Contractor Liability for Unlicensed Subcontractors

As if owning and managing a construction business on a daily basis wasn’t challenging enough, especially given the economic headwinds in recent times, contractors must be aware of the potential liability which arises from doing business with unlicensed subcontractors. In summary fashion I’ll highlight the more important facts/points of a case which illustrates the potential pitfall.

The case of Sanders Construction Company, Inc. v. Martin Cerda [And five other cases] is important because it further established and maintained the liability of a General Contractor for the unpaid wages of his/her unlicensed subcontractors. The following summarizes the basic facts which were not in dispute:

• In September 2006 disputes arose regarding the quality of the subcontractor’s work
  
  
• After Sanders discovered the subcontractor’s license had expired prior to June 2006, Sanders continued to work with the contractor
  
  
• Sanders was paying the subcontractor and did not believe he was responsible for paying the subcontractors workers
  
  
• The subcontractor ceased work on the project in January 2007
  
  
• The workers ceased work either in December 2006 or January 2007
• 
  

The hearing officer cited the holding in Hunt Building Corp. v. Bernick (2000) 79 Cal.App.4^th 213, 220: “Labor Code section 2750.5 operates to conclusively determine that a general contractor is the employer of not only its unlicensed subcontractors but also those employed by the unlicensed subcontractors.” The hearing officer decided Sanders was the statutory employer of the workers employed by the subcontractor, entitling them to wages and interest. (§ 98.1, subd. (c).) The hearing officer declined to award waiting time penalties because he deemed there was a good faith dispute about whether Sanders was the employer.

Sanders filed an appeal and lost, with the superior court adopting the reasoning of the Labor Commissioner. Like the hearing officer, the superior court relied on Hunt and its interpretation of section 2750.5.

There are many issues to be aware of, many items to verify including ensuring the current and active license status of any subcontractors you do business with. The alternative of staying on top of items such as this could be a potentially crushing expense.

How in the World Did That Guy Get a Bond?

By Daniel Huckabay, President – Commercial Surety Bond Agency

It seems like I get asked this question a lot these days - especially when it comes to those one or two contractors on every bid that are below everyone else's cost to do the work. Fortunately for me, I haven't had the question asked about any of my clients. But it does leave you wondering what surety companies are basing their underwriting off of for some of these contractors and what the ramifications will be?

The surety industry has been interesting to watch over the last few years. This decade started with several tough years economically. As a result, sureties took substantial losses and there was a significant reduction in the number of surety companies in California through mergers, some exiting the California market and others going out of business altogether. These tough early years brought the usual disciplined underwriting after surety companies get whacked with losses, and that combined with the very strong economy from 2004 to 2007, resulted in some of the most profitable years in history for sureties as well as for contractors.

As the economy began to take a nosedive at the end of 2007, a strange and counterintuitive thing happened, more surety companies entered the California market. Since the downturn began, there have been at least eight sureties expand their presence or open up completely new offices in California. So just as contractors are facing less work and more competition, so are the surety companies. Most of these new surety companies target smaller contractors bidding jobs less than $5 million, and as a consequence, the surety underwriting for small contractors has become more competitive and in some cases, less stringent.

This change in the surety marketplace has no doubt made it easier for contractors in the private sector that had never previously been bonded to establish a bond program. Surety companies have historically been cautious in granting credit to a contractor making this move unless the owner or a key employee has prior experience in the public works arena or the contractor was going to take a slow and limited approach with say one job at a time.

Today, however, many of the smaller surety companies are not performing a thorough enough evaluation of these contractors. More often than not, they don’t even meet with the contractors, and therefore never hear the contractors plan first hand or whether they have the experience and capability to execute it. Most importantly, the sureties are missing out on the most important piece, which is evaluating a contractor’s character. This has long been the cornerstone of the underwriting process, and an individual’s personal and business philosophies can only truly be understood in face-to-face meetings.

So then what are these surety companies basing their underwriting on? Many of the contractors that previously did private work made a substantial amount of money during the upswing, and I can only guess that surety companies are banking on these strong balance sheets to offset the lack of experience. However, as we all know, it only takes one or two bad jobs in the construction business to wipe out capital that it took years to accumulate. They are also using tools such as fund control and collateral, which will certainly offset some of their added risk and exposure, but how much so remains to be seen.

In a down cycle such as we are in, it typically takes 12 to 18 months for contractors to pick up bad work, stumble and eventually default. If this holds true this time around, we should see many contractors go out of business next year. We've already seen several companies go out of business this year, and I would expect that number to increase significantly by the second and third quarters in 2010.

As contractors default, surety companies will face rising losses beginning next year and continuing well into 2011 and perhaps 2012. This will no doubt cause many of the sureties, especially the smaller ones, to tighten their underwriting standards. This means many of those contractors that do manage to hang in there will face a different problem - having their bonding capacity reduced or cut completely as surety companies shy away from contractors that have losses or show signs of an inability to stay in business.

But with great challenges comes opportunities for those contractors that plan ahead now. Through all of this, the number of contractors that are bondable will shrink and many of those that can get bonds, will be able to get less two years from now. This affords those that can take certain steps to maintain or increase their bond capacity over the next 12 to 24 months a significant competitive advantage. After all, what better way to reduce your competition than to bid work that others can't, because they aren't able to get a bond.

Here are 7 things you can do to improve and expand your bond program.

1. Retain as much money in your company as possible. Because most contractors aren't making much money these days, this really means limiting the distributions you take from your company or lowering your salary/rent paid to yourself wherever possible. Think of investing in your company financial strength as a tool that helps you get bonds to get work, just like investment in equipment allows you to complete work.
   
2. Defer equipment purchases if you can. This will only lower your cash or increase your debt depending on whether you finance it, and surety companies, now more than ever, want contractors with a strong working capital position consisting of plenty of cash and little or no debt. (working capital = current assets minus current liabilities)

3. Improve your internal accounting systems. Surety companies are big on contractors having accounting systems that enable them to know where they are at all times financially. The better, and more timely, you are able to communicate this information to your surety company, the more confident and comfortable they'll feel with you. Remember, surety companies operate under the rule of thumb that bad news travels slow. Avoid the suspicion and concern by producing internal financial statements within 30 days of the period ending, quarterly or six-month CPA prepared financial statements within 60 days and year-end financial statements within 90 days. Any delay could cause a bond to get declined until surety gets a financial statement.

4. Upgrade your year-end financial statement to a review if you currently only get a compiled from your CPA. As sureties experience increased losses due to contractors failing, their requirements across the board are bound to get more stringent. This is particularly true with the smaller surety companies that now except compiled financial statements since they will likely have the highest frequency of losses. We've already seen several change their minimum requirement to a CPA review, and this will definitely become more commonplace.

5. Meet with your bond company at least once a year. Let them know in detail how you are doing and what your projections are. Have a well thought out plan that you can clearly outline to them. Surety companies like to work with contractors that know where they stand now, where they're headed in the future and know how they are going to get there.

6. Make sure you have the right set of advisors guiding you. Now more than ever getting advice from construction specialists is imperative. This includes not only your surety agent, but your CPA, banker and insurance broker.

7. Ask your surety their advice on what you can do to improve your bond program. It comes at a great price, it’s free! You can't get a better deal than that. Plus it will indicate to them that you value their input and treat them as a partner in your business - especially if you follow through on their advice.

Cost Management Tip - Managing Vehicle Fleet Expenses

Over the years, we’ve seen energy costs increasing which has an impact on all our daily lives and businesses. If your company has a fleet of trucks, cars and other equipment which uses fuel, you have undoubtedly noticed the rising cost of gas over the last ten or fifteen years. Today, fuel costs almost 2.5 times what it did in 1995 (per data reviewed at http://www.eia.doe.gov/ the Energy Information Administration). At times in the past few years it has been more than triple 1995 numbers and it wouldn’t be surprising for those energy price levels to return in the next few years. It’s especially important during these challenging times to take advantage of any and all resources available to help manage our business costs in any way we can.

In working with our contractors, as well as discussions with construction industry groups I’ve spoken to in recent years, I’ve raised an issue surrounding the review of fuel transactions. I mention how I’ve heard that a particular individual may fuel up at 2PM on a Friday afternoon and again 8AM the following Monday morning. How can a full tank of gas from Friday afternoon get used so quickly? I usually have people smile and nodding their heads as if they’ve seen that before. I’ve also heard that the frequency with which fill-ups occur begs the question about a card being used perhaps to fill up a spouse’s car with some gas every now and then. Another scenario I’ve been presented with is that many of these fueling stations have mini marts wherein the field personnel will do shopping and add it to the fuel transaction charge resulting in only one charge to appear on the credit card bill.

In the last few years a company called Wright Express has come to my attention. Since Wright Express has been on my radar, I’ve spoken with many contractors who were in fact aware of them and in some cases using them. Many more contractors had never heard of them. If any of the scenarios above resonate with you, you may want to get familiar with Wright Express or a similar service provider. Per their website (http://www.wrightexpress.com/About/index.html) they are a “leading provider of payment processing and information management services to the U.S. commercial and government vehicle fleet industry…The information we collect at the point of sale includes the amount of the expenditure, the identification of the driver and vehicle, the odometer reading, the identity of the fuel or vehicle maintenance provider and the items purchased. This data is captured through our network, which consists of fuel and maintenance locations utilizing our proprietary software.”

I’ve heard from contractors who use their system that the data discussed above is readily available on the statements they receive. I also hear that there are customization options available such that you can control the days/times that fuel may be purchased and set other parameters as well to better control these costs. Every contractor who uses them seems to be very pleased with the service.

I’ve heard, and repeated often, many times over the years “Employees do what we inspect, not what we expect.” The services and information offered by Wright Express seems to provide another means to inspect transactions affecting your businesses.

Please note I have never spoken with anyone at Wright Express nor have any association whatsoever with them.

Employee Empowerment - The Key to Safety Success

by Matthew J. Key – Vice President - Safety - Knight & Carver Wind Group – San Diego, CA

In these times of companies downsizing, out sizing, re-engineering, doing more with less, and compliance to safety regulations, California Occupational Safety and Health Administration and Federal Occupational Safety and Health Administration (CalOSHA/FedOSHA) is requiring companies to have employee involvement and safety committees. Management needs empowered employees to be involved in the safety process.

Management is referred to as: Chief Executive Officers, directors, managers, supervisors, or individuals who have authority and can give authority. Support and commitment to the safety cause is very necessary from all levels of management.

Employees are very effective and motivated when they are empowered and will rally behind the cause of safety. Safety committees are ways that employees can be empowered to decrease incidents, accidents and injuries in the workplace.

Empowerment is defined as “freedom and authority given to employees to pursue their unique vision”. When this is provided to safety committees, strong commitment and support is evident.

The elements critical for safety committee success are: Trust, Communication, Commitment, Teamwork, Training, Awareness, Positive attitude, ownership and recognition. They can be explained as follows:

Trust from management involves demonstrating to the safety committee that they are empowered or have the authority to make decisions and get things done. The committee will not be a figurehead so to speak. Management support and commitment is the number one element crucial for the success of safety committees.

• Communication is critical because everyone (management, safety committee, and employees) needs to be informed regarding safety issues and concerns.
• Teamwork provides the foundation for success. The commonality exists when everyone involved works to have a safe environment. Contribution from each team member gives the uniqueness of different points views and ideas to get the job done successfully.
• Training cannot be overlooked. Having accurate information through training to care for safety concerns provides the safety committee expertise, credibility, and consistency to deal effectively with safety concerns.
• Awareness of safety concerns and how it will be cared for is essential. An awareness campaign can include safety posters, newsletters and safety magazines. When hazards can be identified and eliminated this will bring about a proactive safety program when it comes to reducing or eliminating incidents, accidents and injuries.
• Positive Attitude is strength for a safety committee. Concentrating on what’s going right, what progress have been made, and what can be done to make it better, attaining goals will assist the safety committee to stay motivated.
• Ownership is an important element because all employees including the safety committee need to feel part of the process as owners. Getting employees involved in sub-groups to care for safety concerns, or listening to their suggestions will go a long way for employee participation and involvement.
• Recognition provides an awareness by all that the safety committee is recognized for a job well done. When management shows, in the way of something tangible, (certificates, lunches, dinners, gifts, etc.) this sends a message to the safety committee and employees that their efforts and actions are appreciated and motivate them to do more.

Yes, empowering employees by means of safety committees can have a very big impact in reducing and eliminating near misses, incidents, accidents, and injuries.

Ten Ways to Help You Better Market Your Construction Company

With backlogs beginning to dwindle and concerns about where work will come from as we approach 2010, how to get more work is one of the contractor’s greatest challenges right now. Generally the marketing aspect within a construction company is a weaker element of the overall business. Few contractor’s have a dedicated marketing department or even an outside marketing consultant. Historically word of mouth, reputation, project list, etc. has served as the primary components of the marketing initiative. In this article I’ll offer ten effective ways to get your company’s name in front of the right people. These strategies will help to better your chances of getting new work and establishing your place in the market!

The following is a list of ideas you can review to determine if some are right for your company…

1. Talk to your Bond Agent about getting on Bond Companies Preferred Contractor List

Some jobs go bad and contractors go out of business. The bond company is asked to step in and finish the job. Who actually does the work when the bond company steps in to finish? Contractors do of course…why not you? You own and operate a solid, well run financially stable construction company (even still with the challenges we’ve all faced in this current environment). Your bond agent has relationships with multiple markets and knows you, your company and its history very well. Why not have your bond agent (and CPA and others who know the bond companies) get your name in front of the bond companies and perhaps even arrange meetings? Someone has to do that work (and it’s usually very nice work to have from a profit perspective).

2. Company Newsletters

Most of you receive these articles I publish via a newsletter format. There are many applications, such as ConstantContact and CoolerEmail, which make the preparation and distribution of electronic newsletters relatively easy. The cost of such services can range from generally $30 to $100 for a generous number of emails allowed per month including some Customer Relationship Management (CRM) functionality. Like anything, time must be devoted to this initiative. I have seen several newsletters come through my inbox but actually very few from contractors. In fact I can only think of very few contractors who do newsletters on a regular basis. One electronic newsletter I receive via ConstantContact and another through the regular mail. Both of these are well done, feature projects the company is working on (or recently awarded or completed), contain pictures, etc. The electronic newsletter I receive also has a nice feature focusing on one employee each month. The newsletter concept keeps the company name front of mind, highlights who they are and what they do. All of these elements are critical to establishing and maintaining your company’s place in the market. Using these online service providers such as ConstantContact and CoolerEmail is quite easy if you are comfortable with computers. I’m reasonably confident that most contractors have at least one person within the organization who can manage the creation and distribution of a monthly newsletter. They would need help from you in creating the distribution list and assistance with the content. It’s a relatively inexpensive tool which can yield a reasonable return on the investment.

3. Internal Trade Shows

Your company may have multiple services it provides and/or a variety of ways it performs one or many of the services. There is a good chance that, if asked, some of your employees would not be able to effectively articulate what your company does and/or how it does it. If your employees do not understand who you are, exactly what you do and how you do it they stand little chance of bringing opportunities into your organization. One way to help educate your employees is to have each department or group within your company create a “booth” which can be visited by all of your employees. Each booth might have pictures, props, powerpoint slide shows or any other materials/items which would help tell the story of what that group does and how it does it. This is a fun way for all of your employees to interact amongst different departments and learn about your company at the same time!

4. Create a Target List

If you are a Subcontractor, perhaps there are certain General Contractors with whom you would like to work. General Contractors may be looking to work with certain owners. Create a short list of those prospects and begin asking those with whom you do business whether they have any contacts within those organizations on your target list. As we all are aware, it’s a small world and those of you who use LinkedIn or Plaxo can see many of us are interconnected. Ask your professional service providers, employees, etc. if they know anyone at those companies and you may be surprised at the success you may achieve in getting at least one meeting. Be persistent as it may take time, however if you don’t begin trying you will certainly not make the connections you wish.

5. Industry Associations

Many of you have attended meetings with the Associated General Contractors (AGC), American Subcontractors Association (ASA) and many other alphabet soup organizations over time. They are good venues to receive timely information on topics that affect your business, usually come with a decent meal (not great, but decent) and the ability to interact with your peers, those you work for, those who may work for you as well as professional service providers who understand your industry. One objective you may wish to achieve in attending these meetings might be to get at least one or two cards of people who would want to follow up with. Perhaps a casual lunch meeting in a one on one setting might be mutually beneficial. We need to recognize that simply attending an industry association event is not always (or even usually) enough to help you achieve your goals. It may take the follow up one on one meetings or even participation on committees or the Board of the organization to get meaningful business results. You may also decide that such participation is more about achieving personal satisfaction. Like many things, “you get out of it what you put into it!”

6. Website

Every business can, and should, have a very good website (not just a website). The site should provide a select customer and project list (with pictures), appropriate contact information and be well designed from a graphic and color standpoint. We have all often heard that a receptionist is the “Director of First Impressions” when people call into your office. I’d suggest that the same holds true for your company’s website in today’s internet age. If you see “website under construction” in 2009, that may tell you something. The professional appearance of your website will create, in many cases, the first impression for those looking to learn more about your company. There are many service providers, some who charge very reasonable prices for high quality web design, available such that poor websites for decent sized businesses should be a thing of the past. Email me if you’d like contact information for such services.

7. Employee Involvement and Incentive Plans

I’ve heard more times in recent weeks “All of my employees are business development people.” I think this is a good strategy. The fact is all employees are not business development people…they may have been told they are, but in reality they are not and that’s OK. If that message is delivered to your Project Managers, Field Supers, Office Personnel, etc. and only a percentage of them actually take it to heart and make attempts at getting work and/or contacts for the company you are ahead of the game. I believe all companies should have a business development bonus program. How you structure it is up to you however I’d suggest either relatively small flat amounts perhaps based on contract size or a percentage of the final gross profit (keeping in mind you have back office overhead to cover as well). Those individuals who actually help to deliver results should be awarded for their efforts and productivity.

8. Talk to your CPA, Banker, Bond Agent and Attorney about connecting with their client bases

If you are dealing with service providers who specialize in Construction, ask them if they might be able to make introductions to certain contractors for you. This ties in with the target list recommendation above. You can ask in a generic way without naming a specific connection you’d like to make, however from my perspective you will get more traction if you have a specific contact you’d like help with. They may or may not be able to help, but asking never hurts.

9. Speaking Events

This is a great way to get in front of a number of people at once. If you are a subject matter expert let’s say on government contracting or LEED certification or any topic, many groups are looking for speakers on a regular basis. I know the ASA has a General Contractor talk about their business at least once a year.

10. Advertise in trade magazines, Blue Book, etc.

Obviously there are many magazines and other publications from which to choose and there is no point in aimlessly buying space in a magazine without reasonable comfort that it will provide a good return over time. There are many ways to judge which publications make sense including keeping an eye out in the lobbies of construction firms you respect, reviewing the circulation data published in each magazine, referrals from friends who have had success/traction from certain publications, etc. If possible, find a way to have a specific identifier in each advertisement such that you could measure each placement’s success.

Conclusion

Marketing is perhaps one category where contractors can do significantly better than they are doing today by engaging a few of the ideas (or others of course) above. Some of these ideas are not too difficult to implement. In today’s environment you must pursue every avenue possible to generate more business opportunities for your company.

Step by Step Approach to a Successful Software Implementation

By Steve Antill
Foundation Software

Here’s how to avoid the common mistakes contractors make


It took months of painstaking research. You came up with a budget and a realistic list of must-have features. After narrowing down your search to a few products, you spent the time to see a demonstration of each one, check client references, and investigate the long-term prospects of the developing company. Finally … the best-fit construction
software package has been purchased and installed. In the minds of many contractors, this is where the story ends,
and the business thrives “happily ever after.” In the real world, however, that’s not how it works. Without a thoughtful, stepby- step approach to software implementation, contractors risk replacing one set of headaches with another.
To use a system successfully, it takes more than just a few hours—or even a few days—of initial training. To guarantee that the software investment pays off, it takes the three steps discussed in this article.

Step 1: Implementation Planning

This step occurs immediately after the software’s purchase. During this phase, the contractor should discuss the following things with the software trainer:

• The company’s specific needs
• Expectations for the software
• Requirements that are unique to the business
• Individual users’ responsibilities
• How much time can be set aside each week to train and work on the new software

The planning phase is extremely important because it can save a lot of wasted time and money down the road. When switching from one accounting system to another, for example, the trainer may provide advice on the best methods for converting historical accounting data or how to easily integrate payroll and other field data into the system. With a focus on the flow of information, the processes that are in place, and the people who will be using the software, it is the software trainer’s job to make sure that the system will run as efficiently as possible and meet the company’s needs.

Step 2: Training

Once the implementation plan has been developed, the next step is to have the company’s employees learn the software and set it up for them to use it. During the initial training session, users will learn to navigate the software, perform day-to-day activities, and understand the work flow within the system.

On many systems, training includes setting up reports that will be needed, as well as customizing default settings and user-defined fields. This is where lots of companies make critical mistakes. By not having enough key people involved in the setup and structure, contractors risk setting themselves up for improper data collection and inaccurate reporting down the line. When implementing a new job-cost accounting system, for example, the project manager, estimator, and owner, as well as the accounting staff, should all be included in the system’s setup. Aside from the cost code structure,
the field and accounting staff must agree on the types of reports that are needed, and how the information will be entered and coded.

Generally, software training sessions include tutorials and homework assignments that help prepare both the user and the system for day-to-day use. Some software will even help contractors set up a practice company—using their actual data—so that employees can practice and perform the actual tasks they will be conducting on a daily basis. This allows users to test data flow, run reports, and troubleshoot any problems before actually going live. The last phase of initial training is going live and using the software. As employees begin to use the software, they should have fast and easy access to “live” support. This phase of training can last a few weeks or several months.


Step 3: Wrap Up and Follow Up

This step goes back over everything the client and the software vendor agreed upon in Step 1. After reviewing the initial training phase, which generally runs about 10 to 12 weeks, contractors must decide the following things:

• They are satisfied with the training.
• The system has met their expectations.

Now is the time to go over the implementation plan with the software vendor, point by point, to see if every need was addressed. At this point, the contractor should feel good about the system, confident in the investment, and able to use the software on a day-to-day level to run the business. By no means, after just a few months of initial training, should users expect to be “done” learning the software, however. Ongoing education and training— especially with systems that offer extensive construction-specific features and functionality—are really a given. By following this three-step process, which includes preplanning and postevaluation in addition to training, it is possible to greatly increase a company’s chance for long-term success.

Is an ESOP Right for Your Company

by Hilary Schneider, Chairman/CEO, ESOP Corporate Resources, Inc.

What is an ESOP?

ESOPs can be an incredible corporate financial tool but, they are not for everyone. Generally, ESOPs are most effective for companies that are profitable, tired of paying taxes to the government, have a market value of $2,000,000 or more and, employ 20 or more employees. ESOPs are a very tax efficient method of accomplishing certain corporate and personal goals.

An ESOP is a tax qualified plan similar to a pension or profit sharing plan. What distinguishes an ESOP from other plans is that its mandate is to acquire company stock of the sponsoring corporation and it is allowed to borrow money to acquire that stock. Armed with these two small differences from other tax qualified plans, the ESOP can become a financial tool for the corporation. In fact, the IRS has called the ESOP “the ultimate tool of corporate finance”.

ESOPs are most commonly used to create a private marketplace for shares of departing owners of successful private companies, to motivate and reward the employees who have helped build the company or, to take advantage of numerous substantial tax incentives.

The Section 1042 stock sale to an ESOP provides tremendous tax advantages for both the company and for the selling shareholder. The selling shareholder can permanently defer all capital gains tax on the sale of stock to the ESOP. The company receives a tax deduction for contributions to the ESOP which provides the ESOP with the cash to purchase the stock from the selling shareholder.

Many companies should not borrow money, especially contractors or companies with bonding requirements who may need to maintain ratios to please their surety bond company. Because of this fact we will discuss strategies to address these concerns.

The War Chest ESOP
Many times the owners of the corporation are not ready to sell any part of the company immediately but are considering a number of exit plans in the future. The “War Chest” approach allows the corporation to make tax deductible discretionary contributions of cash in an amount of up to 25% of eligible payroll to the ESOP and get an immediate tax deduction in the year of the contributions. By contributing cash to the ESOP the corporation is using monies that would otherwise be sent to the government. The continuing accumulation of cash creates a “War Chest” that will be used at a later date to buy some or all of stock from selling shareholders and owners without creating debt on the corporate balance sheet. This type of strategy does not affect bonding capacity. This strategy can also be used to supplement a leveraged ESOP discussed below.

The Leveraged ESOP

An ESOP can be leveraged in which case a loan is obtained from a lender. The lender makes a loan to the corporation which in turn loans the same money to the ESOP. Tax deductible contributions are made by the corporation to the ESOP in an amount intentionally designed to equal the principal and interest due to the lender. When the contribution is received by the ESOP it uses the cash to pay its loan debt service to the corporation. The corporation receives its money back and pays it debt service to the lender. This method creates a tax deduction for both principal and interest payments. As an example, in the 40% company tax bracket the after tax cost to repay $10,000,000 of loan principal would be $6,000,000; a tax savings to the company of $4,000,000. Under this method of ESOP the loan must be booked as a liability. The key to this strategy is that principal is tax deductible.


The Non-Leveraged ESOP (Stock and /or Cash Contributions)
Many companies should not borrow money, especially contractors who may need to maintain ratios to please their surety bond company. Immediate current tax deductions can be created by contributions to the ESOP of newly issued authorized stock. While this is dilutive to the outside shareholders, the tax savings is anti-dilutionary.

Cash contributions to the ESOP, as discussed earlier, creates an immediate company tax deduction without a major impact on the financial statements. The cash in the ESOP can accumulate tax free and after a few years this ESOP “War Chest” can be used to augment the purchase of stock from either the company or an outside shareholder.

The Flexibility of ESOPs

ESOPs are very flexible in that they can be used to simultaneously accomplish any combination of the following strategies:

§ Creation of a liquid marketplace for closely held stock which provides a tax advantaged exit strategy for shareholders under Section 1042.

§ Defer or eliminate federal and state capital gains taxes on sale of stock via Section 1042.

§ Sell some or all of your privately held stock, pay no Capital Gains tax and, still maintain control of the corporation.

§ Repay and deduct the principal portion of corporate debt with tax deductible dollars.
§ Buy out minority or majority shareholders with tax deductible dollars and tax free to the sellers.

§ Motivate and reward employees and attract and retain good management.

§ Assist a shareholder to diversify his or her personal net worth.

§ ESOP purchases of stock are deductible to the corporation.

§ Transfer the business to a son, daughter or management group with huge tax advantages and guarantee the perpetuation of the company.

§ Sell the company to an outside buyer with significant tax advantages to both buyer and seller.

§ Cash out investors with pretax dollars and tax free to the investors.

§ Corporate acquisitions can be done with tax deductible dollars.

§ Current long-term debt can be refinanced via the ESOP providing the corporation with tax deductible principal, as well as interest, for debt repayment.

§ Dividends, if paid through an ESOP for debt service, are deductible to the corporation.

§ Recover C corporation income taxes paid over the prior two years.

§ Reduce or eliminate estate taxes with ESOP planning techniques.

§ Increase employee productivity.

§ Corporate acquisition of real estate with pre-tax dollars.

§ Tax free cash out with deductible dollars in a divorce.


Is My Company Large Enough for an ESOP?

There is no quick easy answer to this question. The answer is based on a number of factors such as the purpose and complexity of the ESOP structure and, an analysis of the costs to implement and maintain an ESOP compared to the benefits that will be derived from the ESOP. Every ESOP is specific to the sponsoring company as every owner has different goals…..There are no Cookie Cutter ESOPs.


ESOP design consideration must be given to:
1. The tax bracket of the corporation.

If you are not paying taxes, or are in a very low tax bracket some of the tax advantages to the company will diminish. Tax savings realized by the selling shareholder may still make an ESOP worthwhile.

2. The payroll of the corporation.

Contributions to an ESOP are limited in most instances to 25% of eligible company payroll. A $2,000,000 payroll can allow contributions of up to $500,000 on a tax deductible basis. If the company has an existing 401(k) plan both the employer and employee contributions to the 401(k) plan may be an offset to the 25% contribution limitation.

Union employees can be excluded (or included) from the ESOP as a collective bargaining unit. As such, the union compensation would also be excluded from the eligible payroll calculation. However, many ESOPs include union members.

3. Annual contributions to the ESOP compared to expense to maintain the ESOP.

A $500,000 deductible contribution to the ESOP will generate a $200,000 tax savings in the 40% company tax bracket. If the annual cost to maintain the ESOP is $10,000, as an example, the cost to maintain the ESOP is justified by the annual tax savings generated by the ESOP. Conversely, if the tax savings generated by the ESOP is only $50,000 the ESOP may not be justified when compared to implementation and maintenance expenses of the ESOP.

4. Analysis of the alternatives to accomplish the same goal as an ESOP.

There are many ways to skin a cat and an ESOP may or may not be the best approach. If, for example, a shareholder wants to sell some stock to the ESOP under Section 1042 the capital gains tax on the stock sale can be deferred and, the corporation receives tax deductions for contributions to the ESOP to purchase the stock. This exit strategy could be compared to selling the business through a business broker and the seller paying the capital gains tax. Both the after tax cost to the corporation and the after tax net proceeds to the seller need to be understood. Other alternatives to be considered would include an insurance funded strategy, a management buy-out or, a Section 162 bonus plan. Depending on the strategy the proceeds to the seller will be received as either taxable capital gains or as ordinary income. Corporate funding of the approach make or may not be tax deductible to the corporation.

5. The type of industry of the business.

Every industry has different characteristics. In the construction industry the company may need to have a construction surety bond to serve as a guarantee to the project owner. Surety companies require of their contractor clients that a certain amount of net worth and working capital is maintained to support the business plan. It may be that borrowing cash for an ESOP stock purchase will throw these ratios out of balance and these needs should be carefully addressed. Many contractors make cash contributions to their ESOP to create an immediate tax deduction for the company and build up a “War Chest” of cash inside the ESOP to be used to purchase stock at a later date. Surety companies will also review the continuity plan of the company which can be resolved by the ESOP which creates a private marketplace for the owner’s stock.

6. Other Existing Tax Qualified Plans in the Company.

Many companies already have profit sharing and/or 401(k) plans and the design of an ESOP must take other tax qualified plan into consideration. 401(k) plans can operate side by side with an ESOP or combined with the ESOP. Company 401(k) matching contributions could be diverted to the ESOP to augment cash flow requirements for required debt service on a new ESOP loan used to purchase stock. SIMPLE IRAs prohibit the creation of any other tax qualified plan in the company therefore, the transition from a SIMPLE IRA to an ESOP must be coordinated carefully.

7. Regular C Corporation, Sub-Chapter S Corporation or LLC.

In all the applications of an ESOP only one approach, a Section 1042 tax deferred sale of stock to the ESOP, requires that the company be a C Corporation. For all other ESOP applications the company can be either a C or an S Corporation. Should the members of an LLC desire to take advantage of opportunities afforded by an ESOP the LLC will need to convert to either a C or S Corporation. Consultation with CPAs and tax advisors are necessary in order to determine when and why a entity should convert to a C or S Corporation as there are specific conversion rules.

8. S Corporation M-2 (AAA) Accounts
If the company is an S Corporation and needs to convert to a C Corporation the existence of any M-2 (AAA) account needs to be analyzed. The AAA account is earnings on which the taxes have already been paid. On conversion to a C Corporation the AAA account is re- characterized into retained earnings. An existing AAA account could be paid out to the owner over a period of time or, the owner could take back a promissory note from the corporation in the amount of the AAA account. The latter would have an impact on the valuation of company stock.

9. The Control Issue

The shareholder(s) outside of the ESOP normally need to maintain their control of the company. The shareholder owning more shares than the combined shares of the remaining shareholders will maintain control by appointing himself/herself as the ESOP Trustee which votes the share held by the ESOP. Pre-ESOP if there are three shareholders at 66%, 20% and 14%, the 66% shareholder could sell 30% of his/her stock and still maintain control of the company. The selling shareholder would have 36% of the stock individually owned which is greater than the combined percentage of the 20% and 14% shareholders. As such he/she would appoint himself/herself as ESOP Trustee. The selling shareholder would vote his/her remaining 36% held individually and, as ESOP Trustee would also vote the 30% of stock inside the ESOP thereby voting a total of 66% of the stock.

What To Look For and Potential Pitfalls

Structuring a properly designed ESOP can be fraught with potential pitfalls. ESOPs are a complicated subject and mis-information or incorrect plan design can disqualify your plan and your tax deductions. Frequently, those looking at an ESOP for the first time don’t know what questions to ask or, whom to ask.

The first step is to hire an ESOP Design Specialist who can bring all the required components together. To successfully implement an ESOP you will need the ESOP Design Specialist to coordinate the valuation firm, an ERISA attorney, an administrator, and a lender, with the shareholders of the company, the IRS, corporate officers and management and other company advisors such as the outside CPA and the surety bonding company.

As with any type of industry the ESOP industry has good players and bad players – be careful who you select as your ESOP Design Specialist and thoroughly check out their references.

The ESOP Design Specialist can bring to the table lenders (not all banks understand ESOPs), an ERISA attorney (who has done 1,000’s of ESOPs), a stock valuation firm which understands ESOPs (valuation is an art, not a science) and an administrative firm that specializes in ESOPs (most don’t).

The ESOP design coordinator should be able to take what is a complicated process, explain the ESOP’s mechanics and procedures, advantages and disadvantages and, make it easy for the company owner to understand. Additionally, an ESOP Design Specialist should have a history of unwinding “bad ESOPs” and a history of telling potential clients that an ESOP is NOT suitable for their situation.

Beware of ESOP Designs using cookie cutter documents and unusually low implementation and design fees. Some ESOP Design Specialists quote low fees for implementation and then “run up the bill” for other services that are essential to the continued success of the ESOP.

ESOPs are not for everyone. Many ESOPs should not have been adopted as they would never accomplish their goals. Terminating and unwinding a poorly designed ESOP is expensive and can result in serious consequences for the Corporation and shareholders.

Beware of ESOPs that sound “too good to be true” There are types of ESOP structures that have been declared illegal by the Department of Labor and IRS, unfortunately as of the writing of this article some of these structures are still being implemented. Some of these structures while not illegal are also overly creative and are stretching the DOL and IRS regulations.

There are components of ESOPs that must by law be separate and distinct. One of the most common conflict of interests is that the Valuation Company is affiliated or owned by the ESOP Design Specialist, Client’s CPA firm or, Client’s bank. By law the valuation firm must be a 3rd party independent firm with no financial ties to any of the above entities. ESOP Valuations are very different to any other type of valuation method and the valuation firm must have prior ESOP experience.

ESOPs fall under ERISA (same as 401(k) Plans). Violations of ERISA Laws carry serious penalties and consequences for trustees and sponsoring companies.

A trusted ESOP Design Specialist can easily guide you through these complicated waters.