Succession Planning with ESOPS - SCORE Maine• ESOPs can be used for corporate finance. If ESOP purchases Treasury shares or new shares from the Company with loan proceeds, Company

eatonpeabody.com Augusta I Bangor I Brunswick I Ellsworth I Portland

Succession Planning with ESOPS Maine Tax Forum, November 3, 2016

Leslie C. Hallock, Esq. Eaton Peabody PO Box 15235 One Portland Square, 7th Floor Portland, Maine 04112 207-274-5266 [email protected]


ESOP Acquisition

ESOP Purchase •ESOP purchases shares directly from the Selling Shareholder at “Fair Market Value” in exchange for cash and/or note. •Value of Company reduced by debt to shareholder. •Purchase subject to strict rules under ERISA.

Company Redemption •Company redeems shares from Selling Shareholder in exchange for cash and/or note. •Company Redemption not subject to ERISA. •Value of Company reduced by debt to shareholder. •ESOP buys shares from Company at “Fair Market Value” (reduced value) OR Company contributes shares to ESOP. •ESOP purchase from Company subject to strict rules under ERISA.


Financing an ESOP Transaction

Leveraged ESOP Transaction • Company or Selling Shareholder lends funds to ESOP.

• ESOP purchases shares.

• Shares held as collateral in suspense account.

• Employees are allocated shares annually as the loan is repaid.

• Company may obtain external loan from Bank or Selling Shareholder to finance ESOP loan.

Non-Leveraged ESOP Transaction • Share purchased annually in installments with Employer

Contributions.

eatonpeabody.com Augusta I Bangor I Brunswick I Ellsworth I Portland eatonpeabody.com Augusta I Bangor I Brunswick I Ellsworth I Portland


Company Lender

1. External Loan

3. Cash

ESOP Suspense Account

Company or Selling Shareholder

2. I

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Lo

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4. Stock

1. The Leveraged ESOP Transaction – External Financing



Company Lender

3. Annual Amortization

4. Shares Allocated

ESOP Employees

1. C

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1. External Financing – Repayment and Share Release

2. A

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ual

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Seller Company

4. S

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ESOP Suspense

2. Seller Financing: Redemption

2. Shares

1. Note

3. N

ote



Company Selling Shareholder

3. Annual Amortization

4. Shares Allocated

ESOP Employees

1. C

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Redemption – Repayment and Share Release

2. A

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ESOP

Suspense Account Selling Shareholder

2. Shares

1. Note

3. Seller Financing: ESOP purchase


Financing an ESOP

Company

ESOP

1.

Co

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Employees

Shareholder

2.A

mo

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3. Shares Allocated

Seller Financing: Repayment and Share Release


Loan Repayment – Allocation of Shares

200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 2,200 2,400 2,600 2,800 3,000

0%

20%

40%

60%

80%

100%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Allocated Shares Unallocated Shares


Exempt Loan Requirements

Loan between ESOP and party-in-interest (Company or Shareholder) prohibited transaction under ERISA, unless exemption is satisfied.

• Loan must be used to acquire employer stock or for repayment of prior loan.

• Interest Rate and Purchase Price may not drain off Plan assets.

• Purchase price must not exceed fair market value of stock as of the date of the transaction

• Loan terms must be as favorable as arms-length transaction.

• Collateral is limited to shares acquired with loan.

• Shares must be released from pledge on a pro-rata basis as loan is repaid.

• ESOP liability limited to collateral, employer contributions and earnings on contributions and collateral.

• Fixed term, lender may not accelerate payment in event of default.


S-Corporation Benefits

• S Corp does not pay taxes on earnings attributable to the shares owned by the ESOP.

• If a S Corp is owned 100% by an ESOP, the Company’s earnings will be entirely tax exempt in perpetuity.

• 100% owned S Corp ESOPS have 40 percent more cash flow due to tax savings than other corporations.

• Contributions to ESOP are deductible up to 25% of participant compensation.

• Deduction limitation applies to all defined contribution plans maintained by Employer.

• Elective Deferrals included, subject to Compensation limitation.

• (Interest and S-Corp distributions count toward 25% limits.)

• Deductible contributions used to pay ESOP loan and external loan, if any.


C-Corporation Benefits

• Contributions to ESOP are deductible up to 25% of active participant Compensation

• Contributions used to pay principal on ESOP exempt loan are deductible up to 25% of participant Compensation.

• Contributions to pay interest on ESOP exempt loan are fully deductible and do not count toward 25% limit.

• Dividends on shares held by ESOP are fully deductible and do not count toward 25% limit, provided they are passed through to participants, used to pay ESOP loan, or reinvested as elected by participant.

• External loan repaid with pre-tax dollars.

• Cash flow significantly enhanced.


Selling Shareholder Tax Benefits: Section 1042

Rollover

• Seller obtain diversified investment portfolio. Seller uses sale proceeds to purchase qualified replacement property defined as stocks, bonds, warrants or debentures of domestic corporations.

• Seller defers capital gains on sales proceeds indefinitely. If the qualified replacement property is held until death, it is subject to a stepped up basis and avoids capital gains tax entirely.


Section 1042 Requirements

• Limited to closely held C Corporation shares.

• Seller must hold stock 3 years before sale.

• ESOP must own 30% of each class of outstanding shares or 30% total value of outstanding shares in the Company for 3 years after sale, unless Company is sold.

• Seller must reinvest in Qualified Replacement Property (domestic stock or bonds) during period from 3 mo before sale to 12 mo after sale.

• ESOP purchase price must be determined by independent qualified appraiser.

• 1042 Shares may not be allocated to Seller, family members, or 25% shareholders. (Disqualified person do not participate in ESOP.)


Employee Tax Benefits

• Tax Deferral: no tax on shares allocated to their account until distribution.

• Distributions eligible for rollover treatment.

• Distributions prior to age 59 ½ subject to 10% penalty.

• Generally, contributions to ESOP during loan repayment are often 6% - 10% of compensation, higher than other defined contribution plans.

• Generally, earnings are higher in ESOP Assets than other defined contribution plans


Miscellaneous

• C-Corporation can use 1042 Rollover, then elect S-Corp status.

• S-Corp can convert to C-Corporation to enable 1042 rollover.

• ESOPs can be used for corporate finance. If ESOP purchases Treasury shares or new shares from the Company with loan proceeds, Company can use loan proceeds for any purpose.

• Shareholders electing 1042 Rollover generally cannot participate in ESOP.

• S-Corporations have strict anti-abuse rules which may prohibit selling shareholder from participation in ESOP. Violation of rule is catastrophic: loss of qualified plan status, loss of S-Corporation election.

Documents

Succession Planning with ESOPS - SCORE Maine• ESOPs can be used for corporate finance. If ESOP purchases Treasury shares or new shares from the Company with loan proceeds, Company