Identifying ESOP Opportunities

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1 Identifying ESOP Opportunities Thomas Roback, Jr., CEP, QKA Managing Director Blue Ridge ESOP Associates October I. About Blue Ridge ESOP Associates 1

2 Over 26 Years of Experience Dedicated to proactive client service ESOP Administration Experts ESOP Administration is Our Primary Business One of the Top Four Firms in the US in Number of Clients and the most interactive on-line tools in the industry Professional Staff with a Focus on Outstanding Client Service Directors and Managing Directors with 15 to 25 years of experience Professional Designations required for the staff CEFEX/ASPPA Administration certification II. Why Consider Putting an ESOP in Place? 2

3 ESOPs: A Solution for Private Business Succession At any given time, about 40% of closely-held U.S. businesses are looking for a transfer of ownership solution. Less than 1/3 of closely-held family businesses survive the transition from first to second generation ownership. Plans are unclear for CEOs who are: Retiring in five years 42% have no identified successor. Age 60+/- 28% have no successor. Closely-Held Clients Need Help With Ownership Transition Most hope to cash out or transfer the business to family members. In either case, your autonomy may be at risk. Brokers and M&A specialists prey on business owners with promises which cannot always be kept. You need unbiased strategic counsel to provide integrated options and an understandable process to achieve desired continuity goals. 3

4 Reasons Why Owners Fail to Successfully Transfer Their Business Lack of viability of the business. Reluctance by owner to give up control. Reluctance of next tier management or family members to take the helm. No real buyers. Adverse tax consequences. Lack of planning, the primary cause for failure. Integrated Planning Process 5 MANAGEMENT PHASE Vision, Values, Goals 1 PRELIMINARY INTERVIEW 2 DISCOVERY PHASE 4 IMPLEMENTATION PHASE 3 DESIGN PHASE Strategies and Products 4

5 Comprehensive Planning Approach BUSINESS INTERESTS CREATIVE PLANNING OVERLAP PERSONAL INTERESTS 1. Shareholder Considerations 2. Executive Benefits 3. Company Considerations 4. Employee Benefits 1. Cash Flow 2. Tax Planning 3. Wealth Management 4. Wealth Distribution 5. Personal Legacy Decisions should be made in the context of the complete picture. Options/Structures Available to Business Owners Close/liquidate the business. Gifts of stock, charitable trusts, and/or private foundation. Sell to an outsider. Sell to insiders (management, family members and/or employees). Family limited partnership. Installment sales to family members or rising management. Employee Stock Ownership Plan (ESOP). Retain ownership but hire outside management and keep taking a paycheck or establish deferred compensation arrangements. A combination of the above 5

6 The Vanilla Private Company Deal: Selling to Management The rising manager(s) are not usually high net worth individuals. OK, we ll bonus her the money and she ll buy our stock. $100,000 bonus to a rising manager manager pays $40,000 taxes, leaving $60,000 for stock purchase. Manager buys $60,000 of stock from shareholder: shareholder pays $10,000 capital gains tax (increase after 2012?) Outcome: Government $50,000 - Owner $50,000 Sale of Stock to Outside Buyer Complete sale of stock to an outside purchaser. Partial sale of stock to outside purchaser New purchaser generally will purchase enough to gain control. Minority stockholders then have limited powers. Tax consequences of sale Long-term capital gain treatment vs. ordinary income. 6

7 Sale of Stock to Corporation (Redemption) Sale must not impair capital of the corporation or cause it to become insolvent. Corporate redemption reduces the number of issued and outstanding shares (anti-dilutive): may alter control and share valuation post transaction. Tax Consequences to the selling stockholder May qualify for capital gain treatment or may be treated as dividend. Tax consequences to the corporation No taxable gain to the corporation unless it uses appreciated property in redemption. Stock acquired with after-tax dollars Interest paid on Promissory Note is generally tax-deductible. Which approach can do all of the following? Maintain ongoing company Provide a competitive advantage Allow for tax-advantaged sale by owner of all or part of the business The Answer an ESOP! 13 7

8 What is an ESOP? A defined contribution retirement plan that is qualified under federal tax law (Sec. 401(a)) and is primarily invested in company stock. Similar rules for eligibility and vesting as other qualified plans. 14 Company remains intact Benefits of an ESOP Significant tax advantages Added benefit to employees Benefit linked to company performance Increase in Enterprise Value 15 8

9 ESOP Candidate Criteria Succession Planning for Retirement Need for Diversification Business Cycle Considerations Company Size Strategic Sale Considerations Remaining Management Team Contingent Liabilities Available Collateral Do you believe in Employee Ownership? III. ESOP Mechanics 9

10 How To Create An ESOP Conduct a Feasibility study Hire Independent Appraiser to determine FMV for the company s stock Consult with an Attorney on ESOP plan design/fiduciary issues and preparation of trust, plan, and related documents Hire ESOP Administration firm Appoint the ESOP Trustee Proceed with implementation and sale 18 Leveraged Transaction - Variations Selling Shareholders Cash Contributions Cash Common Stock Company ESOP Loan Payments ESOP Loan ESOP Trust Company Loan Company Loan Payments Stock Allocation s / Distributions Bank Employees QRP 19 10

11 Non-Leveraged Transaction Company Cash Contributions Selling Shareholders Cash Common Stock ESOP Trust Stock Allocation s / Distributions Employees IV. ESOP Tax Incentives and Opportunities 11

12 ESOP Tax Incentives Owner Selling C Corp. shareholder(s) may defer capital gains taxes on sales of stock to an ESOP ( Section 1042 Rollover ) if reinvest in QRP within 12 months from sale. If seller note, can use installment treatment on payments. - Can take below market interest rate in exchange for warrants. If no section 1042 election, owner can participate in ESOP if still an employee. Company Contributions to ESOP are tax-deductible (generally 25% limit, but separate 25% for other DC plan of C Corp.). Contributions to the ESOP to repay both principal and interest on ESOP loan (not just interest). C Corp. dividends paid to participants or used to pay ESOP debt deductible. C Corp. ESOP loan interest do not count toward section 404 limit Employees Contributions and earnings thereon to ESOP accounts are tax-deferred until distribution. Special section 415(c) rules for C Corp. ESOPs. Forfeitures & interest on loan repayment excluded if < 1/3 ESOP contribution goes to HCEs. 22 Tax Incentives continued An ESOP s portion of the income earned by an S Corp. is not taxable. Downside No section 1042 rollover permitted. However, can do deal as C Corp., then switch to an S Corp., or if S Corp. can switch to C Corp. and do deal and then change back to S Corp. Since after 5 years. there are no federal taxes on an ESOP s share Separate of S Corp. anti-abuse income, a testing 100% under S Corp. section ESOP 409(p) does not need to make distributions to shareholders to pay these taxes. Enhanced cash flow! 23 12

13 American Tax Relief Act of 2012 Congress passed ATRA on January 1 st of 2013 ATRA's higher capital gains tax rates increases the value of Internal Revenue Code Section 1042, which allows sellers of stock to C corporation ESOPs to defer capital gains tax on the sale proceeds, subject to meeting appropriate qualifications. The increase in the income tax rate may also increase the value of the S corporation tax benefit. American Tax Relief Act of 2012 and ESOPs Under ATRA, capital gains tax rates will rise from 15% to 20% for single filers with incomes of more than $400,000 and joint filers with incomes of more than $450,000, which would include most sellers. In addition, under the Health Care and Education Reconciliation Act of 2010, as of 2013 an additional 3.8% Medicare surtax will be imposed on certain investment income received by high-income filers. A more complex effect arises from the so-called "Pease" limit, which, as revived under the American Taxpayer Relief Act, reduces itemized deductions by 3% of the amount of adjusted gross income of $250,000 for single filers and $300,000 for joint filers. The overall reduction in itemized deductions cannot exceed 80%. It is estimated this could add another 1% to tax costs, meaning just at the federal levels the total taxes could be as high as 24.8%. State taxes are in addition to this. 13

14 Distributions (Repurchase Liability) Small account balances typically paid in lump sum after year of termination Other payments typically start 6 th years after termination or 1 year after retirement/ death / disability - Participant may delay distribution until age 65 - Paid in cash lump sum or in annual installments up to 5 years Distributions taxed as ordinary income unless rolled over into an IRA In C Corp. leveraged transactions, distributions typically delayed until the loan is paid off Current ESOP Statistics from the NCEO* The National Center for Employee Ownership estimates that there are approximately 7,000 ESOP companies and over 13.5 million employees enjoying ESOP benefits. Due to M&A and other reasons there have been many ESOP terminations over the past few years. There are also about 2,000 profit sharing and stock bonus plans substantially invested in company stock. Plans that have at least 100 participants and have plan assets under $3.1 billion represent 32% of all ESOP and ESOP-like plans, 46% of all participants, and 38% of all plan assets. Small ESOPs and ESOP-like plans together account for approximately two-thirds of all plans, but only about 6% of plan assets and 9% of plan participants. On the other side of the spectrum, public companies with over $3.1 billion in total plan assets are just 0.8% of plans, but account for 55% of plan assets and 45% of plan participants. Some of the more notable majority employee-owned companies are Publix Super Markets (160,000 employees), Lifetouch (25,000 employees), W.L. Gore and Associates (maker of Gore- Tex, 10,000 employees), and Davey Tree Expert (7,800 employees). Companies with ESOPs and other broad-based employee ownership plans account for well over half of Fortune Magazine's "100 Best Companies to Work for in America" list year after year. *Employee Ownership Report, 2014, NCEO. 14

15 Current Events in the ESOP World Gratifying that ESOPs were not mentioned in the Camp proposal. Apparently, some Ways & Means members were impacted by some ESOP company tours over the years! This past summer the Supreme Court ruled that ESOP fiduciaries are not entitled to the special Moench presumption of prudence defense, but they held that plaintiffs will have to plausibly allege special circumstances for imprudence which is a high bar. The Citizen s Share (Blasi, Kruse and Freeman) book was published by Yale Press in 2013 recounting the history of shared ownership in the U.S. dating back to our founding fathers General Social Survey found that only 2.6% of employee-owners reported being laid off in the previous 12 months, compared to 12.1% of non-employee-owners. Also, 24.3% of non-owner employees intend to lok for a new job in the near future, while only 12.9% of employee-owners do. Georgetown Business School study showed that in the most recent recession, S Corp. ESOP companies showed resilience and performed better than other companies in providing for workers' retirement security, job creation, and revenue growth. 83 million Baby-Boomer business owners are starting to think about retirement and an ESOP could be the right solution 1042 may become more fashionable with higher capital gains rate Q&A 15

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