Employee Stock Ownership Plans (ESOPs) 101

Employee Stock Ownership Plans (ESOPs) 101

Presented by:

Roy Farmer

Business Transition Advisors, Inc.

• Full Service Business Transition Services• Employee Stock Ownership Plans

(ESOPs)• Non-Leveraged• Leveraged

• Corporate reorganizations• Corporate refinances• Company stock redemptions• Leveraged mgmt/partner buyouts• Third party/Private equity sales

(affiliates)

Business Transition Advisors - ESOP

• Full Service ESOP Implementation Services

• Preliminary Analysis• Feasibility Studies • Plan and Transaction Design • Financing• Repurchase Liability Studies• Employee Communications• Post Transactional Services

What is an ESOP?

• An ESOP stands for an Employee Stock Ownership Plan

• A tax qualified defined contribution employee retirement plan

• Qualifies under IRC Section 401(a) and Section 4975(e)(7)

• Overseen by the IRS and the Department of Labor

ESOP Statistics

• Modern ESOPs came into being with passage of ERISA-1974

• 10,000 ESOP companies in America today

• Almost 1 Trillion in Assets Held • This includes large and small

Companies • 21% of all U.S. private sector workers

own company stock• Wal-Mart, Lowes, Charles Schwab,

Southwest Airlines, Morgan Stanley, Motorola, Publix

Unique Features

• Must invest primarily in employer stock• Can use borrowed funds (leverage)• No employee contributions generally

allowed• Stock sold to ESOPs can qualify to defer

capital gains tax – certain rules apply • Contributions can vary year to year,

unless borrowed funds are used

Uses of ESOPs

• Business Owner Exit Strategy/Next Generation Transfer

• Liquidity/Diversification for Closely Held Stock

• Partner Buy Out• Desire for Employee Owned Culture • Divorces/Immediate Cash Needs• Enhanced Employee Benefits/Handcuffs• Mergers & Acquisitions

Owner Transition Concerns

• Plan “transition” while alive and healthy• Leave with competent future leadership• Minimize personal and corporate taxes• Leave corporation with proper working

capital and manageable, if any, debt• Asset liquidity and diversification• Convert business to retirement income• Preserve family/community legacy• Exit with the most after-tax dollars

possible

Transition Options Samples

• The following slides show a hypothetical business worth 10-million dollars, selling 60% based on the following methods:

• Corporate Stock Redemption• Management Leveraged Buy-Out • Third Party Sale• ESOP

Corporate Redemption

Company value $10,000,000

Value of 60% majority stock sale $6,000,000

Corp. profits needed to net sale price $10,000,000

Corp. income tax at 40% (35% + 5%) $4,000,000

Net corp. profits available for stock purchase $6,000,000

Sale proceeds to seller $6,000,000

Capital gains tax at 29.2% (fed. & avg. state) $1,752,000

Net sale proceeds to seller $4,248,000

Total Taxes/Fees $5,752,000

Management Buy-Out



Bonus to execs’ needed to net sale price $9,740,000

Exec’s personal income tax 39.4% (35% + 5.4%) $3,740,000

Net corp. profits available for stock purchase $6,000,000

Sale proceeds to seller $6,000,000


Net sale proceeds to seller $4,248,000

Total Taxes $5,492,000

Third Party Sale (Stock)



Pre-fee proceeds to seller $6,000,000

Typical sale transaction fee at 8% $480,000

Gross proceeds to seller $5,520,000


Net sales proceeds to seller $3,768,000

Total taxes & fees $2,232,000

ESOP Sale: C Corp


Value of 60% majority sale $6,000,000

Pre-fee proceeds to seller $6,000,000

Typical transaction fee at 2.5% $150,000

Gross proceeds to seller $5,850,000

Capital gains tax at 29.2% (fed. & avg. state) $0

Net proceeds to seller $5,850,000

Total fees & taxes $150,000

Method “Net” to SellerTotal Taxes &

Fees

Percent of Total to Seller

Corporate Redemption $4,248,000 $5,752,000 42%

Management Buy-Out $4,248,000 $5,492,000 44%

Third Party Sale (Stock) $3,768,000 $2,232,000 63%

ESOP – C Corp $5,850,000 $150,000 98%

How ESOP’s work

Non-Leveraged ESOP

• ESOPs can be leveraged or non-leveraged

• A non-leveraged ESOP allows the corporation to enjoy current corporate income tax deductions by contributing either cash or treasury stock to the ESOP

• Cash contributions are used to buy stock from selling shareholders

• At the time of the actual stock sale, the seller may still take advantage of all of the traditional ESOP advantages

How It Works: Step 1

The Company

ESOP Trust

Adopts

How It Works: Step 2

CONTRIBUTION

Company

ESOP Trust

Stock or Cash

Selling Shareholders

Buys Shares

Leveraged ESOP

How an ESOP Works: Step 1

The Company

ESOP Trust

Adopts


LenderLoan

Loan

Company

ESOP Trust


LenderLoan

Loan

CompanyIRC § 1042

ESOP Trust

Cash

Selling Shareholder

Stock

Cash


LenderLoan

Payment

Loan

Cash

Payment

CompanyIRC § 1042

ESOP Trust

Cash

Selling ShareholderCash

Stock


LenderLoan

PaymentCompany

IRC § 1042

ESOP Trust

Selling Shareholder

Stock

EmployeesBeneficial

Ownership

Payment

Loan

Cash

Cash

Cash


LenderLoan

PaymentCompany

IRC § 1042

ESOP Trust

Selling Shareholder

Stock

Employees

Interest

Payment

Loan

Cash

Cash

Cash

Cash

Death, Disability, Retirement, Termination and Diversification

Sinking Fund

IRC § 1042 Tax Deferral

• Selling shareholder may elect to indefinitely defer all capital gains on sale proceeds regardless of basis

• Similar to real estate provision IRC § 1031 and life insurance IRC § 1035

• Requirements set at a relatively “low bar”

• Financial products specifically made to facilitate liquidity of IRC §1042 assets

IRC § 1042 Requirements

• Must be a “C” Corporation• ESOP must own minimum of 30% of

outstanding stock post-transaction• Shareholder must have owned stock

for minimum of three years• Shareholder must purchase Qualifying

Replacement Property (QRP) within 12 months of transaction

Qualified Replacement Property (QRP)

Note: Eligible issuer must have 50% of its assets used in the active conduct of trade or business and no more than 25% of its gross income from passive sources

Eligible Ineligible

Common Stock Municipal Bonds

Convertible Bonds US Govt. Bonds

Corporate Fixed Rate Bonds Mutual Funds

Corporate Floating Rate Notes Foreign Securities

REITs, Bank CDs

Leveraged QRP Strategy

Cash

Portfolio Floating

Rate Notes

Margin Account

Liquid Cash

Proceeds From Sale

(1042) Balance Income with Interest

QRP can be margined to 90%

Leveraged QRP Strategy

Proceeds

From Margi

n Loan

New Home

Cars

BoatStocks

Bonds

Corporate Governance

IF YOU CONTROL THE BOARD OF DIRECTORS YOU

CONTROL THE COMPANY• Corporate control

• Shareholders Elect the Board of Directors

• Board of Directors appoints the Officers

• Officers responsible for day-to-day operations

ESOP Corporate Governance (Privately Held Company)

In An ESOP

• Board of Directors appoints the ESOP Trustee

• The Trustee votes the stock

“Directed” Trustee

Appoints

Control Can Remain “Undisturbed”

Board of Directors

VotesOwners with stock outside

the ESOP

ESOP Employee Interest

• The “Directed” trustee votes the stock on behalf of the employees

• The employees only have a beneficial interest in the ESOP trust

• Employees “advise” trustee only on Mergers, Sale, Recapitalization or Liquidation

• Employees are not shareholders and do not have Statutory Minority Shareholder Rights

100% “S” Corporation ESOP

• Pays no Federal or State corporate income tax to the extent ESOP owned

• Taxation is “passed through” to shareholders in proportion to ownership

• An ESOP is tax exempt, therefore no tax is paid on percentage owned by the ESOP

• Corp does not have to distribute income• Exempt from prohibited transaction

rules

Qualitative Benefits

• “Golden Handcuffs” for key People• Reduced Turnover • Reduced Worker Comp Claims• Greater Productivity • Greater Profitability • Greater Commitment to the

Company• Better Work Environment

Legacy Full Circle

• Many owners wanted their family and/or key management to have business but:• The owner could not afford to give the

business to them• Family and/or key management could

not afford to buy the business• As shares are repurchased and retired

into treasury, the percentage of ownership of outside shares increases

• In theory, when the last participant share is retired into treasury, any outside shares represent 100% of the company value

Legacy Full Circle: Example

Shares Retired

TotalOutstanding

Shares

Shares InsideESOP

SharesOwned Outside

ESOP(Family/Mgmt)

PercentageOwned Outside

ESOP(Family/Mgmt)

0 100 90 10 10%

20 80 70 10 13%

20 60 50 10 17%

20 40 30 10 25%

20 20 10 10 50%

10 10 0 10 100%

Summary of Tax Benefits

• Deferral and/or Avoidance of Capital Gains Taxes on the Sale of Stock

• Deduction of the Full “Fair Market Value” of the Stock Purchased by the ESOP

• Possibility of becoming “Tax Free” as a 100% “S” Corporation ESOP

WIN-Win-Win For Everyone

• Business owners• Employees • Corporations

That are more advantageous

than any other single vehicle

ESOP Prospect Profile

• Owner wishing to cash out all or portion of business

• Payroll of $800,000 or greater• Strong Succession Management• $3,000,000 or more business value• 15 + Employees or more• Low cost basis

BTA’s Role

Next Steps:• Preliminary analysis • Presentation to the client• Sufficient information to determine

direction • Move to full implementation

BTA’s ESOP Implementation Process

• Educational “ESOPs 101” Presentation• Initial Review of Financials & Fact Finder• Preliminary Valuation• Preliminary ESOP Analysis

Investigative Phase Part 1

• Additional Data Gathering• Feasibility Study• Final Client Approval to Proceed to Next

Step

Investigative Phase Part 2

• ERISA Plan Design• Transaction Design• Engage Other Team Members• Financing• IRC§ 1042 Analysis & Execution

Implementation Phase

• Employee Communications• Management Incentive Plans• Repurchase Liability & Funding• Advanced Planning• Determination Letter

Post Closing Phase

Team Quarterback

Through Entire Process

BTA Team

Leader

Plan DesignERISA

Counsel *

Estate Planning

Stock Valuation*

Employee Communicatio

n

Company CPA *

Repurchase Obligation

Corporate Counsel

TPA*

Trustee*

Banker

Insurance Investments*

*Outside service provider

Team Approach

Contact Information

Roy Farmer

Managing Director

(208) 761-3612

[email protected]

Documents

Employee Stock Ownership Plans (ESOPs) 101