{"id":3850,"date":"2019-02-21T16:14:55","date_gmt":"2019-02-21T21:14:55","guid":{"rendered":"https:\/\/www.stevenslee.com\/sesesop\/?p=3850"},"modified":"2026-07-21T16:16:43","modified_gmt":"2026-07-21T20:16:43","slug":"why-should-architectural-firms-consider-selling-to-an-esop","status":"publish","type":"post","link":"https:\/\/www.stevenslee.com\/sesesop\/resources\/why-should-architectural-firms-consider-selling-to-an-esop\/","title":{"rendered":"Why Should Architectural Firms Consider Selling to an ESOP?"},"content":{"rendered":"<p class=\"wp-block-paragraph\">When contemplating a sale of their business, the owners of a Company have several alternatives to consider. They can (1) sell to a financial investor (private equity or family office); (2) sell to a strategic investor (another business who wants to expand into the Company\u2019s markets); (3) sell to the Company\u2019s management\/key employees; (4) sell to an Employee Stock Ownership Plan (ESOP); or (5) sell to \u201cthe public\u201d (an IPO).<span id=\"more-14827\"><\/span><\/p>\n<p class=\"wp-block-paragraph\">Each of these alternatives provides different degrees of:<\/p>\n<ul class=\"wp-block-list\">\n<li>Liquidity to current owners;<\/li>\n<li>Continuity of management\/control;<\/li>\n<li>Incentive to managers and key employees; and<\/li>\n<li>Preservation of company culture and legacy.<\/li>\n<\/ul>\n<p class=\"wp-block-paragraph\">For architectural (and other professional service) firms, the issue is complicated by the fact that the Company\u2019s greatest assets \u2013 their employees \u2013 walk out the door every day.\u00a0 Furthermore, the culture of many architectural (and engineering) firms is that ownership is perceived as being tied closely to success.\u00a0 In other words, \u201cownership\u201d is part of the culture of these firms.\u00a0 For these reasons, most architectural many architectural (and engineering) firms focus on the management buyout and ESOP alternatives.<\/p>\n<p class=\"wp-block-paragraph\">One problem with the management buyout is that it is enormously inefficient from a tax perspective.\u00a0 Few, if any, employees have the financial means to buy a meaningful amount of equity.\u00a0 Management buyouts are typically financed by the seller (either directly, or through the Company).\u00a0 Repayment of the leveraged financing is funded by paying bonuses to the purchaser (which are taxable to the purchaser as ordinary income), who in turn uses the after-tax funds to pay the seller (which payments are taxable to the seller, typically, as capital gains).\u00a0 The combined tax rate \u2013 depending on what state\/city and tax bracket the purchaser and seller are in \u2013 can be substantially greater than 50%!\u00a0 This approach may also create tension between those employees\/ shareholders who are and are not included in the buyout.\u00a0 The ESOP alternative solves both of these problems.<\/p>\n<h3 class=\"wp-block-heading\"><strong>What an ESOP Is<\/strong><\/h3>\n<ul class=\"wp-block-list\">\n<li>An ESOP is an \u201cEmployee Stock Ownership Plan\u201d \u2013 not to be confused with a \u201cstock option\u201d plan.<\/li>\n<li>ESOPs are tax-qualified retirement plan for employees, with three special attributes:\n<ul class=\"wp-block-list\">\n<li>They are designed to invest primarily in \u201cemployer securities\u201d (the stock of the Company sponsoring the plan);<\/li>\n<li>They can borrow money;<\/li>\n<li>They can engage in a transaction with a \u201cparty in interest\u201d (the current shareholder(s) who wants to sell stock).<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<p class=\"wp-block-paragraph\">Together, these special attributes create a qualified retirement plan that can borrow funds, and buy the Company which sponsors the Plan, from its shareholders.<\/p>\n<p class=\"wp-block-paragraph\">Congress structured the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (the Code), specifically to encourage ESOPs.\u00a0 An ESOP is a defined contribution plan which is a \u201cqualified plan\u201d under the Code.\u00a0 All employees who work 1,000 hours are eligible to participate in the ESOP.\u00a0 Each participant has an account (like a 401(k) plan).<\/p>\n<p class=\"wp-block-paragraph\">ESOPs have been around since ERISA was created in 1974.\u00a0 Originally, only C-corporations could sponsor an ESOP.\u00a0 In 1998, Congress expanded ESOPs to include S-corps.\u00a0 As qualified retirement plans, ESOPs are regulated by the IRS and the DOL.<\/p>\n<h3 class=\"wp-block-heading\"><strong>What an ESOP Is NOT<\/strong><\/h3>\n<ul class=\"wp-block-list\">\n<li><strong>Myth\u00a0\u2013 Owners are \u201cgiving\u201d the Company to the employees.<\/strong>\n<ul class=\"wp-block-list\">\n<li><strong>Facts<\/strong>:\n<ul class=\"wp-block-list\">\n<li>Owners are only \u201cgiving\u201d away the future appreciation (less the return on the cash proceeds, and the seller financing) of the shares sold to the ESOP.<\/li>\n<li>ESOP Trustee cannot pay more than \u201cadequate consideration,\u201d which is fair market value of shares as determined by the Trustee in good faith with the assistance of an independent appraiser.<\/li>\n<li>The legal standard of fair market value is: \u201cthe price at which an asset would change hands between a willing buyer and a willing seller when neither is under a compulsion to buy or sell and both parties are well informed.\u201d<\/li>\n<li>To the extent that there is a competitive sale process, ESOP will likely not be able to match the price. However, it is often close to \u2013 and may even exceed \u2013 the after-tax proceeds received from a competitive process.<\/li>\n<li>In addition, Sellers may retain a significant part of the \u201cupside\u201d in value, through seller financing.<\/li>\n<li>Because of the tax advantages of the ESOP, the seller financing can be paid much more quickly than using a management buyour.<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<\/li>\n<li><strong>Myth\u00a0\u2013 Employees can examine the Company\u2019s books.<\/strong>\n<ul class=\"wp-block-list\">\n<li><strong>Facts<\/strong>:\n<ul class=\"wp-block-list\">\n<li>Participants must receive an annual statement the showing value of their shares, but detailed financial information is not required to be disclosed.<\/li>\n<li>Some companies, as a matter of culture, choose to share some level of detailed financial information, but that decision is up to the Board of Directors.<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<\/li>\n<li><strong>Myth\u00a0\u2013 Employees will control of the Company.<\/strong>\n<ul class=\"wp-block-list\">\n<li><strong>Facts<\/strong>:\n<ul class=\"wp-block-list\">\n<li>If current owners maintain majority ownership, this is simply not true.<\/li>\n<li>Even if the ESOP owns 100% of the Company, the Company will continue to be managed by its Board of Directors and executive officers.<\/li>\n<li>The ESOP Trustee \u2013 not the employees \u2013 elects the Board of Directors. The Board appoints management and manages the Company.\u00a0 The ESOP can even be designed so that the Trustee is \u201cdirected\u201d by the Board.<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<\/li>\n<li><strong>Myth\u00a0\u2013 Significant Transaction Costs<\/strong>\n<ul class=\"wp-block-list\">\n<li><strong>Fact<\/strong>:\u00a0 The transaction costs are usually lower than selling to an outside party and are more than offset by tax savings.<strong>How a Leveraged ESOP Transaction Works<\/strong>In (relatively) simple terms, this is how an ESOP transaction works:\n<ol>\n<li>The Company borrows funds from a senior (bank) lender. If the transaction size exceeds the Company\u2019s bank borrowing capacity, the Company borrows the balance of the funds from the selling shareholder using subordinated debt \u2013 effectively, the seller taking back a promissory note.\u00a0 Together, the senior bank loan and the seller subordinated loan are referred to as the \u201cOutside Loan.\u201dThe Company can pay the \u201cOutside Loan\u201d as quickly as possible \u2013 first to the bank, and then to the selling shareholder.\u00a0 The portion of the Outside Loan funded by the sellers, provides an attractive rate of return, which typically includes a portion of the future value of the Company.\u00a0 In a typical 100% ESOP transaction, the \u201cOutside Loan\u201d takes a total of 8 \u2013 10 years to repay.<\/li>\n<li>The ESOP borrows the proceeds of the Outside Loan, from the Company. This loan (from the Company to the ESOP) is referred to as the \u201cInside Loan.\u201d<\/li>\n<li>The ESOP uses proceeds of the Inside Loan to purchase shares from existing shareholders. The portion of the purchase price funded with the senior (bank) loan, is paid to the Sellers in cash.\u00a0 The purchased shares are held in an \u201cESOP Suspense Account\u201d as collateral for Inside Loan.<\/li>\n<li>The Company makes tax-deductible contributions to the ESOP, which the ESOP uses to repay the Inside Loan.\u00a0 These two payments (from the Company to the ESOP, and from the ESOP to the Company) are cash neutral to the Company, but nonetheless give the Company a tax deduction.\u00a0In a typical 100% ESOP transaction, the \u201cInside Loan\u201d is repaid over 20+ years.\u00a0 This is because (as explained below), the time over which the Inside Loan is repaid, controls the allocation of shares from the ESOP Suspense Account to ESOP participant accounts.<\/li>\n<li>With each Inside Loan payment by the ESOP to the Company, a pro-rata tranche of shares is released from the ESOP Suspense Account and allocated to ESOP participant accounts.\u00a0 The allocation formula (similar to a profit-sharing plan) is typically based on each participant\u2019s relative share, of the Company\u2019s aggregate \u201celigible compensation\u201d expense for that year.\u00a0 The Inside Loan is paid over a longer period, so that shares are allocated gradually, providing a reasonable level of employee benefits.<\/li>\n<\/ol>\n<p><strong>Retirement Plan Attributes of ESOPs<\/strong><\/p>\n<ul>\n<li>The ESOP is managed by a Trustee, who is a fiduciary. There are professional ESOP Trustees who are expert in (a) analyzing and negotiating ESOP transactions; and (b) managing ongoing ESOPs.\u00a0 Some companies use professional trustees for (a), and internal trustees (an employee, or committee made up of employees) for (b).\u00a0 Internal trustees are permitted to fulfill both functions but, as fiduciaries, they will be held to the \u201cprudent expert\u201d standard in doing so.<\/li>\n<li>ESOP recordkeeping is done by a third-party administrator (TPA) who is expert in ESOP account administration.<\/li>\n<li>The value of the stock purchased or owned by the ESOP is determined, at the time of the ESOP transaction and annually thereafter, by the Trustee with the assistance of a qualified independent financial advisor.<\/li>\n<li>Participants become vested in their accounts in the same manner as other defined contribution plans: 3-year \u201ccliff-vesting\u201d (no vesting for the first three years of participation in the plan, after which they become 100% vested in their ESOP account); or six-year graded vesting (no vesting for the first two years, after which they become vested in their account 20% per year after years 2 \u2013 6).<\/li>\n<li>Generally, participants may elect to receive distributions from their ESOP account only after termination of their employment. These distributions are spread over five years, and commence\u00a0<em>either<\/em>\u00a0(a) in the year following termination of their employment, if termination is due to death, disability, or \u201cnormal\u201d retirement; or (b) in the sixth year following termination of their employment, if termination is for any other reason (voluntary or involuntary, with or without cause).<\/li>\n<\/ul>\n<p><strong>Advantages of an ESOP<\/strong><\/p>\n<ul>\n<li><strong>Ownership Transition Structure<\/strong>\u00a0\u2013 In a well thought out management buyout, plans must be made for how and when the sellers will be paid, who will receive shares, how the shares will be valued, to whom will other current shareholders sell their stock when they want to leave, what will happen the new shareholders leave, how ongoing employees will be incentivized, and how the risks and rewards of future financial performance will be allocated among buyers and sellers. An ESOP addresses all these issues, with answers that have proved successful over many decades and thousands of transactions.<\/li>\n<li><strong>Continuity and Legacy<\/strong>\u00a0\u2013 Current shareholders can choose to remain active in the Company \u2013 or not. An ESOP also provides for subsequent ownership transitions \u2013 long after the current shareholders have retired.<\/li>\n<li><strong>Bank Financing for ESOP Transactions \u2013\u00a0<\/strong>Banks compete for opportunities to lend money for ESOP transactions. This senior financing provides a substantial portion of the value of the purchased shares, which is paid to the Sellers at the closing of the ESOP transaction.<\/li>\n<li><strong>Tax Benefits \u2013<\/strong>\n<ul>\n<li><u>Non-Recognition of Gain on Sale<\/u>. If the requirements of Code Section 1042 are satisfied, the selling shareholders can elect to defer recognizing gain on the sale transaction.\u00a0 Properly structured, this deferral can be made permanent.\n<ul>\n<li>Saves 15 \u2013 20% capital gains federal tax (plus most states\u2019 capital gains tax), plus 3.8% Medicare Surtax.<\/li>\n<li>Company must be C corporation at the time of sale. LLCs and S corporations often convert to C corporation for this purpose.<\/li>\n<li>ESOP must own at least 30% of the value of outstanding shares, immediately after the sale.<\/li>\n<li>Seller must invest proceeds in \u201cqualified replacement property\u201d (QRP) \u2013 debt or equity of U.S. operating company(ies). Seller\u2019s estate receives a step up in the QRP basis upon death, resulting in the tax deferral becoming permanent.<\/li>\n<\/ul>\n<\/li>\n<li><u>Deductions for Payment of Purchase Price<\/u>. The ESOP pays for the financing for the purchased shares using contributions from the Company.\u00a0 These contributions are deductible to the Company.<\/li>\n<li><u>Company Can Operate Tax-Exempt<\/u>! If the Company is (or becomes) an S-corporation, neither the Company (because it is an S-corporation) nor the ESOP (as a shareholder) pays any ordinary income tax on the Company\u2019s income.\u00a0 If the ESOP owns 100% of the Company, the Company effectively operates as a for-profit, tax-exempt entity.\u00a0 This allows the leveraged financing created in connection with the ESOP purchasing stock, to be paid off much more quickly than in a non-ESOP management buyout.\u00a0 After the financing has been paid, it allows the Company to accumulate cash for growth and acquisitions.<\/li>\n<\/ul>\n<\/li>\n<li><strong>Attract, Motivate, and Retain Employees \u2013<\/strong>With proper education, the ESOP can make employees (and prospective employees) feel and act like entrepreneurs.\u00a0 The effect on employees\u2019 morale of seeing their ESOP account grow in value is a powerful tool to attract, motivate and retain employees.<\/li>\n<li><strong>Design Flexibility<\/strong>\u00a0\u2013 The ESOP transaction is designed by the Company and its shareholders.\u00a0 The price and terms must be fair, but the percentage of the Company to be purchased by the ESOP, the structure of the financing, the size and timing of subsequent purchases (if any), are all determined by the Company and its shareholders.<\/li>\n<li><strong>Certainty and Confidentiality<\/strong>\u00a0\u2013 The ESOP Trustee, as a buyer, wants the ESOP transaction to close.\u00a0 ESOP Trustees have no hidden agenda or conflicting interests.\u00a0 The Trustee\u2019s only concern is that the price and terms of the transaction are fair.\u00a0 ESOP Trustees are confidential.\u00a0 Your confidential information is not exposed to competitors.\u00a0 Most companies creating an ESOP do not inform their non-executive employees of the transaction until it is closed.<\/li>\n<li><strong>Other benefits \u2013<\/strong>\n<ul>\n<li>If the ESOP purchases less than 100% initially, it can provide a market for future sales of shares.<\/li>\n<li>Sellers who provide financing for a leveraged sale of stock to an ESOP can receive an attractive return on the financing, including sharing in the future value of the Company through warrants (similar to stock options).<\/li>\n<li>Subject to their fiduciary duties as a Board of Directors, the Company\u2019s Board remains free to adopt management incentive plans, cause the Company to acquire other companies, or sell the Company.<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<p><strong><u>Disadvantages of an ESOP<\/u>.<\/strong><\/p>\n<ul>\n<li>The shares must be valued annually.<\/li>\n<li>The Company must plan for and fund future repurchases of shares from ESOP participants\u2019 accounts. Depending on employee demographics and the growth in share value, this can be significant.<\/li>\n<li>Accounting is complex and can be counterintuitive.<\/li>\n<li>The ESOP creates fiduciary duties.\n<ul>\n<li>Cannot pay more than \u201cadequate consideration.\u201d<\/li>\n<li>Trustee is responsible for most fiduciary decisions.<\/li>\n<\/ul>\n<\/li>\n<li>ESOPs operate in a regulated environment \u2013 DOL and IRS oversight.<\/li>\n<li>The size of the ESOP debt (the \u201cInside Loan\u201d) must be designed, taking into consideration deduction limits and compensation limits set forth in the Code.<\/li>\n<li>Participants may direct the ESOP Trustee how to vote shares allocated to their accounts, with respect to certain major (and very infrequent) corporate actions (merger, sale of substantially all assets, etc.) which, under state law, require shareholder approval.<\/li>\n<\/ul>\n<p><strong><u><br \/>\nESOP Issues Specific to Architectural Firms<\/u>.<\/strong>A couple of ESOP issues relate specifically to architects and other professional service firms.<\/p>\n<ol>\n<li><strong>Valuation<\/strong>. The value of the stock of a corporation depends largely on the earnings of the corporation to which the owner of the stock will be entitled.\u00a0 Many professional service corporations pay all their free cash-flow to the owners, as bonuses, at the end of each year.\u00a0 The owners expect this and depend upon it.\u00a0 However, the owners often do not distinguish between the portion of their overall compensation that is based on their employment, as distinct from the portion of their compensation that is based on their ownership.\u00a0 When selling the stock (whether to an ESOP or to any other buyer), this distinction must be made clear and adhered to going forward.\u00a0 Post-closing, the Sellers (former owners) will continue to receive this cash for several years, but as payment for their stock \u2013 not as compensation for their services.\u00a0 The tax treatment of the payments for stock are generally more favorable than the tax treatment of ordinary income.\u00a0 However, the process of distinguishing between the two can be difficult.\u00a0 An ESOP Transaction Analysis (discussed below) should illustrate the cash flow impact of this on all affected parties.<\/li>\n<li><strong>Restrictions on Ownership.\u00a0<\/strong>Many states restrict ownership of architectural (and other professional service) firms to licensed professionals.\u00a0 Some states provide exceptions for firms that were established before these restrictions came into effect.\u00a0 Some states permit ESOPs, or other shareholders who are non-licensed professionals, to own a certain percentage of the firm.\u00a0 ESOPs have been successfully established using a \u201cmanagement company\u201d to provide all services for which a professional license is not required, and contracting with a licensed professional service firm for those services for which a license is required.<\/li>\n<\/ol>\n<p>Recently, some states have expanded ESOP ownership of licensed professional service firms.\u00a0 For example, in 2012 New York \u2013 which has historically been one of the strictest States in regulating ownership of licensed professional service firms \u2013 amended its laws to allow ESOPs to own up to 25% of a \u201cDesign Professional Service Corporation\u201d (engineering, architecture, landscape architecture, land surveying, and geology or any combination thereof).\u00a0 In July 2022 (effective July 21, 2024), New York State allowed ESOPs to own 100% of a DPC.<\/p>\n<p><strong>What\u2019s the Next Step?<\/strong>After discussing your questions with a qualified ESOP professional, the next step to making an informed decision as to whether an ESOP is right for your Company is to obtain a \u201cTransaction Analysis.\u201d\u00a0 This is, essentially, a blueprint for an ESOP transaction.\u00a0 It is based on detailed historical and projected financial information about your Company, and reflects the unique priorities and goals of the Company and its shareholders.\u00a0 The Transaction Analysis will illustrate, in detail:<\/p>\n<ul class=\"wp-block-list\">\n<li>The estimated value of the Company for ESOP purposes;<\/li>\n<li>The estimated amount of senior debt that the Company can raise for an ESOP transaction; and<\/li>\n<li>The projected cash flow impact on the Company and the Sellers, over the life of the financing for the ESOP transaction.<\/li>\n<li>The Transaction Analysis can include multiple variations of transaction structures (e.g., 30% transaction, 100% transaction, 1042 vs. non-1042, etc.).<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<\/li>\n<\/ul>\n","protected":false},"excerpt":{"rendered":"<p>When contemplating a sale of their business, the owners of<span class=\"excerpt-hellip\"> [\u2026]<\/span><\/p>\n","protected":false},"author":46,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"_exactmetrics_skip_tracking":false,"footnotes":""},"categories":[18],"tags":[],"class_list":["post-3850","post","type-post","status-publish","format-standard","hentry","category-resources"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v28.1 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Why Should Architectural Firms Consider Selling to an ESOP? 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