ESOPs--- ACCOUNTING ISSUES AND CONSIDERATIONS. Peter J. Chudyk Maloney + Novotny LLC Cleveland, Ohio

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1 ESOPs--- ACCOUNTING ISSUES AND CONSIDERATIONS Peter J. Chudyk Maloney + Novotny LLC Cleveland, Ohio

2 HOW DOES A LEVERAGE ESOP WORK? Company forms an ESOP In order to effectuate the purchase, the Company (or ESOP) will borrow from a qualified lender the funds necessary for the ESOP to purchase Company s shares. This is called a leveraged ESOP The Company immediately loans the proceeds to the ESOP. The loan from the Company to the ESOP will be secured by a pledge of the ESOP shares.

3 EXAMPLE Company value $10,000,000 Leveraged ESOP 30 percent 30,000 shares $3,000,000 2-step Loan 100,000 shares outstanding $100 per share ESOP price Principal Only Collateral Release Special Rule $3 million Loan 10

4 $3,000,000 loan with bank 10 year equal amortization at 5-1/2% Loan between ESOP and company $3,000,000 loan 10 year equal amortization at 5-1/2%

5 DIRECT LOAN ESOP $3.0m $3.0m SH Stock 30,000 shs. BANK Bank Collateral: Stock guaranteed by company COMPANY

6 2- STEP LOAN ESOP Stock 30,000 shs. SH $3.0m N o t e $3.0m COMPANY $3.0m Note BANK Bank collateral Company assets

7 ESOP debt, whether direct or indirect, is on sponsor s balance sheet. The offsetting entry is to unearned ESOP shares, a contra equity entry.

8 IMPLEMENTATION BEFORE ESOP Assets $10,000,000 Debt Equity $ 5,000,000 $ 5,000,000 Total $10,000,000 Total $10,000,000

9 IMPLEMENTATION IMMEDIATELY AFTER ESOP Assets $10,000,000 Debt $ 8,000,000 Equity $ 5,000,000 Unearned ESOP Shares -3,000,000 Net Equity $ 2,000,000 Total $10,000,000 Total $10,000,000

10 ESOP CONTRIBUTION/LOAN REPAYMENT FLOW OF FUNDS ESOP $550,000 Payment on debt $550,000 ESOP contribution COMPANY $555,000 Payment to bank BANK

11 THE MECHANICS OF A LEVERAGE ESOP As the Company contribution is made and the ESOP repays its loan, shares are released from the suspense account and are allocated to the individual participant s account. The allocation formula is typically based on compensation

12 IMPACT ON INCOME STATEMENT Compensation cost is measured by the FMV of the shares allocated, released or committed to be released.

13 IMPLEMENTATION FIRST PAYMENT/DEPRECIATION 3,000 SHARES RELEASED, AVERAGE VALUE $80 GAAP TAX Pre-ESOP Earnings $2,000,000 $2,000,000 ESOP Expense *-240, ,000 Interest Expense -165, ,000 Net Income $1,595,000 $1,535,000 *Company can use the higher cost basis if plan provides for it, but company must be consistent.

14 IMPLEMENTATION FIRST PAYMENT/APPRECIATION 3,000 SHARES RELEASED, AVERAGE VALUE $120 GAAP TAX Pre-ESOP Earnings $2,000,000 $2,000,000 ESOP Expense -360, ,000 Interest Expense -165, ,000 Net Income $1,475,000 $1,535,000

15 SPECIAL INCENTIVES FOR SELLERS A selling shareholder may defer gain on the sale of shares to an ESOP (1042 transaction), if: The ESOP owns at least 30% of the outstanding shares of a privately owned C corporation The seller owned shares for at least 3 years The seller makes a timely election, and The seller must by qualified replacement property within 3 months before and 12 months after the sale.

16 Qualified Replacement Property Stocks and bonds of US corporations, whether public or private that derive no more than 25% of gross income from passive sources and use more than 50% of the assets in an active trade or business. It does not include US government and municipal securities, mutual funds, limited partnerships, or the stock of the corporation (or its affiliates) that was the subject of the ESOP transaction.

17 1042 TRANSACTION The company must consent to be subject to an excise tax in the event the stock sold to the ESOP subject to the 1042 transaction is sold within 3 years The selling shareholder who takes advantage of 1042 certain individuals may not be allocated any of the shares he sells to the ESOP

18 S CORPORATION Portion owned by ESOP, not currently taxed In order to provide the most tax savings- ESOP ownerhsip should be as close to 100% as possible Loss of 1042 deferral, currently it is only available to selling shareholders of C corporations. In the event Company elects to be a C corporation, it cannot become an S corporation for 5 years.

19 S CORPORATION ESOP accounting is unaffected. Tax provision typically not necessary. Deferred taxes eliminated except for possible built-in gains

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