Many small and medium sized companies wonder if having an Employee Stock Ownership Plan (ESOP) is right for their company’s compensation and ownership structure. Studies show that employee-owned companies benefit from higher worker productivity and certain tax advantages which ultimately result in improved cash flow. These and other potential advantages could apply to government contractors; however, if you are considering implementing an ESOP, consider engaging someone (or an entity) familiar with ESOPs, as well as someone familiar with the cost allowability (regulations) and DCAA interpretations.
(NOTE: There will be a second blog, ESOPs Part II, which will focus on cost allowability regulatory considerations as well as potential cost unallowability interpretations by DCAA.)
1. What is an ESOP?
- An ESOP is a qualified retirement plan that facilitates the transition of a company’s ownership from its current shareholders to its employees. ESOPs are individual stock bonus plans designed specifically to invest in the stock of the employer corporation
- IESOPs can be either leveraged or non-leveraged.
- ESOP contributions may be in the form of cash, stock, or property, and are administered by an Employee Stock Ownership Trust (ESOT).
- Each year, the company makes tax-deductible employee benefit contributions to the plan which are used to repay the loan and/or buy additional shares.
- The shares held in the plan are then allocated to employees over time based on a formula that may include compensation and/or years of service (years of service typically determines vesting and compensation determines allocation).
- An independent appraiser performs a valuation on the company every year that the company acquires stock for the ESOP participants. Individuals who are vested in the plan and leave the company at retirement or termination of employment can sell their shares back to the employer or the ESOP.
2. What is a Non-Leveraged vs. Leveraged ESOP?
- Annual contributions are made by the Corporation to the ESOT in the form of stock, cash or property. If the contribution is in the form of cash, the ESOT uses this cash to acquire company
- The ESOT holds the stock for the employees, and periodically notifies them of how much they own and how much it is
- The employees receive the stock (or the cash equivalent) when they retire or otherwise leave the company (depending upon the provisions of the ESOP). In virtually all cases for non-publicly traded corporations, the company or the ESOT has the rights to re-purchase the shares.
- The ESOT borrows money, usually from a bank, and then uses these funds to purchase company stock, either from existing shareholders or from the company g., treasury stock.
- This stock then becomes collateral for the bank loan.
- Each year the company makes a contribution to the ESOT equal to the total amount of the principal and interest on the loan.
- The ESOT then uses this money to make its annual payment to the bank.
- Upon receipt of the ESOT loan payment, the bank releases an amount of stock in proportion to the loan principal paid by the ESOT.
- The released stock is then distributed by the ESOT to the accounts of the plan participants in accordance with the provisions of the plan.
- The employees receive the stock (or the cash equivalent) when they retire or otherwise leave the company (depending upon the provisions of the ESOP).
3. Are ESOP Costs Allowable?
YES! CAS 412 – Pension Costs and 415 – Deferred Compensation Costs were amended, and ESOP costs should be:
- Measured by the contractor’s contributions, which include interest and dividends.
- Assignable to the cost accounting period to the extent that the stock, cash, or any combination of the contribution is awarded to employees.
- Allocated to individual employee accounts by the tax filing date for that period.
4. How Does DCAA Review/Audit ESOP Costs and Plans?
DCAA will review the following:
- Terms of the ESOP to determine if the plan to certain employees or groups of
- Reasonableness of the amount of stock distributed to employees’ ESOP accounts in conjunction with a review of the employees' total
- Allowable costs incurred and recorded to the proper accounting period.
- Verify contributions have been made.
(NOTE: ESOPs Part II will be a detailed discussion of cost allowability criteria as well as DCAA interpretations which could result in challenges to cost allowability).
5. Tax Benefits
A company can reduce or eliminate its tax burden by implementing an ESOP since contributions of cash and stock of up to 25% of qualified payroll are tax deductible. Since government contractors’ labor costs make up a significant portion of its operating expenses, the annual contribution limit is usually at the higher end of the range when compared with other employee-owned companies of similar size. Additional tax advantages:
- Deductibility of ESOP Contributions and Dividends
- Seller’s Ability to Defer Taxes from the Proceeds of Sale of C-Corporation
- Tax Free Ownership (S-Corporation) and other Unique S-Corp Tax Advantages
- Tax Deferral for Employees
At Redstone Government Consulting, we are qualified to assist your business with the ins and outs of ESOPs, and offer HR services to both small and large contractors, with the knowledge and skills to assist in the preparation of compensation plans. We also are knowledgeable about the unique needs of government contracting and provide special consideration of your organization’s goals and culture.