The ESOP Business Model. February 2013

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1 The ESOP Business Model February 2013

2 Topics to be Covered + Purpose and Regulatory Environment + Major Benefits of ESOPs + ESOP Transactions + Business Valuation Standards + ESOP Accounting Rules + ESOP Problem Areas

3 Purpose + Regulatory Environment + Business Succession tool for closely held corporations + Tax-qualified retirement plan that must be designed to invest primarily in the sponsoring company s stock + The sponsoring company, the selling shareholder and the ESOP participants receive special tax benefits, as well as other advantages + Governed by Internal Revenue Code (enforced by IRS) and ERISA (enforced by DOL) z

4 Purpose + Regulatory Environment + Corporate governance standards for majority owned ESOP company generally requires higher standard of diligence since Tittle v. Enron + Exemptions from prohibited transaction provision of ERISA Section 406 by ERISA Section 408(b) and Code Section 4975(d) + Employer securities must meet requirements of Code Section 409(l) + Certain participant voting rights must be granted per code Section 409(e) + ESOP transactions involving employer securities must meet requirements of Code Section 401(a)(28) and ERISA Section 3(18) z

5 Purpose + Regulatory Environment + Restricted allocation and ownership rules apply to S corp ESOPs under Code Section 409(p) and, under certain circumstances, to C corp ESOPs under Code Section 409(n) + Employer sponsor required to be market maker of its stock in ESOP under Code Section 409(h) and ERISA Section 408(e) z

6 Major Benefits of ESOPs + Instrumental in building a culture that can assure company longevity + Long-term comparative studies by Rutgers University and University of Pennsylvania indicate ESOP companies outperform their non-esop peers in sales, profitability, job growth and longevity.

7 Major Benefits of ESOPs + Selling shareholders may be able to defer or exclude gains on sale of stock to C corp ESOP + Deduction for company contribution used to pay interest on money borrowed to purchase company stock + Deduction for dividends on company stock used to repay money borrowed to purchase company stock with C corp + Offers employees stake in the company with no cash payments + Exemption from U.S. and most state corporate income taxes with S corp to extent of ESOP ownership

8 Major Benefits of ESOPs + Creates an on-going market for the stock of a closely-held company using pre-tax dollars + Selling shareholder and/or management can maintain effective control of the company without having actual ownership of company stock + ESOP holding company provides both tax benefits and asset protection

9 Major Benefits of ESOPs + Section 1042 Rollovers: Gain taxes on sale of shares to ESOP can be deferred or excluded: + Owner sells stock issued by a domestic, non-publicly traded C corp to ESOP + ESOP must own at least 30% of stock after sale + Seller must reinvest proceeds in qualified replacement property (QRP), which are securities of domestic operating companies + Seller, seller s family and 25% owners cannot receive allocations of 1042 stock in the ESOP (for 10 years as to Seller and family members)

10 Major Benefits of ESOPs + Section 1042 Rollovers (continued): + Tax deferral can be permanent if QRP transferred by gift, death of seller or corporate reorganization + Sellers can borrow against QRP and obtain cash without losing tax deferral

11 Major Benefits of ESOPs + S corporation ESOPs + ESOP is a tax exempt shareholder of sponsor company + 401(k), profit sharing plans, etc., are not tax exempt + 100% ESOP owned S corp pays no U.S. or Ohio income taxes + Company can retain tax savings or distribute to shareholders + If distribution made, all shareholders receive pro rata + If profits retained, company stock value increases more rapidly

12 Major Benefits of ESOPs + S corporation ESOPs (cont.): + Owners selling to ESOP of S corp can t elect Sect rollover + Ownership of S corp ESOP must be broadly based + Individual(s) with at least 10% or family with at least 20% of deemed ESOP ownership cannot own 50% or more of all company stock (can include synthetic equity)

13 Major Benefits of ESOPs + Net financial benefit to Company equal to present value of tax shield plus Company or market return on tax shield + Net financial benefit to selling shareholder(s) dependent upon lost net div/distr, net income of sale proceeds and stock allocation inside ESOP + Tax benefits may not capture comparative long-term performance increases because of Company cultural changes + Tax shield and value increases can be used as incentives for acquisition targets

14 ESOP Transactions: Basic Structure z Cash (2) Cash ESOP Participants (1) $ Contribution Company Owners Stock (2) Stock (1) Company makes a tax deductible contribution to the ESOP. (2) ESOP trustee issues a check to the Owners who transfer the stock to the trustee. (3) The stock is allocated to participant accounts (based on compensation).

15 ESOP Transactions: Basic Financing + Non-leveraged ESOP z + Cash from company or from other tax-qualified retirement plans (401(k), profit sharing, etc.) can be used to fund the purchase of stock by the ESOP + Company can also contribute its stock directly to the ESOP and take tax deduction for the value of the stock

16 ESOP Transactions: Leveraged Cash (3) Cash ESOP Participants (5) Loan (2) Contribution (4) Loan Payment (4) Stock Loan pymt (6) (3) Company Loan (1) Owners Bank (1) Bank makes a front end loan to the Company. (2) Company makes a back end loan to the ESOP. (3) ESOP trustee issues a check to Owners who transfer the stock to the trustee held in suspense account. (4) Company makes contribution to the ESOP and ESOP makes loan payment to the Company. (5) Contribution releases stock pro rata from suspense account to participant accounts. (6) Company makes loan payment to Bank.

17 ESOP Transactions: Leveraged Financing + Loan cannot be payable on demand, except to extent of default + ESOP loan must be used only to purchase shares or pay off an existing ESOP loan + Generally amortized over years + Must be for primary benefit of ESOP participants z

18 ESOP Transactions: Leveraged Financing + Leveraged ESOP + Generally, bank lends to company and company lends to ESOP; two loans not necessarily identical company loan to ESOP is often longer term + If bank loans directly to ESOP, company guarantees + Seller financing available using a note from ESOP secured by financed stock + Interest rate must be market rate for similar loans + Stock purchased with loan must be pledged as collateral

19 MESOP Transactions: Mezzanine Cash (4) Cash ESOP Participants ESOP Loan (3) Company Owners Loan (1) Mez Loan (2) Stock (4) Bank Mez Investor Warrants (5) (1) Bank makes a front end loan to the Company (senior debt). (2) Mezzanine lender/investor enables 100% S corp ESOP by taking unsecured sub debt with warrants from Company. (3) Company makes a back end loan to the ESOP (ESOP loan). (4) ESOP trustee issues a check to Owners who transfer the stock to the trustee held in suspense account. (5) Warrants redeemed by Company or sold in IPO

20 ESOP Transactions: Acquisitions ESOP Participants (3) Cash Loan (2) Contribution Loan (2) Company Stock Company Bank (1) Target Stock Sect.1042 Rollover Company Stock Target Company (4) Target Owners (1) Company issues new shares of its stock to the Target Owners for all shares of Target Company (2) Company obtains front end loan from Bank and makes back end loan to the ESOP (3) ESOP trustee issues check to the Target Owners who transfer Company stock to trustee (4) Target Owners may qualify for Section 1042 tax-free rollover Note: Alternative methods are reverse triangular merger or double merger (companies and ESOPs)

21 ESOP Transactions: CHESOP ESOP Participants Loan or Contribution (2) Company Stock Owners Stock (3) (1) (3) Cash Charitable Remainder Trust (CRT) Income (4) (1) Owners contribute stock to Charitable Remainder Trust (CRT) and obtain income tax deduction (2) Company funds ESOP with loan or contributions (3) ESOP trustee issues check to CRT trustee who transfer stock to ESOP (4) Owners receive income for life from CRT investments

22 ESOP Transactions: FLESOP ESOP Loan Cash The Company Cash Family Ltd. Entity Loan Stock Bank Owners Stock (1) Owners form family limited partnership (FLP)or family LLC (FLLC) funded with Company stock and gift discounted non-control FLP interests to children. (2) Bank makes front end loan to Company which makes back end loan to ESOP. (3) FLE sells controlling interest in Company to ESOP with no minority discount. (4) Interests in FLP, and likely FLCC, have some protection from creditors. Caution: Transfer of QRP by FLP results in gain recognition of QRP

23 Real Estate ESOP: RESOP cash proceeds (3) cash proceeds ESOP real estate contribution (1) Company Shareholders FMV price (2) real estate (2) Real Estate LLC stock (3) (1) Qualifying real property with no mortgage contributed to ESOP and fair market value is deferred comp expense (limited to 25% of Company payroll) (2) ESOP sells real estate to Real Estate LLC at fair market value (Real Estate LLC could include some or all Shareholders) (3) ESOP uses cash proceeds of real estate sale to purchase Company stock from Shareholders (pay capital gains taxes) Effect is to sell or distribute real estate without corporate level tax and without ordinary income taxes to Shareholders.

24 Business Valuation Standards + ERISA Section 3(18) adequate consideration standard + Code Section 401(a)(28) independent appraiser standard + IRS Rev. Ruling and DOL Prop. Reg (b) + Requirements for valuator of stock for ESOP + Advisor to trustee and not to company or seller(s) + Trustee, not valuator, determines value of stock + Valuator must be professional business appraiser with no interest in the transaction or the parties thereto

25 Business Valuation Standards + Primary methods under fair market value (FMV) standard + Discounted cash flow (DCF): present value of projected cash flows discounted by cost of capital + discounted residual + Market: sales of similar companies or ratio based values (e.g., P/E ratio) of traded guideline companies + Net asset: asset sale or orderly liquidation value of the company + Value of company equity is obtained by subtracting capital debt from enterprise value (total capitalized value)

26 ESOP Accounting Rules + SOP 93-6 (aka, FASB ) issued December, 1993, by Accounting Standard Division of the AICPA: + An external ESOP loan (e.g., bank loan) is booked as longterm debt (credit to liabilities) and the corresponding leveraged shares are recorded as a contra-equity account or unearned compensation expense (debit to equity) on the balance sheet + An internal ESOP loan (loan from employer to the ESOP), absent an external loan, is booked as a credit to cash and debit to equity (contra account) + ESOP Note is not company asset

27 ESOP Accounting Rules + Principal payments to release shares from the suspense account are booked as deferred compensation expense on income statement, as reductions (debit) to LT debt and an increase (credit) to equity (contra account) on the balance sheet + Deferred comp expense is based upon the current FMV of stock released in the ESOP and any difference from its cost basis is applied to equity (PIC) + The increase (credit) to equity (contra-equity account) is determined by the cost basis of the released stock and the difference between FMV and cost is recognized in equity (debit or credit to PIC)

28 ESOP Accounting Rules + Suspense account shares are not considered in the EPS calculation, but ESOP valuations reflect suspense account stock as outstanding in computing value per share + Dividends on allocated stock are charged to retained earnings and dividends on unallocated stock, which constitute loan payments to release shares, are charged to compensation and interest expense

29 ESOP Accounting Rules + Under section 0.53(f), the existence and nature of any repurchase obligation should be disclosed (i.e., footnoted but not booked), including the fair value of allocated shares subject to repurchase obligation + FAS 150, generally effective for closely-held companies as of December 15, 2003, requires companies that do not follow SOP 93-6 to report all or part of the ESOP repurchase obligation as a company liability

30 ESOP Problem Areas + Defective or Impaired Valuation + Valuator not independent appraiser per Code Section 401(a)(28) (C) + Failure to use accepted methods (DCF, market guideline and net asset) + Assumptions, including projections, not supported or reasonable + Failure to address related party transactions + Improper treatment of transaction debt + Lack of audited or reviewed financial statements + Deficient consideration of repurchase obligation

31 ESOP Problem Areas + Transaction Pitfalls + Major selling shareholder serves as Trustee or as named fiduciary + Trustee fails to conduct independent investigation of transaction + No transaction letter or take down letter to Trustee + No fairness opinion if multi investors or related transactions + Section 1042 election not perfected + Charter documents or shareholder agreements not amended + Deficient planning for 404, 415 and 409(p) restrictions

32 ESOP Problem Areas + Fiduciary Conflicts + Chief corporate fiduciary serves as chief ESOP fiduciary + Ignoring differences in corporate fiduciary duty vs. ERISA fiduciary duty + Failure of fiduciary separation in M & A situations

33 ESOP Problem Areas + Operational Problems + Record keeper (TPA) not competent with leveraged ESOPs or S corp ESOPs + Lack of timely distribution forms and no stock election + Voting procedures ignored as stated in ESOP + Lack of timely account statements and Form 5500 filings + Unauthorized loans or distributions + Lack of timely 404, 415 and 409(p) testing

34 Tim Jochim + Chair of Kegler Brown s ESOPs practice area + National authority on ESOPs and business succession. He also has expertise in corporate finance, M+A and employee benefits + Adjunct professor of corporate finance at the Capital University School of Law, Columbus, Ohio + Member of corporate boards and frequent speaker to business and trade organizations Tim Jochim, Kegler Brown (614) keglerbrown.com/jochim 65 E. State St., Suite 1800 Columbus, OH Author of Employee Stock Ownership and Related Plans and of articles published in Ohio Business, The Journal of Employee Ownership Law and Finance, Taxation for Accountants, and Taxation for Lawyers + Co-founder of the Ohio Chapter of The ESOP Association and a member of the legislative committee of The ESOP Association + Recognized as an expert attorney on ERISA and ESOP law and its application to closely held businesses by Chambers USA and received Martindale-Hubbell rating of AV

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