An Alternative to Selling Your Business: Employee Stock Ownership Plan

Transcription

1 An Alternative to Selling Your Business: Employee Stock Ownership Plan JANUARY 22 nd Sheraton Columbia Town Center Hotel Wincopin Circle Columbia, MD Steven B. Greenapple, Esq. Shareholder Steiker, Fischer, Edwards & Greenapple, P.C. Cedar Knolls, NJ David L. Gaver, CPA, CGMA Director Watkins Meegan LLC Tysons, VA JANUARY 15 th The Tower Club 8000 Towers Crescent Dr. Suite 1700 Tysons, VA Scott D. Miller, CPA/ABV, CVA President Enterprise Services, Inc. Delafield, WI

2 Agenda Liquidity/Succession - Reality What is an ESOP? Advantages of an ESOP Transaction Common ESOP Misperceptions ESOP Tax Benefits Disadvantages of an ESOP Transaction ERISA and Tax Requirements Rights of ESOP Participants

3 The Problem of Liquidity and Succession All businesses must be sold or transferred privately-held companies have no ready market Current economic conditions have slowed private M&A transactions but have not eliminated need/desire for liquidity and succession Approach should be based on shareholder goals in the context of achievable alternatives

4 Liquidity & Succession: Alternatives A finite range of choices: External buyers Strategic competitors or new entrants Financial private equity IPO Internal Buyers Family Management Partner (Redemptions & Buy-Sells) ESOP Liquidation

5 Management Leveraged Buy Out (LBO) The Company Guarantee Lender Management $10 Million Cash Stock Owner

6 Payment of Management LBO Financing $907K* Tax Payments Management (Buyer) $1,093K Loan Payment *Assumes S corp shareholder ordinary income tax rate of 39.6% Federal, 5.75% VA = 45.35% combined The Company $2MM Earnings Before Taxes Lender

7 What They Are Leveraged ESOPs as a Tool for Shareholder Liquidity: What They Are Not

8 What is an ESOP? Employee Stock Ownership Plan Qualified retirement plan under IRC Regulated by US DOL and IRS Company funded benefit - no employee contributions Assets held in a Trust; employees do NOT own the stock directly Intended to be invested primarily in company stock Only qualified retirement plan that can: Borrow money Engage in transaction with related party

9 What is an ESOP? Tax efficient and controlled means of selling stock Since 1974 over 20,000 companies have adopted an ESOP Today, ESOPs include over 13.7 million employeeparticipants with over $923 billion in assets (average of over $67,000 per participant)

10 The Leveraged ESOP ESOP Promissory Note XYZ Corp. $10 Million $10 Million Promissory Note Lender ESOP SUSPENSE ACCOUNT P1 P2 P3 P4 P5 $10 Million Stock Selling Shareholder

11 Payment of Leveraged ESOP Financing XYZ Corp. $2 Million Earnings Before Taxes $2 Million Loan Payment Lender $2 Million Contribution ESOP SUSPENSE ACCOUNT P1 P2 P3 P4 P5 Participant Allocations 1. XYZ makes a tax-deductible contribution to the ESOP 2. ESOP uses the contribution to repay its loan from XYZ 3. Participant allocations 4. XYZ repays Lender

12 Advantages of an ESOP Transaction Maximize after-tax proceeds Get paid fair market value for business Sell stock (capital gains) vs. sell assets (ordinary income and C corp. double taxation) Pay no tax on sale of company stock (C corp. / 1042 election) Flexibility Control transaction timing & design % of stock sold diversify wealth, resolve incompatible shareholder goals, or sell 100% timing of sale subsequent transactions single or multiple transactions, you don t have to decide now Seller financing attractive IRR, equity based return Process is confidential Opportunity for highly effective estate planning

13 Ongoing Advantages of an ESOP Company Tax Benefits for Company Deduction of loan interest AND PRINCIPAL Pay little or NO federal and state corporate income taxes (S corp.) Control Seller may continue as executive and Board member Legacy Preserve Company identity Preserve employees jobs Preserve relationships with professional advisors

14 Ongoing Advantages of an ESOP Company Motivate and attract employees ESOP does not limit options for management incentive plans ESOP does not limit options for future M&A transactions

15 Common ESOP Misperceptions An ESOP is a Stock Option plan ESOP is a qualified retirement plan under ERISA. Employees are entitled to the company s financial information Employees are entitled to their own account statement. Company has to be a C corporation Since 1998, S corporations can also be ESOPs. ESOP must own 30% of the company ESOP can own any %, and can buy/sell shares in one or more transactions. Employees own the stock of the company Stock is owned by a Trust, for the benefit of employees/participants. Employees are not shareholders and do not have shareholder rights. True or False True or False True or False True or False True or False

16 . Total Tax Deferral/Savings on Hypothetical $10,000,000 Transaction To Seller using 1042 (Deferral on Fed. and State Capital Gains Tax (29.6%*)) *Assumes Capital Gains Tax Rates of 20% Federal and 5.8% VA, plus 3.8% Federal Investment Income Tax¹. To Company (Tax-Deductible Principal at 45.35%* tax rate) *Assumes Corporate Gains Tax Rates of 39.6% Federal and 5.75% VA. Total Tax Deferral/Savings 74.95% of the transaction value! $2,960,000 $4,535,000 $7,495,000 ¹This Calculation ignores $250K threshold.

17 C Corporation ESOP Tax Benefits IRC 1042 IF: IF: Company is a C corporation on the day of closing; ESOP Company owns is at a least C corporation 30% of Company on the day after of closing; closing; Seller ESOP has owns a 3 at year least holding 30% of period; Company after closing; Stock Seller satisfies has a 3 the year definition holding period; of employer securities (best dividend rights and Stock best satisfies voting rights); the definition of employer securities (best dividend rights and Seller best invests voting rights); proceeds of sale to ESOP in Qualified Replacement Property (QRP) within 12 months; Seller invests proceeds of sale to ESOP in Qualified Replacement Property (QRP) within 12 months; THEN: Seller may elect not to recognize THEN: any gain on the sale Seller may elect of not stock to recognize to the ESOP. any gain on the sale of stock to the ESOP.

18 C Corporation ESOP Tax Benefits IRC 1042 Qualified Replacement Property Eligible* Common Stock Convertible Bonds Corporate Fixed Rate Bonds Corporate Floating Rate Notes (FRN) Not Eligible Municipal Bonds U.S. Government Bonds Mutual Funds Foreign Securities REITs Bank CDs * Issuer must be a U.S. Operating Corporation : Incorporated in the U.S. More than 50% of its assets used in the active conduct of a trade or business No more than 25% of its gross income from passive sources

19 C Corporation ESOP Tax Benefits QRP Floating Rate Note Specially designed as Qualified Replacement Property: Highly rated issuer; Long term; Floating rate; Put option. All result in Floating Rate Note: Stable value; Highly marginable. Allows Seller to satisfy requirements of 1042, AND obtain an actively managed investment portfolio.

20 S Corporation ESOP Tax Benefits S corporation shareholders are responsible for paying for their pro rata share of the company s tax liability An ESOP is a non-tax paying shareholder and is exempt from paying federal income taxes Thus, a 100%* ESOP-owned S corp operates completely tax-free - Doesn t have to be 100%; the percentage owned by the ESOP is tax-exempt.

21 ESOP Ownership: Beneficial vs. Direct Shares purchased by the ESOP are owned in a trust, not by employees directly Employees are beneficial owners of the trust Beneficial owners/employees are not entitled to company financial statements or the ESOP valuation The ESOP has a trustee who will represent the plan interests The ESOP Trustee will vote the stock owned by the ESOP, except in special cases (pass through voting) Special cases are merger or consolidation, sale of substantially all assets, liquidation, dissolution, recapitalization

22 ESOP Provisions (Plan Document) Allocation Formula Most common formula allocates contribution proportional to compensation Vesting 3 year cliff or 6 year graded Benefit Distribution Timing Permissible delays following termination of service; five installments

23 ESOP Stock Appraisals ESOP Trustee hires a third-party, independent appraiser as an advisor Appraiser should be experienced in valuing stock for ESOP transaction purposes ESOP stock must be reappraised annually

24 Characteristics of Best ESOP Candidates Profitable and growing Not overleveraged Strong financial reporting Deep and broad management team Employees are an important part of the value of business Owner(s) concerned about Legacy Owner(s) wants to retain control Owner(s) strongly dislikes paying taxes

25 Allowability of Costs Costs of ESOPs are allowable subject to the following conditions: Contractor measures, assigns, and allocates costs in accordance with 48 CFR Contributions that exceed the deductibility limits of the IRC are unallowable Contribution of stock is limited to the fair value of the stock on the date title is transferred to the trust Cash purchase in excess of fair market value is unallowable

26 Disadvantages of an ESOP Complex regulatory environment Tax Rules ERISA Rules Initial setup involves a team of advisors CPA firm, Attorney, ESOP Stock Appraiser, Benefits Administrator, Trustee, Independent Fiduciary, Investment Advisor, Financial Institution, Communications

27 Disadvantages of an ESOP Finding advisors that are knowlegable Fiduciary responsibilities Repurchase obligation Employees fail to understand Employees fail to appreciate the ESOP Annual audit requirement

28 Disadvantages of an ESOP Small Business Administration does not look through to the ESOP to determine the following: Minority-Owned Women-Owned Veteran-Owned Service-Disabled Veteran-Owned

29 ERISA and Tax Requirements Annual valuation by an independent appraiser Account Diversification Qualified participants have the right to diversify up to 25% of their account balance during the 90-day period following each of the six plan years after they become qualified participants. Up to 50% of the account balance may be diversified in the sixth year Qualified participants are those who have participated in the ESOP for at least 10 years and are at least 55 years of age

30 ERISA and Tax Requirements Exceptions to Prohibited Transaction Rules The 10% limit on the acquisition of qualifying employer securities does not apply to ESOPs ESOPs may borrow from a party in interest if the loan is to benefit plan participants, the interest rate is reasonable, and the only collateral is employer securities

31 ERISA and Tax Requirements ESOPs may not file Form 5500-SF (short form) Unrelated Business Income Leveraged ESOPs may purchase employer securities with borrowed funds, and the interest and dividends earned on such securities would not be considered unrelated business income. Annual Audit Requirement

32 ESOP Trustee(s) Typically appointed by the company s board of directors ERISA requires that the plan trustee(s) act prudently, and solely in the interest of the plan participants

33 ESOP Trustee(s) Three of the more important responsibilities include: Securing a proper valuation of the stock Assuring the interest of plan participants are protected in ESOP transactions Approving purchase and sale of ESOP stock

34 Rights of ESOP Participants Plan members are participants in a qualified defined contribution plan Actual stock is owned by the ESOT Plan participants are not shareholders in the company Plan fiduciary, in most instances, votes the shares of the ESOP in accordance with the discretion or direction from the board of directors

35 Rights of ESOP Participants Right to Demand Employer Securities Closely held companies routinely amend their articles of incorporation and bylaws to restrict stock ownership to employees or a qualified trust S corporations do not have to distribute stock Diversification Requirements Dispute Settlement

36 Rights of ESOP Participants Written Materials General ESOP Materials Summary plan description Summary annual report A report on any material modifications ESOP Participant Account Balances Number of shares in account Value per share and extended amount Value and asset allocation of other account assets Percentage vested

37 Rights of ESOP Participants Stock Repurchase Obligation The ESOP sponsor must make a market for the stock as employees who are participants in the plan become eligible for distributions or diversification requirements ESOP companies must continually be aware of the repurchase obligation because the total value of the employer s stock in the plan represents a financial commitment that will have to be funded eventually

38 Additional Resources The following web sites may be of interest The ESOP Association esopassociation.org The Employee Ownership Foundation employeeownershipfoundation.org The National Center for Employee Ownership nceo.org Employee-Owned S Corporations of America esca.us

39 Questions?

40 Contact Us Tysons, VA 8000 Towers Crescent Drive Suite 950 Tysons, VA P: Bethesda, MD 6720-B Rockledge Drive Suite 750 Bethesda, MD P: Annapolis, MD 888 Bestgate Road Suite 401 Annapolis, MD P: Herndon, VA Dulles Technology Drive Suite 220 Herndon, VA P:

41 Presenters David L. Gaver, Director Watkins Meegan Steven B. Greenapple, Shareholder Steiker, Fischer, Edwards & Greenapple, P.C Scott D. Miller, President Enterprise Services, Inc