By Otto Lange
The drawbacks of U.S. Government regulations surrounding ESOPs have been well-documented within the employee ownership community. A recent case has once again brought these drawbacks to the public’s attention.
Precise Systems, Inc. was a service-disabled veteran-owned small business (SDVOSB) awarded a SDVOSB government contract for the State Department’s aviation program in 2014. After receiving the contract, four competitors filed a complaint with the Small Business Administration (SBA) claiming Precise Systems did not satisfy the SDVOSB requirements because of their ESOP.
According to SBA certification requirements, eligible owners must hold 51 percent ownership of the company and 51 percent in each class of share. For simplicity, many small businesses keep their shares the same class, so there is no class difference between shares held by the owner and shares in the ESOP. In this scenario, eligible owners simply hold 51 percent of outstanding shares for their company and can maintain their SBA certifications.
However, Precise Systems split their shares into two classes. The owner, John Curtis, held 51 percent of the company entirely in Class A shares. The Class B shares (49 percent) were held by the ESOP. Although Mr. Curtis was still the majority owner of the company, the SBA suit claimed he did not own 51 percent of the company and 51 percent of the Class B shares.
After review, the SBA determined that Precise Systems did not meet the certification requirements, and their SDVOSB certification was revoked. On appeal, Precise Systems claimed that the U.S. Department of Veterans Affairs offered certain exceptions to ESOP shares, and the SBA ruling was acting against the administration’s own interest because it discourages small business owners from establishing ESOPs. The decision was upheld and Precise Systems lost their SDVOSB certification. The company was no longer a SDVOSB, and was therefore ineligible for the contract they had previously won.
These SBA requirements make it difficult for owners to establish ESOPs and meet minimum certification requirements. This problem is compounded when you consider additional government agencies that have contradictory legislation in similar scenarios. The Internal Revenue Service allows business owners to defer taxation on their sale of stock to an ESOP. This benefit, called Internal Revenue Code “Section 1042,” has been an incentive encouraging business owners to establish ESOPs. However, to meet the requirements for Section 1042, selling shareholders cannot accept any shares in the ESOP.
This leaves Mr. Curtis in an unfavorable situation. With the Class B Shares being held in the ESOP, he is faced with the decision to accept shares in the ESOP to keep the SDVOSB Certification and lose eligibility for Section 1042, or not accept shares in the ESOP to elect 1042 but lose the SDVSOB certification. Both benefits became mutually exclusive, and put Precise Systems and Mr. Curtis in an onerous situation. Business owners should not be punished for increasing employee ownership.
The Precise Systems lawsuit has brought attention to the limitations of ESOP regulations, and has once again restarted discussions on how government agencies should promote employee ownership. To address these concerns, U.S. Congressman Dave Reichert (WA-8) recently submitted H.R. Bill 2092: Promotion and Expansion of Private Employee Ownership Act of 2017 to improve the SBA certification process, and provide more incentives to companies establishing ESOPs.
For my detailed summary of H.R. 2092, please follow the link: Submitted H.R. Bill 2092 Would Improve ESOP Environment for Small Businesses
Otto Lange, graduate student associate, Beyster Institute and Rady MBA candidate 2018