A BUSINESS SUCCESSION, CORPORATE FINANCE, AND ESTATE TOOL AS THE OWNER OF A PRIVATELY HELD C CORPORATION, DID YOU KNOW...

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1 THE PRUDENTIAL INSURANCE COMPANY OF AMERICA BUSINESS STRATEGIES An Employee Stock Option Ownership Plan (ESOP) A BUSINESS SUCCESSION, CORPORATE FINANCE, AND ESTATE TOOL AS THE OWNER OF A PRIVATELY HELD C CORPORATION, DID YOU KNOW... 4That you can sell your stock and defer capital gains tax on the sale possibly permanently? 4That you can purchase capital assets or another company for your business using pretax dollars? 4That you can refinance existing debt with fully tax-deductible principal and interest on the replacement loans? A properly structured ESOP transaction not only provides tax-qualified retirement benefits to your employees, but it can also serve as a business succession, corporate, and estate finance tool loan. WHAT IS AN ESOP? An ESOP is a tax-qualified defined contribution retirement plan designed to provide employees with an ownership stake in the company. Surveys show that ESOPs, combined with a participative management style, can boost morale and performance. In addition, ESOPs are unique in the qualified plan arena because they are allowed to borrow money to purchase employer stock. When an ESOP borrows money, it is called a leveraged ESOP. A leveraged ESOP is a powerful financial tool that not only grants equity ownership to a company s employees but can simultaneously provide important advantages to the company and its current owners. Perhaps the most common use of a leveraged ESOP is to buy out the existing owners through a taxadvantaged strategy. CONSIDER THE FOLLOWING BENEFITS OF ESTABLISHING AN ESOP FOR THE SHAREHOLDERS 4Creates a market for shareholders of closely held corporations who want to sell their stock in a taxefficient manner. 4Provides a means for owners to defer taxation on gains from the sale of their corporate stock sometimes permanently. 4Allows shareholders to gradually sell stock over a period of time while remaining in control, allowing for a more orderly transition of management responsibilities. 4Potentially reduces a shareholder s investment risk through tax-deferred diversification from closely held company stock to a portfolio of publicly traded investments Prudential Financial, Inc. and its related entities Ed. 03/2016 Exp. 09/23/2017

2 CONSIDER THE FOLLOWING BENEFITS OF ESTABLISHING AN ESOP (CONTINUED) FOR THE EMPLOYEES 4Allows the employees to share in the value of the company they helped build. 4Provides tax-deferred benefits, since employees pay no tax on stock allocated to their ESOP accounts until they receive actual distributions. FOR THE CORPORATION 4Serves as a tax-deductible recruitment and retention tool by offering equity compensation to talented 4When the transaction is properly structured, the corporation can deduct principal and interest on the ESOP loan as well as dividends paid to the ESOT and its participants. This can result in an increased cash flow to the corporation. 4Allows the corporation to finance acquisitions or refinance existing debt on a tax-deductible basis. 4ESOP loans often receive preferred lending rates and provisions from third-party lenders. 4Collateral for an ESOP loan is often created outside the corporate structure (i.e., the use of qualified replacement property), leaving the business with better debt capacity. HOW A LEVERAGED ESOP WORKS (SEE ILLUSTRATION ON THE NEXT PAGE) Like any other ESOP transaction, a leveraged ESOP starts with the services of a professional independent business appraiser who helps to determine the fair market value of the stock. The appraisal is important since tax law requires that an ESOP pay no more than fair market value for the shares acquired. The company then implements the ESOP plan, which involves written documentation and the establishment of an employee stock ownership trust (ESOT) that will hold the stock to be purchased for the The trustee of the ESOT then borrows the purchase funds from a third-party lender with a company guarantee. In the alternative, the loan is made to the company and the company in turn lends the funds to the ESOP. The ESOT uses the borrowed funds to buy stock from the shareholders. While the loan is outstanding, the stock is held in a suspense account. As the company makes annual contributions to the ESOP and funds become available to pay down the loan, shares of stock are released into individual employee accounts in proportion to the loan repaid. Employees receive their vested account balances in stock or cash when they retire or otherwise leave the company. The chart that follows illustrates this transaction.

3 LEVERAGED ESOP 1. Guarantee CORPORATION 3. Cash 1. Loan LENDER ESOP TRUST EMPLOYEES 3. Loan Payments 2. Cash/Stock 4. Stock or Cash SHAREHOLDERS THE LEVERAGED ESOP CAN BE USED IN A VARIETY OF SCENARIOS FOR BUSINESS SUCCESSION By selling stock to the ESOP, owners in a closely held corporation can create a private market for their company stock. In addition, 4The company can fund the transaction using pretax dollars (subject to restrictions). 4The owner can defer (sometimes permanently) capital gains on stock sold to the ESOP if, after the sale, the ESOP owns 30% or more of each class of outstanding stock and the proceeds are reinvested by the seller into stocks and/or bonds of certain U.S. operating corporations ( qualified replacement property ). AS A FINANCIAL TOOL By using a leveraged ESOP, the business is, in effect, financing acquisitions with pretax dollars. Financed dollars can be used to refinance existing debt and purchase capital assets or even another company. The ESOP technique allows the business to fully deduct the amount financed, giving the company additional cash flow. AS AN ESTATE SETTLEMENT TOOL ESOPs are not only a business tool but can also play an important role in estate settlement for the business owner who has the majority of his/her wealth invested in the business. ESOPs are required to be valued by an independent appraiser at implementation and on an annual basis. A properly documented appraisal can help establish the value of the stock prior to an owner s death, avoiding delays in settling the estate. ESOPs can help reduce the value of the estate by removing stock prior to a majority owner s death. Because the ESOP serves as a ready buyer for any stock held by the estate, it helps to avoid a forced estate sale. In addition, where there is a need for asset protection and portfolio diversification, the ESOP paired with a family limited partnership results in additional leverage for estate tax purposes.

4 ESOPS ARE NOT FOR EVERYONE By now you may be thinking that the benefits of establishing an ESOP look very attractive. In situations where ESOPs are appropriate, there are undeniable advantages. However, they are not for everyone. There are certain factors that should be present before an ESOP is considered. SOME OF THE KEY FACTORS TO CONSIDER: 4The business must be structured as a corporation. 4The shareholders should have objectives that an ESOP can help solve, such as those previously described above desire to create a market for the stock, desire to diversify business interest on a taxfavored basis, desire for additional working capital, etc. 4The shareholders must be willing to share equity ownership. 4The corporation should be financially strong with a promising future profitable with debt capacity. 4The corporation should have a high labor-intensive factor in relation to gross earnings gross earnings in excess of $10 million annually, payroll in excess of $1 million (excluding the owners), taxed at or near the top corporate bracket. 4There should be strong second-line management desiring to take over the business. 4The corporation should be in a position to continue to operate profitably after the present managers/ owners are gone. 4The corporation should be one whose success is due in large part to the efforts of the rank-and-file An ESOP may be the solution if the majority of these factors apply and the owners have a desire to create a market for their stock or to diversify their stock ownership, or a need for additional working capital. But, like any tax strategy, ESOPs have their advantages and disadvantages. Before establishing an ESOP, it s important that all parties to the transaction consider the following: FOR THE SHAREHOLDER 4Where the ESOP strategy requires the corporation to issue additional shares, dilution may result. But dilution isn t always bad. Consider an ESOP strategy where the acquisition of a company adds significant profit to the bottom line. Here, the existing shareholders have a smaller piece of a bigger pie. 4A loss of voting control may occur over time as a large block of minority shareholders is created. This is less of an issue during the working years since stock is held in the ESOT and is normally voted by an ESOP committee elected by the corporate board. Buyout provisions in the ESOP document can help alleviate block control when stock is distributed. FOR THE EMPLOYEES 4If the company suffers financially, employees may reach retirement age with little or nothing they can count on for retirement. FOR THE CORPORATION 4ESOPs are complex and costly to develop, implement, and maintain. Legal fees, appraisal fees, and other costs to establish an ESOP can exceed $100,000. In addition, there are annual costs for stock appraisals and plan administration. 4When shares of closely held companies (whose shares are not publicly traded) are distributed from the ESOT, participants must be given an opportunity to sell the shares back to the plan sponsor at fair market value for a limited period of time. This repurchase obligation creates a liability that the company must be prepared to honor.

5 IMPORTANCE OF PLANNING FOR THE REPURCHASE OBLIGATION The repurchase obligation is one of the important issues facing closely held companies with ESOPs. Companies that fail to plan properly to meet this obligation put employee morale, the continuation of the ESOP, and even the future of the company at risk. THE ROLE OF LIFE INSURANCE Life insurance can play a role in the overall ESOP strategy. Life policies held by the corporation on the lives of key executives can provide the funding needed to honor the repurchase obligation. THE NEXT STEP If, after studying the pros and cons of an ESOP, you think that an ESOP is the right solution for your company, the next step is to have a feasibility study conducted by a qualified advisor who specializes in ESOP transactions. As of December 2015, the National Center for Employee Ownership (NCEO) estimates there are approximately 9,323 ESOPs in place in the U.S., covering 15 million Source: This document is provided for information and educational purposes only to an individual or entity that may be interested in the purchase of life insurance. It provides general information concerning employee stock ownership plans ( Concept ). Prudential will only act in the capacity of a product provider with regard to the Concept and will not provide the Concept to you. You must obtain the Concept from an individual or entity that is independent of Prudential and who has responsibility for implementing the Concept. Additionally, Prudential will not provide tax or legal advice and has not endorsed or promoted the use of the Concept nor how a life insurance policy is used within the framework of the Concept. If you desire to use the Concept and purchase life insurance from Prudential, you must also engage the services of your own legal counsel. When you purchase a life insurance policy from us, we will require that you sign a Disclosure Letter that acknowledges that you have discussed the Concept with your independent legal counsel and obtained advice related to the Concept s risks and benefits. Life insurance is issued by The Prudential Insurance Company of America and its affiliates. All are Prudential Financial companies located in Newark, NJ, and each is solely responsible for its own financial condition and contractual obligations. Life insurance policies contain exclusions, limitations, reductions of benefits, and terms for keeping them in force. Your financial professional can provide you with costs and complete details. The availability of other products and services varies by carrier and state. Investment and Insurance Products: Not Insured by FDIC, NCUSIF, or Any Federal Government Agency. May Lose Value. Not a Deposit of or Guaranteed by Any Bank, Credit Union, Bank Affiliate, or Credit Union Affiliate. Prudential, the Prudential logo, and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities Prudential Financial, Inc. and its related entities.