owned companies, which in turn lifts productivity and profitability.
Tax and Accounting Aspects of ESOPs
In addition to the cultural and image value of an ESOP, there are direct and indirect financial benefits as well. As with other qualified retirement plans (IRAs or 401Ks among others), company contributions to an Employee Stock Ownership Plan are tax deductible. This type of tax deferment is subject to specific IRS regulations, but it can significantly reduce an A&E firm’s overall tax burden either through the contribution of stock or cash which in turn is converted to company stock. An ESOP sponsor may deduct the fair market value of stock contributions each tax year up to an amount equaling 25 percent of covered payroll. Both C corporations and S corporations may take advantage of specific incentives.
One upside of ESOPs for participating employees is that they pay no tax on their contributions until a distribution takes place–presumably at a more favorable rate as they enter retirement. Furthermore, distributions can be rolled over into an IRA or other qualified retirement plan without being taxed. All contributions are subject to certain IRS limits and distributions are subject to penalties if they occur before the prescribed retirement age. For the ESOP sponsor, the overall tax savings associated with ESOP contributions can be thought of as freeing up cash for reinvestment in the growth and health of the firm.
As with all tax planning considerations, it is vital to consult a qualified tax specialist when considering an Employee Stock Ownership Plan to ensure IRS code compliance and to weigh the plan’s specific tax advantages and disadvantages for your A&E firm.
Could an ESOP be Right for Your Firm?
It is no longer up for debate that Employee Stock Ownership Plans are becoming more prevalent in the A&E industry, and that a strong employee base is vital for your firm’s long-term success. To make the right decision, it is essential to have an honest conversation with your co-owners (as well as with financial experts you trust) about your firm’s eligibility, the current state of your succession plans, and the engagement of the key leaders you rely on to take care of your clients.
Here are some critical factors you will need to evaluate:
- Some entity types such as partnerships or LLCs are ineligible to set up an ESOP
- You need a management team that is ready for eventual transfer of ownership
- You need to prepare your workforce to take over future operations of the firm
- You need time to organize your firm, obtain a valuation, and put a plan in place
- You may need to take on additional debt to fund a leveraged ESOP
- You need to evaluate the company size and profitability to determine ESOP appropriateness
Once you determine eligibility, settle on how the ESOP will be funded, and make any necessary organizational changes, you will need sufficient time to implement the plan, which could realistically take from one to two years to fully plan and execute. An ESOP should be considered as carefully as any other business transaction and will require at least as much financial documentation. In general, all employees are eligible to participate in an ESOP, but firms with fewer than 20 employees may find that setting up an ESOP is not feasible.
Coordinating succession planning with an owner’s need for a viable exit strategy can be complicated, and the urgency is only going to increase as the baby boomer cohort of A&E owners moves into their retirement years. ESOPs can be a highly attractive and potentially profitable solution in this business environment. Selling to the next tier of management can be problematic, not only because they may not be able to afford a buyout, but also because they have not been properly prepared or motivated to assume the responsibilities of ownership. Starting early with a greater number of employees can help ensure the success of an ESOP for all interested parties in the employee and shareholder communities.
Continue the Conversation
Clayton & McKervey advises clients in the A&E industry on tax strategy, succession planning and overall financial reporting. If you need support with the tax and accounting aspects of ESOPs, we can help. Contact us today to learn more. We look forward to speaking with you soon about your individual business situation.