Succession Planning Considerations as Year-End Approaches
When the ball finally drops to introduce 2020, organizations will hopefully look back fondly at 2019 as a successful year. For many, business has been very good. So good, in fact, that the consensus seems to suggest the biggest obstacle facing construction companies today is a lack of talent to complete the work.
For many businesses, this is the season for planning, including annual budgeting. Organizations should invest time with their management team to update business plans for the year ahead. The same can be said of ongoing succession and continuity planning.
Succession and continuity planning begins with establishing your goals and objectives and ends with your successful transition. In between, your business actions should focus on and contribute to growing transferable value, which includes developing a capable management team. If you work at this every day and your business and personal plans are aligned, you’re much more likely to achieve your ultimate goals.
As you contemplate the coming year, consider the following objectives:
- Preserving Value – Is your company doing everything it can to reduce its tax liability?
- Protecting Value – What steps should your company take to protect its value from creditors?
- Promoting Value – What areas does your organization need to improve to increase company value?
- Business Contingency Planning – What must be done to help ensure your business will continue in the event you lose a member of leadership, financial resources, vital talent or key customers?
- Wealth Preservation Planning – What can you do to reduce estate taxes, treat all children fairly, provide financial security for your family and, if applicable, transfer the business to one or more of your children?
- Transfer Objectives – Are you on track to transfer the company to the party of your choice on your desired timetable—and at a price that meets your personal needs and goals?
When it comes to transfer objectives, owners should consider their business, financial and personal goals to arrive at the best option. Owners’ goals often include receiving ample proceeds to meet retirement goals, continuing the company legacy, keeping the business in the family, rewarding key employees and exiting within a specific time frame.
In general, there are a finite number of ownership transfer choices. In the construction industry, these often include sale to an outside party (this is often a company looking to expand its footprint), management buyout or an employee stock ownership plan (ESOP). For family businesses, options also include the sale and/or transfer to children. In this case, it’s paramount to align transfer plans with estate plans.
Each option carries with it both financial and nonfinancial considerations. Selling to an outside party is typically completed faster and often at a higher price. Management buyouts, when funded solely with company cash flow, typically take the longest time to complete. But when structured properly, the owner can continue to participate in growing company value and have a say in the organization’s direction and legacy. For companies large enough to support it, an ESOP can provide fair market value to the owner and maintain company legacy.
More on ESOPs
As 2019 comes to a close, interest in ESOPs among construction companies continues to run high. An important characteristic of an ESOP is its ability to borrow money to purchase company stock—a leveraged ESOP. This is similar to a traditional leveraged or management buyout—but with significant tax advantages and greater employee participation in growth. The ESOP can purchase any percentage of the company’s stock. Due to significant potential tax savings, many companies are choosing to become 100 percent ESOP-owned.
Not only can the ESOP pay fair market value for the owner’s stock, but the sale transaction can be structured to create tax advantages for the seller. In general, the ESOP purchases stock instead of company assets. Sellers with a holding period longer than one year can take advantage of long-term capital gain rates. In addition, a seller financing all or part of the purchase price can opt for installment treatment, allowing the seller to pay the capital gains tax as the seller note is repaid.
Sellers taking back a note may be provided with detachable warrants as an interest rate enhancement for financing a portion of the transaction. The warrants are considered part of the overall financing package, along with the cash payments of interest. Because a leveraged ESOP can deduct principal payments on debt used to purchase company stock, a significant portion of the transaction can be repaid with company tax savings.
There are even greater benefits for ESOPs taxed as S corporations. The portion of the company’s earnings attributable to the ESOP is exempt from federal and most state income tax (except in states that don’t recognize S corp status). When an S corp is 100 percent owned by an ESOP, the potential for savings is even greater. In this case, the company no longer pays federal or, in general, most state income taxes.
As the company makes contributions to the plan each year, the ESOP uses those contributions to make payments on the ESOP loan. These loan payments trigger the release of shares, which are then allocated to eligible participants. This allocation typically is on a pro rata basis according to each employee’s eligible compensation.
Key management members will usually participate in the ESOP along with other employees. However, to help retain key management and properly align goals and objectives with the ESOP, it’s often important to provide additional equity incentives, such as incentive stock options or stock appreciation rights. Such incentives, when taken into consideration with the total compensation package, must be considered reasonable by the ESOP trustee.
Planning & Your Objectives
In this year-end season of planning, set aside time to work on your business plans, as well as your business transfer and succession plans. If you’re not working toward these objectives, consider reaching out to your team of advisors for guidance. Perhaps a New Year’s resolution could be to establish an annual planning and checkup process. If you’re not sure where to start, reach out to your BKDnext® trusted advisor or use the Contact Us form below.