OEOC 2012 Annual Conference Special Issues for S Corp ESOPs

Transcription

1 OEOC 2012 Annual Conference Special Issues for S Corp ESOPs Introduction S Corp Basics 409(p) Issues Repurchase Obligation Issues Have and Have Not Issues Questions & Answers

2 S Corporation Basics Mary Giganti Waldheger Coyne Co., LPA 1991 Crocker Rd., Ste. 550 Westlake, OH

3 Pass-Through Tax Treatment An S corporation is generally not subject to federal income tax. The shareholders are taxed on the corporation s income, whether it is distributed to them as dividends or retained in the corporation. Each shareholder is allocated his proportionate share of each item of corporate income, deduction, loss and credit. Example: Mr. Brown owns 60% and Mr. Green owns 40% of Blue Corporation. Blue Corporation had a profit of $100,000. Mr. Brown has $60,000 of taxable income and Mr. Green has $40,000 of taxable income.

4 Shareholder s Basis in Stock A shareholder s basis in stock of an S corporation is increased by his share of the corporate income and is decreased by any distributions and his share of the corporate deductions and losses, but not below zero. Stated more simply, a shareholder s basis is his cost, plus a share of each year s corporate income, less each year s deductions. Example: Assume Mr. Brown s cost basis was $0.00 and Blue Corporation made a distribution of 40% of the profits to cover tax liability. Mr. Brown s new stock basis is $ $60,000 (profit) - $24,000 (40% distribution) = $36,000.

5 S Corporation ESOP Most efficient, tax effective structure. Major tax incentive to become and stay an S corporation ESOP company. Gives ESOP companies an significant business advantage. If ESOP owns 100% of the S corporation, generally no federal income tax is paid. Per S corporation rules, all items of income and deduction flow through to the shareholder. The shareholder, the ESOP, if properly qualified and operationally remains qualified, is tax-exempt and does not pay any income tax. Income tax is ultimately collected when participants take taxable distributions from the ESOP.

6 Federal Income Tax Comparison C Corporation S Corporation Type of shareholder Individuals ESOP Taxable Income 1,000,000 1,000,000 1,000,000 Corporate Tax 340, Net 660,000 1,000,000 1,000,000 Assume Distribute Net to shareholders 660,000 1,000,000 1,000,000 Dividend Tax (15%) 99, Income Tax (35%) 0 350,000 0 Shareholder Net 561, ,000 1,000,000

7 S Corporation Requirements Number and Type of Shareholder In order to elect and maintain S status, the following requirements must be met: No more than 100 shareholders. An ESOP counts as one shareholder, regardless of the number of participants. All shareholders must be U.S. citizens or U.S. residents, natural persons, estates or certain types of trusts.

8 S Corporation Requirements One Class of Stock The corporation can have only one class of stock. must have identical rights to distributions and liquidation proceeds Voting and non-voting is permitted. Options, warrants, shareholder agreements can inadvertently create a second class of stock. Debt can be deemed to be a second class of stock if it has characteristics that more closely resemble equity than debt.

9 S Corporation Requirements Tax Year The corporation must use a calendar year unless the year of a majority of the taxpayers is a different fiscal year or the corporation obtains consent from the IRS to use a natural business year.

10 S Corporation Requirements The Election The S election (Form 2553) may be made any time prior to the beginning of the tax year. The S election can be made within the first 2 ½ months of the tax year, and be retroactive to the first day of the tax year as long as the corporation is eligible during the entire retroactive time period.

11 Advantages of an S Corporation Avoids the Double Tax. Because the S corporation itself is not generally subject to tax, there is only one level of tax, paid by the shareholder. C corporations are subject to two layers of tax, one at the corporate level, and one at the shareholder level. The C corporation pays tax on its profits. The C corporation shareholder pays tax on dividends.

12 Advantages of an S Corporation Cont. Savings on Sale or Liquidation. Shareholders of an S corporation pay tax once, at their individual tax rates, upon the sale of the corporation s assets or upon liquidation of the corporation. However, shareholders of a C corporation are subject to double tax upon the sale of the corporation s assets or upon liquidation of the corporation. The corporation pays a tax on the difference between the sale or liquidation proceeds and the corporation s basis in its assets. The shareholders will then pay tax on the distribution of the after-tax proceeds from the sale or liquidation.

13 Advantages of an S Corporation Cont. Pass-Through of Losses. The shareholders of an S corporation may apply corporate losses to reduce their income from other sources, up to their tax basis in their stock. Losses of a C corporation may be used by the C corporation (and not the C corporation shareholders) to offset prior or future corporate income.

14 Advantages of an S Corporation Cont. Other Advantages: avoidance of the corporate alternative minimum tax Avoidance of the accumulated earnings tax availability of the cash method of accounting.

15 Disadvantages of an S Corporation Shareholder limits - number and type of shareholder is limited as noted previously. One class of stock - restricts planning opportunities for the capital structure of an S corporation. Distributions must be pro-rata to all shareholders Cash Flow Considerations. If there are non-esop shareholders, the S election may have a negative impact on cash flow. Typically, S corporations distribute sufficient funds for the tax-paying shareholders to pay the tax liability. Distributions must be made pro rata to all shareholders, including the ESOP. Cash may build up within the ESOP and not the company. This may skew ESOP participant accounts in favor of longer term employees and even terminated employees whose ESOP account holds employer stock.

16 Disadvantages of an S Corporation Cont. Subject to 409(p). S corporation ESOPs must comply with Code Section 409(p) or be subject to draconian excise taxes. 409(p) will be discussed later in the presentation. Other Disadvantages. 2% or more shareholders are subject to income tax on the value of certain fringe benefits, such as medical insurance and group term life insurance.

17 Converting to an S Corporation Built-in Gains Tax An S corporation is subject to tax on the sale of assets within the first 10 years of the corporation s election to be tax as an S corporation (the built-in gains tax). The built-in gains tax only applies to sales of assets which were owned by the corporation on the effective date of the S corporation election. Internal Revenue Code Section Appraising assets at the time of conversion is recommended. For a cash basis corporation, accounts receivable collected after the conversion are subject to the built-in gains tax.

18 Converting to an S Corporation Cont. LIFO Recapture A C corporation that uses LIFO inventory accounting and elects to become an S corporation is subject to LIFO recapture. The LIFO recapture is the aggregate difference between LIFO and FIFO in existing inventory and is paid over four years, beginning with the last C corporation year. Internal Revenue Code Section 1363(d).

19 Converting to an S Corporation Cont. C Corporation Earnings and Profits (E&P) There are potential taxable dividends if distributions exceed the Accumulated Adjustments Account (AAA) In general, the AAA is the aggregate, undistributed taxable income or loss of the S corporation Distributions are generally treated as paid from AAA first. To eliminate E&P, all shareholders can elect to treat distributions as being paid first out of E&P (taxable) and then from the AAA.

20 Converting to an S Corporation Cont. Passive Investment Income There is a limitation on the amount of passive investment income an S corporation with E&P can have. If net passive investment income exceeds 25% of gross receipts during the tax year, the excess is subject to the highest rate of corporate tax. If passive investment income exceeds 25% of gross receipts for 3 consecutive years, the corporation s S status is terminated at the end of the third year. Internal Revenue Code Section 1375.

21 Converting to an S Corporation Cont Treatment is not available to an S corporation. If a shareholder desires 1042 treatment, create the ESOP and sell shares to the ESOP while a C corporation and then convert to an S corporation. Make sure the 1042 transaction does not occur within the 2 ½ month retroactive S election time period.

22 Mary Giganti Waldheger Coyne Co., LPA 1991 Crocker Rd., Ste. 550 Westlake, OH

23 The Unique Alternative to the Big Four 409(p) Testing Legislative provision to tackle perceived abuses of great tax advantages of being an ESOP-owned S-Corp Unlike other compliance tests, there are no retroactive corrections and the penalties are nuclear: Disqualified Person s prohibited allocations are subject to current income tax as distributions Penalty tax for S-Corp: 50% excise tax on all prohibited allocations In first nonallocation year, 50% excise tax on value of deemedowned shares of DPs 50% excise tax on value of synthetic equity owned by DPs in any nonallocation year Member Horwath International 2010 Crowe Chizek and Company LLC 23

24 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Start with balances held by participants in the ESOP at the time for which test is being run 12/31/2011 Share Name Balance Heather M. 100 Jessica 95 Melissa 75 Dustin 60 Bob 55 Kristin 40 Heather J 50 Tammy 35 Jaime 67 Aaron 75 Lori 58 Mark 90 TOTALS 800 Member Horwath International 2010 Crowe Chizek and Company LLC 24

25 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Allocate any suspense account shares (for 409(p) testing purposes only) based on most recent share release allocation Pro-Rata Suspense 2011 Portion of Share Name Allocation 2011 Allocation Allocation Heather M % 20 Jessica % 10 Melissa % 16 Dustin % 24 Bob % 26 Kristin % 16 Heather J % 4 Tammy % 12 Jaime % 18 Aaron % 16 Lori % 14 Mark % 24 TOTALS % 200 Member Horwath International 2010 Crowe Chizek and Company LLC 25

26 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Add actual ESOP shares and suspense account shares together 12/31/2011 Suspense Deemed-Owned Share Share ESOP Name Balance Allocation Shares Heather M Jessica Melissa Dustin Bob Kristin Heather J Tammy Jaime Aaron Lori Mark TOTALS ,000 Member Horwath International 2010 Crowe Chizek and Company LLC 26

27 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Determine percentage of ESOP shares owned by each participant 12/31/2011 Suspense Deemed-Owned Share Share ESOP ESOP Name Balance Allocation Shares Ownership % Heather M % Jessica % Melissa % Dustin % Bob % Kristin % Heather J % Tammy % Jaime % Aaron % Lori % Mark % TOTALS , % Member Horwath International 2010 Crowe Chizek and Company LLC 27

28 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Determine family members and family ownership 12/31/2011 Suspense Deemed-Owned Individual Individual Share Share ESOP ESOP Family ESOP Name Balance Allocation Shares Ownership % Members Ownership % Heather M % A 22.50% Jessica % A 22.50% Melissa % Dustin % Bob % Kristin % Heather J % Tammy % Jaime % Aaron % Lori % Mark % TOTALS , % Member Horwath International 2010 Crowe Chizek and Company LLC 28

29 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Determine Disqualified Person based on ESOP ownership % 12/31/2011 Suspense Deemed-Owned Individual Individual Share Share ESOP ESOP Family ESOP Disqualified Name Balance Allocation Shares Ownership % Members Ownership % Person? Heather M % A 22.50% Yes Jessica % A 22.50% Yes Melissa % Dustin % Bob % Kristin % Heather J % Tammy % Jaime % Aaron % Lori % Mark % Yes TOTALS , % Member Horwath International 2010 Crowe Chizek and Company LLC 29

30 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Add in Synthetic Equity (limited to percentage ESOP owns the company) and determine percentages again Deemed-Owned Deemed-Owned Ownership % Individual ESOP Synthetic ESOP + With Family ESOP Disqualified Name Shares Equity Synth Equity Synth Equity Members Ownership % Person? Heather M % A 25.98% Yes Jessica % A 25.98% Yes Melissa % Dustin % Bob % Kristin % Heather J % Tammy % Jaime % Aaron % Yes Lori % Yes Mark % Yes TOTALS 1, ,140 Member Horwath International 2010 Crowe Chizek and Company LLC 30

31 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Determine ownership of all shares and Synthetic Equity held by Disqualified Persons Deemed-Owned Disqualified ESOP Synthetic Non-ESOP Total Name Person? Shares Equity Shares Ownership Heather M. Yes Jessica Yes Melissa Dustin Bob Kristin Heather J Tammy Jaime Aaron Yes Lori Yes Mark Yes TOTALS ,442 Member Horwath International 2010 Crowe Chizek and Company LLC 31

32 The Unique Alternative to the Big Four 409(p) Testing Steps to the test: Determine Disqualified Person Ownership Percentage A: Disqualified Persons Ownership 1,442 B: Total Shares (ESOP and non-esop) 5,000 C: DP Synthetic Equity 140 D: B+C 5,140 A / D 28.05% Test Passes DP Ownership is less than 50% Member Horwath International 2010 Crowe Chizek and Company LLC 32

33 The Unique Alternative to the Big Four 409(p) Testing Non-allocation year: DP: Plan year in which DPs own >= 50% of aggregate outstanding shares of S-Corp, including deemed-owned shares Plan year in which DPs own >= 50% of aggregate outstanding shares of S-Corp, including deemed-owned shares and synthetic equity Owns >= 10% of aggregate deemed-owned shares Together with family, owns >= 20% of aggregate deemedowned shares Owns >= 10% of deemed-owned shares plus synthetic equity Together with family, owns >= 20% of deemed-owned shares plus synthetic equity Member Horwath International 2010 Crowe Chizek and Company LLC 33

34 The Unique Alternative to the Big Four 409(p) Testing Synthetic equity: Stock warrant, restricted stock, deferred stock right, stock appreciation right payable in stock, or similar interest or right to acquire stock in the future Right to future cash payment based on stock value or appreciation or nonqualified deferred compensation Right to acquire ownership in related entity Right to acquire S-Corp assets, other than goods/services at FMV in ordinary course, fringe benefits excludable from income Right to receive non-vested IRC 83 property or IRC 83 property in future Certain split-dollar life insurance arrangements Other deferred compensation arrangements payable after 15 th day of 3 rd month after S-Corp s fiscal year Member Horwath International 2010 Crowe Chizek and Company LLC 34

35 The Unique Alternative to the Big Four 409(p) Testing Synthetic equity: Exclude: Stock that is issued, outstanding and held by a taxable person other than the S-Corp, the ESOP or a related entity, although that stock is counted to determine if nonallocation year occurs Deemed-owned shares Attribution of ownership applies: partnerships, trusts, estates, corporations owned >= 50% Related entity: Q-Sub (disregarded 100% S-Corp subsidiary), other disregarded entity (LLC, etc.), partnership or trust Cash or property value is converted to shares with the same FMV; can use FMV as of first day of plan year or other reasonable date used consistently Member Horwath International 2010 Crowe Chizek and Company LLC 35

36 The Unique Alternative to the Big Four 409(p) Testing ESOP provisions required Include 409(p) provisions Provide for correction of allocations that may violate 409(p) Provide for avoiding allocations that may violate 409(p) Specify special alternatives for synthetic equity other than stock-based arrangements, i.e., nonqualified deferred compensation Can determine non-stock synthetic equity annually Must recalculate non-stock synthetic equity at least every 3 years Testing required Requirements must be satisfied on each day during the plan year Member Horwath International 2010 Crowe Chizek and Company LLC 36

37 The Unique Alternative to the Big Four 409(p) Testing Very broad definition of family Spouse, any lineal ascendants and descendants of the individual or spouse, any siblings of the individual or spouse, any lineal descendants of such siblings and any spouse of any of the family members listed above (e.g., spouse, parents, grandparents, brothers, sisters, in-laws, nieces, nephews, etc.) Member Horwath International 2010 Crowe Chizek and Company LLC 37

38 The Unique Alternative to the Big Four 409(p) Testing Prospective testing required Stock acquisitions, redemptions, sales, marriages, deaths, and changes in executive compensation can all affect testing Need to pass testing on daily basis Member Horwath International 2010 Crowe Chizek and Company LLC 38

39 The Unique Alternative to the Big Four 409(p) Testing Adjustments where ESOP owns < 100% of S-Corp Number of synthetic equity shares is reduced ratably with regard to percentage of S-Corp stock held by non-esop owner For example, if an ESOP owns 150 shares and Joe owns 50 of the S-Corp total 200 shares, and Joe otherwise would have 200 synthetic equity shares, Joe is treated as only having 150 synthetic equity shares (ESOP s 150/200 x Joe s 200 = 150) Synthetic equity with greater voting rights Number of synthetic equity shares is increased in proportion to greater voting rights For example, if ESOP shares have 1 vote per share, and Joe s 1 synthetic equity option share has 100 votes, Joe is treated as having 100 synthetic equity shares Member Horwath International 2010 Crowe Chizek and Company LLC 39

40 The Unique Alternative to the Big Four 409(p) Testing Prevent nonallocation year from occurring Rearrange stock ownership through redemption, stock transfers from DPs to non-dps, issuance of new stock to non-dps outside of ESOP Limit allocations to DPs, if they are also highly-compensated employees Establish non-esop component of the ESOP Redesign synthetic equity End participation by DPs Make payments to DPs from nonqualified deferred comp. plans Cannot merely increase interests of non-dps Terminate ESOP to maintain S-Corp status Distribute accounts to participants Convert plan to non-esop Terminate S-Corp status Revocation by 15 th day of 3 rd month of tax year Disqualification Member Horwath International 2010 Crowe Chizek and Company LLC 40

41 The Unique Alternative to the Big Four Stock Distributions Stock distributions cannot be demanded by participants unlike in a C-Corp ESOP (IRC 409(h)(2)(B)) Distributing in stock could violate S election due to the 100 shareholder limitation Generally done under automatic put option described on prior slide to protect S election Member Horwath International 2010 Crowe Chizek and Company LLC 41

42 The Unique Alternative to the Big Four Stock Distributions Direct rollover of S-Corp stock (Revenue Procedure ) ESOP must require immediate repurchase of stock (automatic put option) The S-Corp actually purchases the stock the same day of the distribution No income, loss, deduction or credit is allocated to the IRA related to the S-Corp stock This allows the S-Corp sponsor to redeem the shares from the IRA Difficult to do rollover is often accomplished through a 60-day rollover Member Horwath International 2010 Crowe Chizek and Company LLC 42

43 The Unique Alternative to the Big Four Stock Distributions - Other Issues Delay of distributions related to shares purchased by loan until loan repaid 409(o)(1)(B) not clear if this applies to S-Corps Practitioners differ in opinions May depend on entity status when loan established Plan document provisions and determination letter should control Member Horwath International 2010 Crowe Chizek and Company LLC 43

44 The Unique Alternative to the Big Four Cost Basis Adjustment Cost basis is the price at which shares are acquired by the ESOP Examples: An ESOP borrows $10 million and purchases 100,000 shares of the sponsoring employers stock for that amount Per share cost basis = $100 ($10 million 100,000 shares) An employer contributes 1,000 shares of stock to the ESOP, when the fair market value is $10 per share Per share cost basis = $10 Member Horwath International 2010 Crowe Chizek and Company LLC 44

45 The Unique Alternative to the Big Four Cost Basis Adjustment Revenue Ruling Holds that the stock in an S-Corp ESOP stock must be adjusted in the same manner as S-Corp non-esop stock is adjusted Cost basis increased for certain income items of the company Cost basis decreased for expense items and for S-Corp Income Distributions Member Horwath International 2010 Crowe Chizek and Company LLC 45

46 The Unique Alternative to the Big Four Cost Basis Adjustment For non-esop shareholders, adjustments are made on a per share, per day basis (Regs (d)) For ESOPs, this is not practical, since actual cost basis may not be known until several months after the end of the plan year One possible method of dealing with the adjustment: Allocating cost basis adjustments annually (like earnings) Applying prior PYE cost basis to distributed shares (i.e. 12/31/09 cost basis for 2010 stock distributions) No adjustment for period 12/31/09 through date of distribution Footnoting cost basis adjustment in Form 5500 Member Horwath International 2010 Crowe Chizek and Company LLC 46

47 The Unique Alternative to the Big Four Cost Basis Adjustment Except for adjustments described here, cost basis is static, does not change over time Movement of stock from one participant s account to another forfeiture reallocation, share recycling, rebalancing does not change the cost basis of the stock ESOP remains the shareholder of record Cost basis is attached to and follows stock within the ESOP If stock is redeemed and repurchased or re-contributed, cost basis changes Member Horwath International 2010 Crowe Chizek and Company LLC 47

48 The Unique Alternative to the Big Four Cost Basis Adjustment If stock distributions are paid, the cost basis of the distributed stock often determines the tax consequences to the participant: If the distribution is a single payment (not installments); and If the participant elects to receive the distribution (not a rollover) Member Horwath International 2010 Crowe Chizek and Company LLC 48

49 The Unique Alternative to the Big Four Cost Basis Adjustment Stock lump sum distributions Cost basis of stock is taxed as ordinary income at the payee s personal income tax rate in year of distribution 20% withholding on the cost basis, but shares are not sold to generate funds for withholding (Regs (d)) 10% early withdrawal penalty, if payee is under 59½ Net unrealized appreciation (NUA) = FMV cost basis Generally taxed as a long-term (LT) capital gain in year of share sale at participant s election Appreciation above NUA is taxed as a LT or ST capital gain in year of sale, depending on the holding period Member Horwath International 2010 Crowe Chizek and Company LLC 49

50 The Unique Alternative to the Big Four Cost Basis Adjustment Example of NUA Calculation: Item Calculation Result Cost basis 100 shares * $10/share $1,000 FMV@Distribution 100 shares * $15/share $1,500 NUA 100 shares * ($15 - $10)/share $500 Member Horwath International 2010 Crowe Chizek and Company LLC 50

51 The Unique Alternative to the Big Four Cost Basis Adjustment Federal Tax Differences: Taxes on Stock Distribution ($1,000 Cost basis * 28%) + ($500 NUA * 15%) Total Taxes $355 Cash Distribution $1,500 FMV * 28% $420 Difference $65 Member Horwath International 2010 Crowe Chizek and Company LLC 51

52 The Unique Alternative to the Big Four Pass-through Issues C-Corps Can pay dividends directly to ESOP participants or through ESOP no later than 90 days after the plan year end Known as a pass-through dividend Deduction for the company Not considered a distribution to participant (IRC 404(k)(5)) No notice and consent requirements (IRC 401(a)(31); 411(a)(11)) No mandatory withholding (Regs (c)-2(b)) Not eligible for rollover (Regs (c)-2(b)) No early withdrawal penalty (IRC 72(t)) Reported on 1099-DIV not 1099-R Member Horwath International 2010 Crowe Chizek and Company LLC 52

53 The Unique Alternative to the Big Four Pass-through Issues S-Corps Pass-through of S-Corp income distributions are treated as distributions, either in-service or normal because IRC 404(k) specifically applies only to C-Corps No deduction for company Notice and consent requirements apply Mandatory withholding Eligible for rollover Early withdrawal penalty Reported on 1099-R No in-service distributions in money purchase pension plan Member Horwath International 2010 Crowe Chizek and Company LLC 53

54 The Unique Alternative to the Big Four Pass-through Issues S-Corps Communicate S-Corp advantages and impact on stock account balances Pay bonus based on ESOP stock account balances Taxed at ordinary income tax rate, not dividend rate Generally paid only to active employees Combine with carefully constructed communication to link employee ownership to bonus Member Horwath International 2010 Crowe Chizek and Company LLC 54

55 The Unique Alternative to the Big Four Contact Information Pete Shuler Crowe Horwath LLP 10 West Broad Street, Suite 1700 Columbus, OH (614) Member Horwath International 2010 Crowe Chizek and Company LLC 55

56 OEOC 26 th Annual Employee Ownership Conference Akron/Fairlawn Hilton Repurchase Obligation Funding and Managing in a Mature ESOP April 20, 2012 Kenneth E. Serwinski Prairie Capital Advisors, Inc.

57 What Causes Repurchase Obligation to be Large? Large percentage of company owned by ESOP Old days lots of ESOPs held less than 50% Today much more 100% ESOPs Nature of industry Some industries grow faster than others and companies grow along with them Upward value trajectory Can be caused by external and/or company growth But may also occur because of ESOP and non-esop debt repayment ESOP account growth occurs as more shares are allocated [Value growth]+ [share count growth] = [even more repurchase obligation] Demographics of employees Especially in smaller companies, where aging may not be smooth Half of our people are 50 years old 57

58 Managing the ESOP Repurchase Obligation Each time stock is ready to be put to the Company by a former participant, the Company must make a decision how it will satisfy its obligation. The available options include: Redeem the shares directly using operating cash flow or current liquid assets, Recycle using current Company funding, or Recycle using cash already in the ESOP With two Recyclings we ll give each a different name Redeeming Recycling ESOP Investing Each of the options has different impacts and implications 58

59 Consequences of Redeeming v. Recycling Redemptions take shares out of circulation Through a company buy-back from participants The shares leave the ESOP Trust Absent any other facts, redeeming yields an ESOP for the employees here now and they become the Haves A leveraged redemption transaction can also lead to significant value trajectory Thus the Haves become even more enriched Recycling can happen in two ways Recycling via ESOP contributions into the ESOP Trust Leaves the shares in the plan, and Allocates the shares based on compensation Recycling via S-corporation distributions 59

60 Consequences of Contributions v. S-Corp Distributions Contributions are allocated based on payroll Subject to limitations under the tax law All participants receive an allocation S-Corp distributions and C-Corp dividends are allocated based on share balances Thus, they behave like dividends the $ s follow the shares Older, larger accounts get more $ If this cash is used to buy back shares, then these participants get more shares This means that repurchases are accelerated Because bigger accounts are typically older accounts This distinction can also lead to a Haves and Have-nots situation 60

61 Managing the Process Requires Some Open Dialog ESOP Companies need to establish a policy Valuation of ESOP Shares And Appraisers need to reflect that policy in their valuations RO Cash Flows The Company s RO Policy 61

62 How Do Companies Decide? Start With a Simple Idea Repurchases At Market Contribute and Recycle When the Repurchase Obligation for a year falls in the range for the Market Level of Benefits, then Recycling the shares will provide employees with a level of benefits that meets the Company s objectives. Repurchases Below Market Contribute at Market Store the extra cash in the ESOP. When the Repurchase Obligation for a year falls below the Market Level of Benefits, then extra cash can be contributed to the ESOP or another qualified plan to meet the Company s objectives for the market level of benefits. This cash can be used for future repurchases that are to be recycled. Repurchases Above Market - Combination: When the Repurchase Obligation is above the Market Level of Benefits, then a Redemption could be used to repurchase some shares representing the above Market portion. The remaining shares can be Recycled. These concepts can be modeled, iterated and discussed 62

63 Repurchase Obligation Funding methods The typical list of methods for funding repurchase obligations: Pay-as-you-go Reserves Cash accumulation in ESOP Cash accumulation in corporation Contributions v. S-corp. distributions Debt Internal or external or both includes installment notes to participants Internal market Sale or initial public offering Not really funding methods Funding method is separate from repurchase method!

64 Pay-as-you-go funding No advance funding or reserves Just pay out of current cash flow Advantages Flexibility to redeem or recirculate Doesn t tie up assets Disadvantages No cushion increased risk Cash requirements that vary from year to year Benefit levels that vary from year to year Questions to consider How volatile or cyclical is the business? How predictable are repurchase obligations? Do your demographics result in periods of high repurchase obligations? How risk-averse are you? 64

65 Creating reserves for repurchase obligations There is no legal requirement to create reserves for repurchase obligations Many ESOP companies feel more comfortable having reserves, especially in light of the financial strains created by the current recession Anecdotally, a reserve equal to two to three years of projected repurchase obligations is the comfort level Reserves can be set up in the ESOP or in the company with different consequences 65

66 Holding Reserves in the ESOP Reserves in the ESOP are useful only when you are planning to recirculate shares Reserves can be created in the ESOP by contributing more than is needed for current distributions The contributions are allocated to participants accounts, and the cash is used in subsequent periods to fund repurchase obligations Reserves can also be created through dividends or S corporation distributions These are allocated pro rata to stock balances and will tend to exacerbate any have and have-not issues in the ESOP 66

67 Holding Reserves in the ESOP, continued Advantages Deductible contributions Tax-free investment yield Reduces lumpiness of Cash requirements Expense P&L impact Benefit levels contributions are more predictable, easier to communicate Tends to increase participant benefit levels this can be a double-edged sword Disadvantages Lack of flexibility Assets off balance sheet Contributions to trust will reduce earnings May be dilutive to value, if contributions exceed normal benefit levels, depending upon how appraiser treats the expense in the valuation May increase total cost of repurchase obligations because of leakage Possible fiduciary issues 67

68 Holding Reserves in the Company Reserves in the company are created by retaining more cash than is needed for other corporate purposes Funds may be co-mingled or set aside in separate account Advantages Company retains control of reserve Retains flexibility to redeem or recirculate Budgets cash requirements Strengthens balance sheet Has no current effect on earnings Creates comfort for various stakeholders Bank ESOP participants Management/BOD Disadvantages Created with after-tax dollars Investment yields taxable Remains within reach of creditors May result in higher repurchase obligations, if reserve increases the value of the company The reserve is a non-operating asset that is typically added to the operating value of the company in determining the value of the stock 68

69 Funding Repurchases With Debt Debt funding can take two forms: Borrowing from a bank or other lender Issuing installment notes to participants in payment for their shares This is seldom done, because of the cost of providing suitable security for the note typically a letter of credit or surety bond The company, not the ESOP, is typically the borrower An ESOP can only borrow to acquire shares not to fund repurchase of shares that are already in the ESOP Thus, debt is usually used in combination with redeeming The shares may be retired, or The shares may be contributed to the ESOP, or The shares can be sold to the ESOP with an internal loan (i.e., from the company to the ESOP) This is commonly referred to as a releveraging of the ESOP 69

70 Releveraging the ESOP Releveraging refers to the ESOP s leveraged purchase of shares that have previously be distributed from the ESOP The purchase is financed with a loan from the company to the ESOP typically with a long amortization schedule The shares are placed in loan suspense and released over time as contributions are used to amortize the loan Releveraging has become an increasingly popular way to manage ESOPs for the long term, By creating a source of shares that can be allocated over time It is typically used in periods when repurchase obligations are unusually high Avoids reallocating a large number of shares at one time There are associated complexities and costs similar to any ESOP transaction Advantages Creates a source of shares to be allocated over a period of time Avoids the effects on value per share resulting from fluctuations in share count 70

71 What about COLI as a Funding Strategy? COLI (corporate-owned life insurance) is technically any life insurance policy that is owned by the company and of which the company is the beneficiary COLI usually refers to life insurance products that have been designed specifically to accumulate cash to fund executive deferred compensation liabilities The products are characterized by lower charges to earnings than regular insurance policies in the first several years COLI is sometimes used to fund ESOP repurchase obligations by insuring the lives of participants with large account balances and/or a company will suffer a financial detriment as a result of someone s death 71

72 What about COLI? continued The potential advantages of COLI derive from the special tax treatment of life insurance products The death benefit is tax free The investment returns inside the policy (i.e., the increases in cash value) are not taxed However, premiums are not deductible In C corporations, the potential tax benefits may make COLI attractive as an alternative to other investment vehicles In S corporation ESOPs, the tax benefits of COLI are wasted There is a cost to these tax benefits The mortality charges (i.e., the actual cost of insurance) Administrative charges Investment charges Commissions 72

73 Thank You! Questions? More Info? Ken Serwinski direct 73

74 Have s v. Have Not s Andrew J. Kulesza ~ Kramig Insulation Cell: [email protected] Service - Quality - Value - Since 1896

75 Have s v. Have Not s Company Founded Company Incorporated in Ohio Kramig Family Sells to 100% ESOP - No Recycling of Shares - Approximately 30 participants Formation of Indiana Subsidiary - Formation of Holding Company Elect S-Corp Status Service - Quality - Value - Since 1896

76 Have s v. Have Not s Traditional Have v. Have Not Culture - Approximately 12 participants - 409(p) concerns - Determination to Recycle Shares - Indiana subsidiary embraces decision Service - Quality - Value - Since 1896

77 Have s v. Have Not s Business growth of Indiana subsidiary Indiana participant growth steady - REPOs adequately funded by: - Retained Earnings - Debt Financing Large portion of Have s retire / diversify Indiana participants exceed Shift in REPO allocation to Indiana - Indiana margins shrinking due to: Economies of Scale Operational inefficiencies ESOP cost allocation - Profits available for bonus minimal - Indiana leadership unhappy - Politically, ESOP taking blame Service - Quality - Value - Since 1896

78 Have s v. Have Not s Currently: - Stock price must accurately reflect challenges so ESOP (Have Not s) avoid overpaying. - Have s need to communicate to the Have Not s about how they were once Have Not s and paid their dues when ESOP was formed. - Trustees restructure holding company board - To better align members with ESOP interests - Board meetings to address Indiana Issues - Hold Indiana officers accountable to ESOP - Communicate value of S-Corp ESOP to overall culture. - Communicate tax exemption responsibilities to Indiana officers. - Identify operational issues as separate item from ESOP REPO. Service - Quality - Value - Since 1896

79 Have s v. Have Not s The tax advantages given to a 100% S-Corp structure often result in excess cash flow and higher earnings. In the spirit of employee ownership, the funds are to be used for reinvestment in the company and adequately fund repurchase obligations thereby growing the business, employee base, and retirement. When carried out in aggregate, the ESOP community ultimately contributes to a healthier and more prosperous economy. Service - Quality - Value - Since 1896