EMPLOYEE STOCK OWNERSHIP PLANS FOR THE ARCHITECTURE/ENGINEERING/CONSTRUCTION

INDUSTRY Presented by: Anthony Hakes, Hal Hunt,

Cindy Dwyer and Mark Welker

June 13, 2013

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Before We Get Started…

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This webinar is eligible for CPE credit. To receive credit, you will need to answer periodic polling questions throughout the webinar.

External participants will receive their CPE certificate via email immediately following the webinar.

CPE Credit

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The information in this Executive Education Series

course is a brief summary and may not include all the details relevant to your situation.

Please contact your MHM service provider to further

discuss the impact on your financial statements.

Disclaimer

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Today’s Presenters

Hal Hunt, CPA Shareholder 913.234.1012 | hhunt@cbiz.com

Hal leads MHM’s Employee Benefit Plan (EBP) Audit Practice. With over 25 years of diverse experience with EBP accounting, auditing and compliance issues, he is also a member of the firm’s Professional Standards Group as EBP subject matter expert. As the EBP National Practice Leader, Hal is responsible for providing internal training, along with providing technical support to engagement teams, serving as engagement quality reviewer and developing resource tools for our EBP audit professionals. He served on the AICPA’s Employee Benefit Plan Audit Quality Center (EBPAQC) Executive Committee and is currently a member of the EBPAQC ESOP Task Force.

Anthony M. Hakes (Tony), CPA Shareholder 602.650.6225 | ahakes@cbiz.com Tony is a Director/Shareholder in the Phoenix office and joined CBIZ and Mayer Hoffman McCann P.C. (MHM) in June 2002 and has approximately 15 years of experience with national and international public accounting firms. Tony serves as the Western Region ERISA Audit Leader for MHM and is a member of the MHM ERISA Task Force. Through these roles, Tony participates in designing and implementing MHM’s audit approach as well as ensuring audit quality for approximately 1,000 ERISA audit clients firmwide.

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Cindy Dwyer Shareholder 913.234.1022 | cdwyer@cbiz.com Cindy is the President of MHM Retirement Plan Solutions and a Shareholder of Mayer Hoffman McCann P.C. She supervises staff, oversees technical research, and provides quality control services. She has previously served as the national Chairperson of the American Institute of Certified Public Accountants Employee Benefits Technical Resource Panel (TRP) and has recently been reappointed as a member of the TRP. Additionally, Cindy has been a recurring speaker at the American Institute of Certified Public Accountants National Conference on Employee Benefit Plans. Cindy is also a committee member and current chair of the Employee Benefits Institute sponsored by UMKC School of Law.

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Today’s Presenters

Mark D. Welker Partner, Husch Blackwell 816.983.8148 | mark.welker@huschblackwell.com Chair of the firm's Tax & Benefits Department, Mark is considered clients’ go-to advisor on any important benefit or compensation matter. He focuses on all benefit and compensation matters, including the creation and operation of employee retirement plans, deferred and equity executive compensation, employee stock ownership plans, and health and welfare plans. Mark is highly regarded for his strategies and management of fiduciary and tax disputes.

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How Does an ESOP Work?

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Today’s Agenda

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ESOP Overview

ESOP Advantages/Disadvantages

Creating an ESOP and Candidate Checklist

Management Incentives in ESOP Companies

Operational Issues

ESOP OVERVIEW

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More than 11,000 ESOPs in U.S. (10% of private sector workforce—ESOPs cover 10.3 million employees)

5,000 majority owned by an ESOP 4,000 are 100% owned by an ESOP 2,000 are minority owned by an ESOP Approximately 1/3 are S-Corporation ESOPs Approximately 1/2 are ESOPs with <250 participants

Found in all industries with a very significant concentration in the A/E and construction sector

At least 70% of ESOPs are or were leveraged, (i.e. they used borrowed funds to acquire stock bought by the ESOP)

(Source: The ESOP Association)

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ESOP Population

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1950s—ESOP concept developed 1970s—Employee Retirement Income Security Act of 1974

(ERISA) 1990s—ESOPs became eligible to hold shares of

S-Corporations in 1998 2000s—Clarification and definition of abusive

S-Corporation ESOP structures, IRC 409(p) in 2001

(Source: The ESOP Association)

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ESOP History

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An ESOP is a tax-qualified, defined contribution, employee benefit plan (ERISA)

Invests primarily in the stock of the sponsoring company

“Tax-Qualified” in that sponsoring company and selling shareholder receive various income tax benefits

Technique of corporate finance

May use debt to purchase employer securities

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What is an ESOP?

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One of many alternatives for business perpetuation to be explored Sales to third party Merger Sale to management Corporate stock redemption Initial public offering Gift or other transfer to heirs Wind-up business and liquidate Leveraged recapitalization Sale to Employee Stock Ownership Trust (potential tax deferral or sale)

Creates liquidity, in part or whole, enabling the business owner(s) to diversify their portfolios.

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Why ESOPs?

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Provide a market (at fair-market value as determined by an independent appraiser) for partial or complete sale by existing shareholders, potential “tax-deferred” rollover treatment if ESOP ownership in a C Corporation is 30% or greater (IRC 1042) and “qualified replacement property” is acquired

Borrow from a bank, the sponsoring company, or sellers to purchase a block of stock

Make corporate tax-deductible contributions, including loan principal and interest payments via the ESOP (25% of Payroll + C Corporation Interest)

Gain a corporate tax deduction for C Corporation dividends passed through the ESOP to employees, or used to repay ESOP debt (excluded from 25% limit)

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Why ESOPs? (cont’d)

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Income attributable to S Corporation stock owned by an ESOP is not subject to federal income tax

Raise working capital (dilutive)

Charitable giving

Going private (usually a public company selling a subsidiary or division to an ESOP)

401(k)/ESOP combination plan

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Why ESOPs? (cont’d)

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Plan qualification requirements of the IRC require that an independent valuation of privately held employer securities, (acquired after December 31, 1986), must be performed annually.

However, the DOL strongly encourages all ESOPs holding private securities to obtain such an independent valuation and requires a valuation for any employer security purchase or sale transactions between the plan and a party in interest.

This annual valuation is used to allocate shares to participant accounts, and to redeem shares from retiring plan participants to put back to the employer.

Valuations are also used for annual ESOP administration and ESOP plan and plan sponsor reporting purposes.

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ESOP Complexities

HOW DOES AN ESOP WORK?

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(1) Company sets up an ESOP Trust. (2) Company makes annual tax-deductible

contributions in cash or stock to the ESOP.

(3) Cash is used to buy stock from current shareholders.

(4) Shares are allocated to the accounts of eligible employees within the ESOP based on salary.

(4) ESOP holds stock for employees and annually notifies them of how much they own and how much the stock is worth.

(4) Employees receive stock or cash after they retire or leave the company, a vesting schedule applies.

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Non-Leveraged

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The ESOP receives a loan and uses the proceeds to purchase stock from current shareholders.

These shares are held in trust and are released into employee accounts at a rate corresponding to debt amortization.

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Leveraged ESOPs

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1) Lender lends to company. 2) Company lends to ESOP. 3) ESOP buys stock from existing shareholders. 4) Company makes annual tax-deductible contributions to ESOP. 5) The ESOP then in turn repays lender. 6) Employees receive stock or cash when they retire or leave (vesting schedule).

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Leveraged ESOP

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Owner/Selling Shareholder Take back a note in exchange for shares Taxed on principal upon receipt at capital gains and interest as ordinary

income (if installment sale treatment is elected) Advantage: Entitled to higher interest rate; subordinated to bonding

company and bank Disadvantage: 1042 Tax Free Roll over requires proceeds to be reinvested

within 12 months Bank

Loan is to the company which makes “mirror” loan to ESOP Typically 7 years Assessment of company credit Advantage: Selling shareholder ends up with cash up front Disadvantage: Lenders look to collateralize short fall with proceeds, Bank will

not subordinate to bonding company The Company

Cash rich company can make loan to the ESOP Advantage; Company repays itself with market rate of interest

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ESOP Lenders

ESOP ADVANTAGES/DISADVANTAGES

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Substantial tax savings (40% to 100%) Increase ability to attract and retain

talent Corporate perpetuation Cash flow increased Pre-tax dollars repay debt S Corporation stock owned by an

ESOP is not subject to federal tax (most states mirror)

Tax-deductible C Corporation dividends

Justifies accumulated retained earnings

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Advantages for the Company

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Advantages for Selling Stockholders

Creates liquidity at fair market value (as determined by an independent appraiser)

Control maintained (if desired)

Deferral of capital gains taxes available to qualified sellers of C corporation stock (IRC 1042)

Establishes value and provides liquidity for estate planning

Selling shareholders excluded from ESOP participation can be “made whole” by the corporation (deferred compensation)

Additional equity incentives still available (stock option, bonus, purchase, phantom stock, etc.)

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Provides employees an opportunity to obtain ownership Employees share directly in equity growth of company ESOP employer contributions tend to be larger than profit

sharing contributions Proven motivator and builds unity and team spirit Retains key employees (25 years of studies) ESOP accounts accumulate tax-free and are tax-favored at

distribution Employees can realize dividend income Buy/sell agreements ensure future employee ownership

through the ESOP

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Advantages for Employees

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Qualified seller can elect to defer gain on C Corporation shares sold to ESOP by reinvesting all or any portion of the sale proceeds in Qualified Replacement Property (“QRP”)

Note that IRC 1042 treatment can be elected for less than 100% of sales proceeds – amount not reinvested is taxed

QRP is stock or debt instruments of a domestic operating corporation

QRP must be acquired within 12-months of the ESOP sale (or 3 months before – use of actual proceeds is not required)

After the sale, ESOP must own at least 30% of company #MHMWebinar

Planning for C Corporation IRC 1042 Deferral of Capital Gains Taxes

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Qualified Replacement Property General Guidelines*

Not Eligible

Common Stock

Convertible Bonds

Corporate Fixed Rate Bonds

Corporate “Floating Rate Notes”

Municipal Bonds

US Government Bonds

Mutual Funds

Foreign Securities

REITs

Bank CDs

* QRP must be evaluated by an experienced investment advisor to ensure compliance guidelines are met.

* *Eligible issuer must have: • 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

Eligible**

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Qualified seller must have owned stock for at least three years prior to sale: Seller cannot have acquired the stock in a compensatory stock option

plan or any other section 83 transaction, nor from a qualified retirement plan.

Seller, certain related individuals, and greater-than-25% owners generally cannot participate in ESOP allocations.

10% excise tax applies if ESOP disposes of stock within three years, except for normal benefit distribution.

Above rules do not apply, if seller does not elect the deferral (“tax-free” rollover).

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Planning for C Corporation IRC 1042 Deferral of Capital Gains Taxes (cont’d)

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Tax status conversion, if necessary Convert an S corporation to a C corporation, if tax deferral is desired

by selling stockholders

Execute IRC 1042 “tax-free” rollover as C corporation transaction

May want to consider converting back to an S corporation post IRC 1042 transaction (five year wait to convert to S)

Convert C corporation post IRC 1042 transaction to S corporation if tax benefits of S corporation ownership of ESOP are desired

100% shareholder approval for S Corporation election

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Planning for C Corporation IRC 1042 Deferral of Capital Gains Taxes (cont’d)

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Comparison of After-Tax Proceeds

90%

8%

50%

40% 100%

100%

100%

75%

50%

25%

0%

IPO Recap Stock Swap ESOP

Percent available to invest in diversified portfolio

Percent remaining in company stock

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(The ESOP can own less than 100%, with a proportional reduction in tax-free income.)

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100% ESOP – Five-Year Value of Tax-Free Operations by Electing S Corporation Status

Assume: $500,000 pretax income 10% growth rate 40% effective tax rate

Total Tax Savings: $1,221,020 = more than two times the current income!

1 2 3 4 5 Pretax Income $500,000 $550,000 $605,000 $665,500 $732,050

Tax Savings $200,000 $220,000 $242,000 $266,200 $292,820

CREATING AN ESOP

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Preliminary Assessment Questionnaire

Business Matters Are the owners ready to sell?

What are the sellers’ valuation expectations?

Who will run the company?

Is there adequate cash flow to service debt, provide working capital, provide adequate capital expenditures and cover ESOP repurchase liability?

How much stock to be sold? (100% sales work best)

Are the sellers willing to take notes?

Are the sellers willing to give reps and warranties?

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Creating an ESOP – Preliminary Analysis

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Legal Matters Controlled group Is it a corporation? Union contracts Fiduciary issues

Accounting Matters Financial statement impact Bonding Loan covenant compliance

Tax Matters Individual and corporate

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Creating an ESOP – Preliminary Analysis

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Creating an ESOP – Phase 1

Preliminary valuation

Basic Transaction Design

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Implementation Detailed transaction design Seller note terms Warrants in lieu of interest Post – close management incentives Stock sale agreement

Plan design Financing Repurchase obligation planning Independent transaction valuation Independent trustee analysis Employee communication #MHMWebinar

Creating an ESOP – Phase II

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Ongoing

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Creating an ESOP – Phase III

Keep plan up-to-date Communications Annual

Valuation Administration

CANDIDATE CHECKLIST

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Is an ESOP Right for You? ESOP Candidate Checklist

Yes/No

___/___1. At least some stockholders are motivated to sell some stock; e.g., planning for retirement, liquidating an estate, entering a new business venture, children not involved in business, etc.

___/___2. The owners are psychologically ready and willing to transfer ownership to an employee trust, assuming an attractive transaction can be arranged.

___/___3. If one or more principal executives will be departing in the foreseeable future, there is a viable management transition plan.

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Is an ESOP Right for You? ESOP Candidate Checklist (cont’d)

Yes/No

___/___4. The entity is a corporation taxed in the normal manner.

___/___5. The company has a strong pretax, pre-distribution and bonus earnings and cash flow over the previous few years.

___/___6. The company expects to have strong pretax, pre- distribution and bonus earnings over the next few years.

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Is an ESOP Right for You? ESOP Candidate Checklist (cont’d)

Yes/No

___/___7. The company customarily makes payments to a 401(k) or profit sharing or other employee benefit plan that could in the future be made to an ESOP.

___/___8. The company has payroll adequate to support the proposed ESOP.

MANAGEMENT INCENTIVES IN ESOP COMPANIES

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Management Incentives

Management’s interest through ESOP is generally inadequate

Most common design Annual cash bonuses

Tied to no breach of debt covenants or payment obligations

Stock appreciation rights This is a contract: “Company will pay you cash equal to rise in

ESOP appraisal multiplied by ‘x’ hypothetical shares.” Based on post-debt, depressed value Payable after seller notes repaid Generally 5-15% for management team

Establish as part of deal and communicate to trustee

OPERATIONAL ISSUES

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Operational Issues

Handling Liquidity or Repurchase Obligation Process of Distributions

Diversification Rules Use of Dividends Overview of Anti-abuse rules 409(p)

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Handling Liquidity or Repurchase Obligation

Form of Benefit Paid in Cash and/or Employer Securities

Who decides the form of Benefit? Participant Plan Sponsor

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Know the plan document Distribution provisions –

Immediate pay-out, delay for 5 years, installments?

Annually prepare a Repurchase Obligation Study Properly plan for cash flow requirements

Handling Liquidity or Repurchase Obligation

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Handling Liquidity or Repurchase Obligation

Source of the money to fund distributions Cash contributed and distributed

Recycle/Reshuffling

Shares distributed and repurchased by ESOP with cash Where did the cash come from?

Shares distributed and repurchased by ESOP with note Re-leverage

Securities acquisition note subject to all of the leveraged ESOP rules

Shares distributed and repurchased by Plan Sponsor Repurchase transaction is outside the plan

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Handling Liquidity or Repurchase Obligation

Cash contributed and distributed —Recycle/Reshuffling One of the most common Cash is distributed from the plan and the shares allocated to

the remaining participants. Benefits:

i) It’s easy ii) tax deductions created by the ESOP sponsor’s contributions to

fund the cash recycling distributions to former participants. Disadvantages:

Distribution obligations may be setting the Plan Sponsors contribution decision

May contribute to the have and have not issue

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Recycling/Reshuffle Example

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Handling Liquidity or Repurchase Obligation

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Shares distributed and repurchased by…? The ESOP with Cash The ESOP with a Note The Plan Sponsor – “put option”

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Handling Liquidity or Repurchase Obligation

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Why would an ESOP want to distribute shares? May help resolve the “have and have nots” issue

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Handling Liquidity or Repurchase Obligation

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Redeem / Re-contribute vs. Recycle

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Eligible participants have the right to elect to diversify up to 25% of their post-1986 stock accounts First 5 years up to 25% Last year (year 6) up to 50% of stock

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Diversification

Eligible participants

10 years of participation

Age 55 or older

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Election Period: 90 days after the end of the Plan Year The ESOP trustee has 90 days from the end of the election

period to actually satisfy or implement the participant’s election.

Satisfaction of Requirements distribute cash equal to the stock value distribute the stock that is diversified offer 3 or more alternative investment funds for the

liquidated shares within the ESOP Transfer the liquidated shares to another plan

sponsored by the employer than offers 3 or more alternative investment funds

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Diversification

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Sometime called “account segregation”

Converting a terminated participant’s account balance from company stock to other investments of equal value. Segregation happens before a participant is eligible to

receive a distribution and therefore is technically not part of a plan’s distribution policy.

Helps the Plan Sponsor plan for repurchase obligation.

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Mandatory Diversification

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Dividends Used for Debt Service

Dividends on allocated shares MAY be used for debt service if “return for value” rule is satisfied. IRC §404(k) (aka “Dividend Short Fall”) Shares allocated to participant due to use of dividends must

at least equal in value the dividend dollars applied. Other allocations to account due to contributions cannot be

used to satisfy this test. Typically any shortfall is made up through allocation of

shares attributable to dividends paid on collateral IMPACT: This is a condition of the right to use dividends for

debt service. Violation may result in an additional employer contribution or a prohibited transaction, subject to correction.

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Dividends Paid to an ESOP

Example: Suppose a participant receives a dividend of $1,000 on shares allocated to his account in the ESOP. The $1,000 is used to repay the exempt loan. Twenty shares are released and returned to the participant. The share value at the end of the plan year is $40 per share, or $800 for the 20 shares returned. This is $200 less than the value removed from the account.

“Dividend shortfall” or “return of value” issue

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Dividends Paid to an ESOP

Violation may result in an additional employer contribution or a prohibited transaction, subject to correction.

Particular issue for S Corporations as correction methods may be limited.

Dividend short fall rules do not apply to shares held in the suspense account.

A rising stock price does not guarantee that the plan will not have a dividend short fall issue.

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S Corporation Anti-abuse — Rules 409(p)

To ensure that ESOPs that are established for S Corporations provide broad-based employee coverage, and to benefit rank-and-file employees as well as highly compensated employees and historical owners

Prohibited allocation rules — no portion of the plan attributable to employer securities may accrue during a “nonallocation” year to “disqualified persons”

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S Corporation Anti-abuse — Rules 409(p)

“Disqualified Person” — An individual is a disqualified person if:

1. The aggregate number of “deemed-owned shares” of such individual and the individual’s family unit is at least 20% of the number of all deemed-owned shares or

2. The number of “deemed-owned shares” held only by the individual is at least 10% of the number of all “deemed-owned shares”

≥20%

≥10%

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S Corporation Anti-abuse — Rules 409(p)

Non Allocation Year: Defined A plan year under the ESOP is treated as a nonallocation year if

at any time during the plan year Disqualified persons own at least 50% of the outstanding S

Corporation shares (both shares outside the ESOP and “deemed-owned shares” in the ESOP)

Non Allocation Year Consequences An excise tax (50%) is imposed on the S Corporation the disqualified person is treated as having received a

distribution in the amount of the prohibited allocation ESOP no longer eligible for the prohibited transaction

exemption with respect to any outstanding loan to the ESOP S Corporation income is subject to UBIT Results in plan disqualification

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S Corporation Anti-abuse — Rules 409(p)

Synthetic equity — can also be included in the computations Stock options Warrants Restricted stock Deferred issuance stock right Non-qualified deferred compensation

plans

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S Corporation Anti-abuse — Rules 409(p) Summary

Before implementing an S Corporation ESOP examine the test and all family relationships.

Address synthetic equity.

ESOPs with numerous, broad-based employee participation generally should not have a problem passing the section 409(p) test but watch family relationships.

Testing should be done at the beginning of the plan year; corrective action must be taken AFTER preliminary testing but BEFORE any formal allocation is made.

Annually, make sure your third-party administrator is performing this test and review the results.

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Questions?

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If You Enjoyed This Webinar…

Join us for these related EES courses: Oct. 24: The Role of ESOPs in Private Equity Firms Nov. 14 and 19: Employee Benefit Plan Accounting Issues

Update

Read these related publications: MHM Messenger 11-13: FASB Proposal Affects Employee

Benefit Plans Employee Stock Ownership Plan Primer

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Today’s Presenters

Hal Hunt, CPA Shareholder 913.234.1012 | hhunt@cbiz.com

Hal leads MHM’s Employee Benefit Plan (EBP) Audit Practice. With over 25 years of diverse experience with EBP accounting, auditing and compliance issues, he is also a member of the firm’s Professional Standards Group as EBP subject matter expert. As the EBP National Practice Leader, Hal is responsible for providing internal training, along with providing technical support to engagement teams, serving as engagement quality reviewer and developing resource tools for our EBP audit professionals. He served on the AICPA’s Employee Benefit Plan Audit Quality Center (EBPAQC) Executive Committee and is currently a member of the EBPAQC ESOP Task Force.

Anthony M. Hakes (Tony), CPA Shareholder 602.650.6225 | ahakes@cbiz.com Tony is a Director/Shareholder in the Phoenix office and joined CBIZ and Mayer Hoffman McCann P.C. (MHM) in June 2002 and has approximately 15 years of experience with national and international public accounting firms. Tony serves as the Western Region ERISA Audit Leader for MHM and is a member of the MHM ERISA Task Force. Through these roles, Tony participates in designing and implementing MHM’s audit approach as well as ensuring audit quality for approximately 1,000 ERISA audit clients firmwide.

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Cindy Dwyer Shareholder 913.234.1022 | cdwyer@cbiz.com Cindy is the President of MHM Retirement Plan Solutions and a Shareholder of Mayer Hoffman McCann P.C. She supervises staff, oversees technical research, and provides quality control services. She has previously served as the national Chairperson of the American Institute of Certified Public Accountants Employee Benefits Technical Resource Panel (TRP) and has recently been reappointed as a member of the TRP. Additionally, Cindy has been a recurring speaker at the American Institute of Certified Public Accountants National Conference on Employee Benefit Plans. Cindy is also a committee member and current chair of the Employee Benefits Institute sponsored by UMKC School of Law.

#MHMWebinar

Today’s Presenters

Mark D. Welker Partner, Husch Blackwell 816.983.8148 | mark.welker@huschblackwell.com Chair of the firm's Tax & Benefits Department, Mark is considered clients’ go-to advisor on any important benefit or compensation matter. He focuses on all benefit and compensation matters, including the creation and operation of employee retirement plans, deferred and equity executive compensation, employee stock ownership plans, and health and welfare plans. Mark is highly regarded for his strategies and management of fiduciary and tax disputes.

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