An ESOP is a very flexible instrument that uses tax-deductible or tax-free dollars to achieve a variety of corporate objectives, as outlined below:

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1 Summary of ESOP Uses An ESOP is a very flexible instrument that uses tax-deductible or tax-free dollars to achieve a variety of corporate objectives, as outlined below: 1. Provide a market (at fair-market value) for partial or complete sale by existing shareholders with a "tax-free rollover" treatment if ESOP ownership is 30% or greater. 2. Make tax-deductible contributions and loan principal and interest payments via the ESOP. (Professional Service Companies make reimbursable contributions and loan payments.) 3. Provide for the acquisition or divestiture of a company or division using pre-tax funds. 4. S corporation stock owned by an ESOP is not subject to federal tax. 5. Allow tax deduction for dividends paid to employees or used to repay ESOP debt. 6. Convert an existing profit sharing (or money purchase) plan into an ESOP, whereby the funds can be made available for the purchase of new company shares and/or existing stock. 7. Raise working capital by selling newly-issued stock to a leveraged ESOP, or refinance existing debt by contributing stock to the ESOP and deducting the full value of the contribution. 8. Recapture up to 2 years of prior paid federal taxes. 9. Other applications include privatization, perpetuation, an IPO alternative, charitable giving, going private, and 401(k)/ESOP combination plans. ESOP Tax Shields "Tax-Free Rollover of Stock Sold to the ESOP Shareholders of a closely-held C corporation may sell their stock to the ESOP, and under certain circumstances pay no tax, provided the proceeds are reinvested in the securities of operating domestic, public or private corporations within twelve months after or three months before the sale to the ESOP (IRC 1042). In order to qualify, the stock sold cannot be Section 83 stock, and it must be held for a three-year period prior to the sale to the ESOP. Tax-Deductible Loan Payments Contributions used to make ESOP loan principal payments are tax deductible to the corporation.

2 Tax-Free S Corporation Income Income attributable to stock owned by an S corporation ESOP is not subject to federal tax. This benefit may not be available for smaller companies with approximately ten or fewer employees, due to IRC 409(p). Tax-Deductible Dividends When Paid Through the ESOP Dividends on C corporation ESOP stock that are passed through the ESOP to participants or used to repay ESOP loans may be tax deductible to the corporation. These dividends are not counted in the normal contribution limit of 25% of payroll Tax Free Liquidity For owners of privately-held companies, tax-free liquidity may seem like a farfetched dream. While selling stock in a tax-free "stock-swap" is theoretically possible, it is the type of transaction that rarely occurs. Even when it does, the former owner or owners of the privatelyheld company now own stock in another corporation (usually public) and are at the mercies of the marketplace as to what the value of their new stock is or will be. An alternative strategy that has now been employed by thousands of privately-held companies throughout the U.S. is a Controlled Employee Stock Ownership Plan, or CESOP. Under this strategy existing shareholders sell a portion of their stock to the Employee Stock Ownership Plan (ESOP), but still retain operating control of the corporation (thus the name CESOP). There are almost an infinite number of variations of ESOPs for corporations. Not only do the rules differ depending on whether a company is private or public, an S Corporation or a C Corporation, but they even differ within those categories depending on whether the ESOP borrows money to buy stock (leveraged), or just makes annual contributions similar to a profit sharing plan (non-leveraged), whether or not employees vote their stock for the board of directors, or own enough shares in the ESOP to have control. This article will focus on the CESOP where employees do not have control, and do not vote for the board of directors. CESOP The owners of C corporation stock will sell the ESOP less than 50% of the stock that they own (the minimum is 30%). In turn, they can avoid paying any income or capital gains-tax on the transaction provided that a number of criteria are met and they follow certain rules, including those outlined below. Funds must be reinvested within 12 months after the sale to the ESOP in the securities of domestic operating companies. Stocks or bonds of a public or private company are eligible provided that they are not majority owned by a foreign entity. Investors can be conservative or aggressive. Individuals who have invested in this diversified portfolio of securities have an investment portfolio that is no different than any other diversified investment portfolio that an investor might have, except the original basis of the privately-held company stock is carried over to the diversified portfolio. As a result, the investor can borrow against the portfolio (unless the

3 securities are already pledged as collateral), receive interest and dividend income (which will be currently taxable) and sell any portion of the portfolio at any time. The sale of any portion of the portfolio will trigger a capital gains tax only on that portion of the portfolio that is sold, at the capital gains rates then in effect (currently 20% federal). If the portfolio is held until death, the individual's estate receives a "stepped up" basis (with the exception of 2010), capital gains taxes have been totally avoided. Not only does the ESOP "tax free" rollover allow the private company owner to diversify his or her investment, thus substantially reducing risk, but it also facilitates estate planning. Estate Planning 1) Transfer of Assets - Now that some or all of what was stock in a privately-held company is invested in securities in a diversified portfolio of liquid marketable securities, the ability to transfer assets to family members and others is greatly enhanced. 2) This diversified liquid marketable portfolio can be used to provide advance funding for the payment of estate taxes. 3) If an estate is eligible for "spread out" tax payments, stock can be sold to the ESOP by the estate to generate the cash necessary to make tax payments. Since the sponsoring corporation funds the ESOP, on a tax deductible basis, it is the corporation that bears the cost of paying the estate taxes. Corporate Advantages In addition to the first tax shield discussed above, the "tax-free" rollover available for C corporation stock sold to an ESOP, the second major tax shield that the ESOP provides is to the corporation. Contributions made to the ESOP by the corporation are fully tax deductible. This includes the repayment of both principal and interest on any loans that are made through the ESOP. (Unlike profit sharing plans, 401 (k) plans, and pension plans, the ESOP can borrow money to buy stock.) S corporations can also sponsor ESOPs, but the "tax-free" rollover is not available. However, the S Corporation can convert to C Corporation status. Another substantial benefit to the corporation is the proven increased employee motivation and productivity that occurs when employees receive meaningful benefits through an ESOP. As stated earlier, this does not impact on the control of the corporation, but it can have a dramatic impact on increased employee performance. Summary ESOPs can truly be win-win-win programs, benefiting the existing shareholders, the corporation, and its employees. This is made possible through the generous tax incentives provided to privately-held companies to motivate them to install ESOPs. And ESOPs are here to stay. Originally promoted by Louisiana Senator Russell Long, ESOPs have been installed by thousands of privately-held mid-size businesses and have strong bipartisan support in Congress. ESOPs aren't for every company. But the potential benefits are so substantial for the right company that we encourage every stockholder in a privately-held company, along with that

4 individual's professional advisers, to take a serious look at whether or not an ESOP will be beneficial in their situation. Tax-Free Income Available for Most Private Companies - S Corporation ESOP Rules IRS Regulations Issued December 2004 IRS regulations issued in December 2004, (1.409(p) 1T), clarify several changes made by the Tax Act of 2001 to the rules that apply to S Corporation ESOPs. While the law and the regulations generally impact smaller S Corporations with approximately 20 or fewer employees, IRC 409(p) must be carefully studied prior to any final determination regarding eligibility for tax-free S Corporation income. The 1997 Tax Act allowed S Corporation stock to be owned by an ESOP. An S Corporation ESOP will not be subject to federal income tax on its share of the net income of the S Corporation or on gains realized upon the disposition of employer stock. Also, an S Corporation ESOP will not be required to offer participants the right to receive distributions in the form of employer stock these plans may make all distributions in cash. Note, however, that certain special ESOP tax incentives (including the tax-free sale provisions of IRC 1042) will not be available to S Corporation ESOPs. The 2001 Tax Act included an anti-abuse provision IRC 409(p), that imposes an excise tax on an S Corporation if share ownership through the ESOP is or becomes highly concentrated (generally more than 50%) among one or more ESOP participants. The anti-abuse provisions prohibit an ESOP from allocating shares of stock in the corporation to a disqualified person during a non-allocation year, and also limit other types of compensation. C Corporations currently sponsoring ESOPs can convert to S Corporation status, and the percentage of stock owned by the S Corporation ESOP is not subject to federal (and most states ) income tax. Thus a 100% ESOP-owned S Corporation no longer pays federal income tax. Privately held C Corporations can first execute a tax-free (IRC 1042) rollover transaction in which eligible selling shareholders pay no capital gains tax on the transaction. At the beginning of the company s next fiscal year, the C Corporation can convert to S Corporation status, and the S Corporation will receive tax-free income. The conversion from C Corporation to S Corporation status involves a number of significant accounting issues, and complex ESOP rules, including IRC 409(p), which should be thoroughly reviewed by experienced professional advisors prior to any final decision being made.

5 Advantages of an ESOP COMPANY STOCKHOLDERS EMPLOYEES 1. Substantial tax savings (up to 100%) 2. Corporate perpetuation 3. Cash flow increased 4. Pre-tax dollars repay debt 5. S corporation stock owned by an ESOP is not subject to federal tax 6. Tax-deductible dividends 7. Net worth increased 8. Provides a match on employees' 401(k) deferrals 9. Justified accumulated retained earnings 10. Buy/sell agreements funded with pre-tax earnings 1. Creates liquidity at fairmarket value 2. Control maintained (if desired) 3. "Tax-free" rollover treatment available to sellers in closely-held companies 4. Establishes valuation and provides liquidity for estate tax purposes 5. Selling stockholderemployee participates in ESOP if "rollover" not elected 6. Selling shareholders excluded from ESOP participation can be "made whole" 7. Additional equity incentives still available 1. Employees share in equity growth of company 2. ESOP employer contributions tend to be larger than profit sharing contributions 3. Proven motivator, builds unity, and team spirit 4. Accounts accumulate tax-free. Tax favored at distribution 5. Employees can realize dividend income 6. Buy/sell agreements insure future employee ownership through the ESOP (k) plans can be enhanced with ESOPs

6 Steps to an ESOP 1. Consideration "...an ESOP is a win-win-win situation." -Business Review- Preliminary Analysis Initial review of corporate objectives and data (no fee charged). Determine if S corporation status is a viable alternative. Preliminary Stock Appraisal Estimate the company's fair-market value. Financial Analysis Estimate long-range effects of an ESOP on company operations under a variety of circumstances. Repurchase Obligation Study Conduct an analysis to establish the future payout requirements of the ESOP. Design Study Determine features of an ESOP that will positively affect employee motivation while implementing corporate objectives. 2. Installation Plan Implementation Execute all documents and file all required forms to secure an I.R.S. Favorable Determination Letter. Appoint trustee. Financing Secure appropriate financing for a leveraged transaction and recommend alternatives for structuring an ESOP loan. Communications Introduce the ESOP and related plans to employees with an audio-visual presentation, a "plain English" summary and a Q & A session that targets crucial employee concerns. Independent Stock Appraisal Arrange for the transaction appraisal, strictly interpreting the independence requirement. Repurchase Obligation Funding Explore funding alternatives for private companies to buy back ESOP stock upon distribution.

7 Administration Initiate record keeping services with experience and expert third-party administrators. Provide a comprehensive manual for dayto-day administration. Professional Liaison Maintain liaison with attorneys, accountants, investment managers and trust officers and commercial lenders to assure a smooth and efficient installation. "ESOPs have become more popular in the past few years as a way to raise capital for new and ongoing concerns." -Success Magazine- 3. Operation Appraisal Annual independent appraisal to determine current fair-market value. Legal Monitor tax law changes and regulatory developments and amend documents as needed. Financial Assist in capital formation and/or acquisition of other companies, including subsequent leveraged transactions. Repurchase Obligation Study Periodically review and update repurchase obligation projections. Communications Assist in ongoing communication, including communication updates and annual employee meetings. Liaison Maintain liaison and coordinate with other professional advisors. Administration Assist in day-to-day operation and interpretation of plan features. 4. Affiliated Services Deferred Compensation Assist in structuring non-qualified compensation programs to supplement or replace ESOP benefits for key employees.

8 Investment Management Recommend investment advisors experienced in the "tax-free" rollover and other investment account areas for existing qualified plans. Related Benefits Assist companies in the design and implementation of other qualified plans, such as 401(k), and coordinate these related plans with the ESOP.

9 ESOP Research In the Largest and most significant study to date, of ESOP performance in closely-held companies, Drs. Kruse and Blasi of Rutgers University, found overwhelmingly positive results. ESOPs increase sales, employment, and sales per employee by 2.3% to 2.4% per year over what would have been anticipated in a non-esop company. ESOPs increase sales, employment, and sales per employee by 2.3% to 2.4% per year over what would have been anticipated in a non-esop company. ESOP companies are substantially more likely to have other retirement-oriented benefit plans than comparable non-esop companies. While the results are in line with previous research, no study of closely-held companies has matched the scope of this one. Their study surveyed companies establishing ESOPs between 1988 and 1994, matching companies with ESOPs to comparable non-esop companies. Sales and employment at these companies were compared for a period of three years before and after the plan's start, 343 companies were represented. The results showed that ESOP companies perform better in the post-esop period than their pre- ESOP performance would have predicted. The table below shows the difference in the pre-esop to post-esop period for ESOP companies on sales growth, employment growth, growth in sales per employee and average employee productivity: Difference in Post-ESOP to Pre-ESOP Performance Change In: Annual Sales Growth 2.4% Annual Employment Growth 2.3% Annual Growth in Sales per Employee 2.3% Average Employee Productivity 4.4% Projected over 10 years, an ESOP company with these differentials would be a third larger than its paired non-esop match. Blasi and Kruse examined whether ESOP companies stayed in business longer than the paired comparisons. The study tracked over one thousand ESOP companies from 1988 to 1999 and compared those companies to the same number of non-esop companies. Eleven years later, this larger group of companies survived at a higher rate. Of the companies that did disappear, they were less likely to go bankrupt.

10 ESOPs and Corporate Survival Percentage Survival Through ESOP Companies Non-ESOP Companies Difference % 89.2% +8.7% The final point of comparison was whether the companies had other kinds of benefit plans In a 1998 study by Kardas & Keogh, Washington Department of Community Trade & Economic Development and Adria Scharf, University of Washington, the average total value of all retirement accounts per employee in ESOP companies was found to be $32,213 while in non- ESOP companies it was only $12, 735. ESOP and Benefit Plans Other Pension Plans ESOP Companies Non-ESOP Companies Difference Defined Benefit Plans 20.1% 4.9% +15.2% 401(k) Non-401(k) Profit Sharing Other Defined Contribution Plans The Rutgers Study was funded by the Foundation for Enterprise Development, The Employee Ownership Foundation, The National Center for Employee Ownership, Rutgers University and Dun & Bradstreet. President Reagan on ESOPs Meanwhile, what about the workers in those state monopolies that are being put up for sale? I am reminded of a technique for employee ownership that has worked well for many U.S. companies. It goes by various names but the best known is Employee Stock Ownership Program or E.S.O.P.. With such a program, the employees of a company create a trust which borrows money from a bank to buy shares of stock in the company. The loan is paid back over several years from the employees share of the company s profits. How can they be sure the company will be profitable? The workers, as owners, make sure by insisting that unprofitable or obsolete products be replaced by new ones; that operating costs be kept down; and that new efficiencies of operation are adopted. In the U.S. we have seen it happen time and again. It is another fact of human nature: When a person owns assets a house, land, a small business or shares of stock in a big one he or she will look after those assets -From a speech delivered on September 15, 1990 in Gdansk, Poland President Reagan Video on ESOPs A 10 minute video of Ronald Reagan's Speech on Project Economic Justice on

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