Government Contractors Leveraging ESOPs for Competitive Advantage

At Kreischer Miller, we have many government contractor and engineering clients that are ESOP-owned and we are seeing more and more exploring the possibility. Government contractors, in particular, tend to be good candidates for an Employee Stock Ownership Plan (ESOP) since they often have predictable cash flows.

An ESOP functions much like a qualified retirement plan. It is typically used to transfer ownership from specific individuals to a plan that can benefit all of the company’s employees. A leveraged ESOP borrows money and then uses the proceeds to purchase stock from the current owners.

While the Department of Labor has numerous rules and regulations surrounding these plans that a company will need to navigate, there are many benefits of establishing an ESOP. These are a few:

  • It can decrease turnover and increase profitability. In an ESOP, all employees can become owners of the company and participant compensation is directly related to the company’s performance. These factors tend to assist with job retention and enhance company profitability, since employees who are owners and are in a position to participate in decisions that impact their work have a vested interest in contributing to the company’s success. Customers also benefit from increased employee engagement, leading to higher levels of client satisfaction and retention.
  • It can be a very tax-effective way to transfer ownership. If structured properly, owners can defer their gain on the sale of the company and future profits may be tax free. Contributions, although limited, are tax-deductible. ESOP participants do not pay tax on their value of the stock until it is redeemed.
  • It offers additional tax advantages. In most cases, when a company only borrows money, the interest, or a portion of the interest, is tax-deductible. When a company makes a contribution to a leveraged ESOP to repay a loan, the entire contribution is tax-deductible and it is not subject to the new interest expense limitation rules. And, if the company pays a reasonable dividend, the portion payable to the ESOP is tax deductible.
  • It provides multiple options for owners of closely-held companies. Owners can elect to sell all or just a portion of their ownership and they do not have to give up control. An ESOP can also be an attractive alternative – financially and otherwise – for an owner who would prefer not to sell the company outright, because the after-tax benefits to an owner can exceed offers from outside buyers.
  • Contributions to an ESOP are allowable expenses under the Federal Acquisition Regulations and can be reimbursed through cost-plus contracts.
  • Establishing an ESOP may preserve MBE status, if structured properly.
  • Costs related to departing employees can be spread out over time. When employees retire or leave the company, they are entitled to receive a cash benefit equal to the value of the stock that they have accumulated in the ESOP. With proper planning, this benefit can be paid by the company over a number of years.
  • S Corporation ESOPs may have significant advantages when purchasing other companies.

If you are looking for a flexible exit strategy beyond selling your business outright and/or you are seeking additional ways to incentivize your employees, you may be a good candidate for an ESOP. However, with so many rules and regulations surrounding ESOPs, it can be easy to “trip.” So, obtaining good professional advice is essential. The costs of establishing a plan and the annual “maintenance” costs are not negligible, but they can provide many benefits to the right contractor.

David E. Shaffer can be reached at Email or 215.441.4600.

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