GETTING THE MOST OUT OF YOUR ESOP

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1 GETTING THE MOST OUT OF YOUR ESOP Michael G. Keeley Hunton & Williams LLP 1445 Ross Avenue Suite 3700 Dallas, Texas (214)

2 Traditional Sources of Capital for Community Banks Private Placements Local rights offerings Public markets Pooled trust preferred Bank stock loans 2

3 Employee Stock Option Plan ESOP can provide ready source of capital to support growth, fund acquisitions or improve capital ratios. Can add capital on tax advantaged basis. 3

4 What is an ESOP? An ESOP is a tax advantaged retirement plan for employees of a bank which invests primarily in stock of the employer. The employer can contribute employer stock to the ESOP, the employer can contribute cash to the ESOP which the ESOP uses to buy stock, or the ESOP can borrow funds to purchase stock. Generally stock held by the ESOP is allocated among the employees in proportion to their relative compensation. 4

5 What is an ESOP? Cont d After an employee has been with the employer for a pre determined length of time, he becomes vested and has the right to receive the stock allocated to his account when he dies, retires or leaves the employer. The retiring employee can keep the stock or he can require the ESOP or the employer to repurchase the stock. 5

6 The ESOP as an Employee Benefit Employees become part owners of the bank and should become more motivated to improve corporate performance and shareholder values since they benefit directly. If the bank grows and is successful, ESOP benefits are often superior to those of other employee retirement plans. Studies indicate that employee productivity in fact improves when ESOP s are put in place. 6

7 Four Ways ESOPs Can Be Used to Raise Capital Voluntary rollover of 401(k) funds into ESOP by 401(k) plan participants. Employee rollover from IRA or other qualified plan into ESOP. Employer contribution to ESOP. Leveraged ESOPs. Funds in ESOP are then used by ESOP to purchase authorized but unissued stock. 7

8 Rollover of Employee Funds from 401(k) Bank with a 401(k) plan can add an ESOP feature to that plan to create a KSOP. Employees can be given the opportunity to move funds from their account in the 401(k) to their account in the ESOP. Funds moved to ESOP are then used to purchase authorized but unissued stock in the bank, thus increasing capital. Purchase is at appraised fair market value. 8

9 Rollover from 401(k) Cont d This is completely voluntary no employee is required to move any funds. Maximum permitted rollover is typically limited to percent of total in employee s account. Disclosure document is required this is an offering of securities by the employer. 9

10 Employee Rollovers Bank can allow new or existing employees to roll funds in rollover IRA or other qualified plan into their account in the bank s ESOP. These funds can then be used to buy authorized but unissued employer stock which will increase bank capital. This rollover option can also be offered to target bank employees at the time of an acquisition. 10

11 Employer Contributions Most banks make periodic contributions to a retirement plan for employees. Profit sharing plan. Employer match for 401(k) Plan. $1.00 contribution to 401(k) Plan costs the bank $1.00 before taxes. It does benefit employees, but provides no capital for the bank. The same dollar contributed to an ESOP and used to purchase authorized but unissued stock costs the bank $1.00 before taxes. It will both benefit employees and add $1.00 in capital for the bank. 11

12 Leveraged ESOP ESOP can borrow funds from third party bank to purchase authorized but unissued stock. Loan is repaid from dividends on shares and from contributions by the bank to the ESOP. As the loan is repaid, capital of bank is increased and shares are allocated to employees. Contributions to ESOP to repay interest and principal are tax deductible to the bank so the after tax cost of repaying the loan is $.65 on the dollar. Compare after tax cost of this capital to holding company debt, debentures or trust preferred which must be repaid in after tax dollars. 12

13 Subchapter S ESOP Can have even greater benefits. No tax at holding company level Sub S. No tax at shareholder level ESOP. When Sub S tax dividends of 35% - 40% of taxable income are paid out to holding company shareholders, ESOP gets its share, but it owes no federal income taxes. 13

14 Subchapter S ESOP Cont d Can provide comparable retirement benefit at lower cost or greater retirement benefit at same cost. When employee of Sub S bank retires, holding company or ESOP repurchases those shares. All appreciation in the stock is taxed at capital gains rates. Compare tax treatment to cash distributions from 401(k) Plan. Be aware of 409A limitations on Sub S ESOPs for closely held banks. 14

15 Important Considerations Dilution of existing shareholders. Does occur but dilution occurs with any common equity raise. Ability of bank to repurchase stock of retiring employees give board the ability to reverse dilution. 15

16 Important Considerations - Cont d Control Board selects trustees of the plan and they are typically directors. Trustees vote the shares held in the ESOP for election of directors. Pass through voting is required on mergers or sales, but these transactions will only come to the shareholders if approved by the board. 16

17 Important Considerations - Cont d Cost Setting up ESOP. Annual appraisal. Plan administrator. Fiduciary duties 17

18 Tax Deferral for ESOP Purchases General ESOP purchases from existing shareholders: Provides additional purchaser for shareholders. No dilution to existing shareholders 18

19 1042 Transaction Tax Deferral for ESOP Purchases Cont d The selling shareholder can defer any federal income taxes on the sale of his stock by investing the proceeds of the sale in marketable stock or bonds. If securities are held until date of death, estate will get a step up in basis to fair market value at date of death. Estate can then sell the securities without triggering the gain on the original sale of the bank stock. Federal income tax on the sale of the selling shareholder s bank stock is then avoided completely. 19

20 Requirements For Section 1042 Sale: The selling shareholder must have held the bank stock for at least three years prior to the sale to the ESOP. Immediately after the sale, the ESOP must own at least 30% of the stock of the bank. The sale must otherwise qualify for long term capital gains treatment. Within a 15 month period beginning 3 months prior to the sale to the ESOP, the selling shareholder must purchase qualified replacement property and must file certain written statements with the IRS. 20

21 Qualified Replacement Property Qualified replacement property: Common stock, preferred stock, notes, debentures or bonds issued by an unaffiliated domestic operating corporation other than an insurance company. Qualified replacement property certificates of deposit, government securities or mutual funds Qualified replacement property securities of a company which has a passive income in excess of 25% of its gross receipts. However, qualified replacement property does include stocks and bonds of literally thousands of companies whose securities are listed on major stock exchanges or are traded over the counter. 21

22 Tax Deferral Federal income tax on the sale of the bank stock is deferred as long as the qualified replacement property is held. Tax is not triggered by: a gift of the qualified replacement property by the selling shareholder. most tax free reorganizations 22

23 Tax Deferral Cont d If the selling shareholder holds the qualified replacement property until date of death, his estate will get an automatic step up on basis under Section 1014 of the Internal Revenue Code. His estate could then liquidate the securities to pay estate tax and distribute the proceeds to his heirs without triggering federal income tax on the original sale of his bank stock. Federal income tax on the sale of the bank stock would then be avoided completely. 23

24 Possible Investment Strategy Can have even greater flexibility on use of funds: Invest the proceeds of the sale of the selling shareholder s bank stock in marketable common stock or long term bonds of highly rated, investment quality companies. Use dividends and interest from these securities to maintain the selling shareholder s lifestyle. Use the securities as collateral to purchase a variety of other investments which can be modified or sold without triggering federal income taxes on the original sale of the bank stock. 24

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