Why ESOPs Are Becoming More Popular Among Architecture and Engineering Firms
Why ESOPs Are Becoming More Popular Among Architecture and Engineering Firms
Every year, the National Center for Employee Ownership (NCEO) publishes a list of the nation’s 100 largest employee-owned companies. In 2020, architecture and engineering (A&E) firms accounted for 17 of these companies making the industry one of the most prominent on the list. Over 80% of those A&E firms utilize an Employee Stock Ownership Plan (ESOP) to achieve broad employee ownership, as opposed to other employee ownership options, such as worker cooperatives. An ESOP is a unique ownership transition tool that allocates a firm’s stock to employees over time, capturing value attributable to future growth, motivating employees and empowering them to think like owners.
ESOPs are qualified retirement plans, regulated under the Employee Retirement Income Security Act of 1974 (ERISA), which allocate shares to employees over time, typically as a percentage of total compensation. Using an ESOP as a succession planning strategy can help clearly define a firm’s ethos, especially for A&E firms that thrive on reputation, legacy and employee morale.
Maintaining Reputation and Culture
A&E firms are typically founded by a few practitioners who build a reputation that is tied directly to the founder’s name(s) and core principles. As founding shareholders approach retirement, maintaining their longstanding reputation in the community becomes one of their primary goals. A founders’ legacy is at greater risk with a typical outside sale. For example, a financial buyer will be driven to achieve a certain return and, therefore, may look to reduce overhead and other fringe benefits and a strategic buyer may have an entirely different culture to the detriment of current employees. ESOPs can create a flexible path for shareholders to transition ownership at fair market value while preserving the legacy and culture of the business.
A&E professionals are in high demand with many A&E firms facing the ongoing challenge of qualified talent shortages. This demand leads to competing firms poaching top talent by offering higher salaries and/or better benefits.
An ESOP is an effective tool to both attract and retain talent that provides year-over-year value to professionals, especially those with the longest tenure. An employee that is an ESOP participant will need to consider the “switching cost” or opportunity cost before moving to another firm. From a recruitment perspective, an ESOP makes attracting young and qualified professionals easier by enticing them with an immediate opportunity to build equity in the business and could be the key differentiator, not only due to the financial benefits but also due to the culture of the business. There has been a pattern of established A&E firms that have a group of key managers that are ready to become owners but do not have the financial resources to buy out current shareholders. This creates a dilemma for A&E firms that would like to retain their most senior and key employees that are seeking ownership but do not have a mechanism to provide meaningful ownership in the firm. An ESOP can be an attractive option for these firms.
ESOPs can provide a range of tax benefits to the sellers and the firm, including potential deferral of capital gains for the seller on the sale of the business, reduction or elimination of the income tax burden to the firm, deductibility of ESOP contributions and an opportunity for tax-deferred growth on the retirement benefit to employees.
If the firm transacts as a C Corp, according to Section 1042 of the Internal Revenue Code, the sellers may be able to indefinitely defer paying tax on capital gains derived from the sale. When the seller passes away, his or her estate receives a step-up in basis, making the deferral permanent. If following the sale, the ESOP-owned firm is an S Corp, all income that is attributable to the ESOP shares is passed through to an income tax-exempt qualified retirement plan, making that income exempt from federal income taxes and most state income taxes. This creates a cash flow advantage for the firm, with the extra cash available to be used to pay off debt created by the leveraged ESOP sooner and grow the business in a more efficient and effective manner.
In the case of a legacy C Corp transaction where a seller elects Section 1042 treatment, in some circumstances, the firm can immediately convert to an S Corp following the transaction, enabling both capital gains tax deferral for the seller and an income tax exemption for the firm. If the firm chooses to convert from an S Corp to a C Corp for the transaction, the firm must remain a C Corp for five taxable years. Thereafter, the firm can make an “S” election and benefit from an income tax exemption. As an employee-owned C Corp, the firm realizes a tax benefit through the deductibility of ESOP contributions and optional dividends to the ESOP. Finally, since the ESOP is a qualified retirement plan, much like a 401(k) plan, participants benefit from tax-deferred growth, paying ordinary income tax when distributed from the plan, usually when the employee retires. There are clear tax advantages for all parties in an ESOP transaction, making the ESOP structure a win-win scenario for all.
ESOP Issues Unique to A&E Firms
The A&E professions are highly regulated, demanding a proactive approach to compliance and posing significant challenges with respect to the sale of stock. Each state has unique requirements and restrictions on corporate structure, ownership, nomenclature and supervisory functions. These requirements can vary by type of license that the firm is seeking—architecture, landscaping architecture, engineering, surveyor, geologist, etc. Any transaction will directly affect corporate structure and ownership. In most cases, entity type will not prevent an A&E firm from doing business, but it is important to ensure that the transaction structure follows the relevant rules in each state. With respect to an ESOP transaction, close attention should be paid to ownership restrictions in each state in which the firm does business or plans to conduct business. In an ESOP structure, a trust becomes the direct owner of the shares, while the employees are considered beneficial owners once vested. When applying ownership rules, states may look at the trustee(s) of the ESOP, the beneficial ownership of the participants or neither.
Here are several examples of differences in state licensing and ownership rules:
- Arizona: The voting shares of a professional corporation are limited to licensed individuals, certain partnerships, other persons if total ownership of other persons does not exceed 49% and ESOPs. In the case of an ESOP, all voting trustees of the plan are required to be licensed in Arizona and the ownership interest must be directly owned by the employee stock ownership trust or licensed professionals.
- Iowa: There are no specific ownership restrictions for architecture or engineering firms, but professional services are limited to firms that regularly employ one or more licensed professionals who directly control and service any professional work.
- North Carolina: Professional corporations that practice architecture or engineering must be at least two-thirds owned by licensed professionals in the relevant profession and at least one licensee must be a North Carolina licensee, as well as an officer, director or shareholder. IRC section 401(a) qualified defined contribution plans, such as an ESOP, are considered “licensed” if the trustee or trustees of the plan are licensees. To further add to the complexities, North Carolina does not allow business entities to be owners in a professional corporation, which can limit the transaction structure possibilities in any M&A transaction.
- Ohio: Architecture firms must be owned 50% or more by licensed professionals. In the case of an ESOP, 50% of the trustees must be licensed in the relevant profession. There are no specific requirements for engineering firms, however, each firm must designate one or more owners or directors as being responsible for and in charge of professional activities.
These examples clearly illustrate that understanding and navigating state licensing and ownership requirements is challenging and requires expertise. In any transaction, extensive state-by-state due diligence should be performed.
Client Success Story: Real Life Example
A civil engineering firm (Firm) recently decided to pursue an ESOP using BDO’s ESOP Advisory Services team as their exclusive financial advisor to the transaction. The Firm was founded over 60 years ago, headquartered in the mid-Atlantic, offering a variety of engineering services to a diversified group of markets in the public and private sectors. At the time of the transaction, the Firm conducted business in seven states (including North Carolina) and had plans to expand into four additional states in the immediate future. While most of these states did not provide any challenges to the ESOP structure, North Carolina’s ownership restrictions created a significant transaction hurdle. As described above, North Carolina requires that at least two-thirds of the owners be licensed professionals. A look through to the trustee(s) or participants is not acceptable.
After careful research and analysis, BDO advised the Firm of an exemption to the ownership requirement. For engineering firms doing business in North Carolina, there is an exemption for corporations or limited liability corporations that were permitted by law to practice engineering before June 5, 1969. These “pre-1969” entities must apply to the North Carolina Board of Examiners for Engineers and Surveyors for the exemption. However, for architecture firms, this exemption must have been applied for from the North Carolina Board of Architects before October 1, 1979.
Having advised and structured several ESOP transactions for A&E firms across the country, BDO was able to give the owners comfort on licensure requirements, as well as safeguard that future growth plans would not be limited by the transaction. BDO successfully facilitated the Firm’s transition to a 100% employee-owned company, allowing it to realize many of the benefits outlined above.