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 Value of 60% majority stock sale Corp. profits needed to net sale price

Corp. income tax at 40% (35% + 5%)

Net corp. profits available for stock purchase Sale proceeds to seller

Capital gains tax at 29.2% (fed. & avg. state) Net sale proceeds to seller

Total Taxes/Fees $10,000,000 $6,000,000 $10,000,000

$4,000,000

$6,000,000 $6,000,000

$1,752,000 $4,248,000

$5,752,000

Management Buy-Out

Company value Value of 60% majority stock sale Bonus to execs’ needed to net sale price Exec’s personal income tax 39.4% (35% + 5.4%) Net corp. profits available for stock purchase Sale proceeds to seller

Capital gains tax at 29.2% (fed. & avg. state) Net sale proceeds to seller

$10,000,000 $6,000,000 $9,740,000

$3,740,000

$6,000,000 $6,000,000

$1,752,000 $4,248,000

Total Taxes $5,492,000

Third Party Sale (Stock)

Company value Value of 60% majority stock sale Pre-fee proceeds to seller Typical sale transaction fee at 8% Gross proceeds to seller

Capital gains tax at 29.2% (fed. & avg. state) Net sales proceeds to seller

Total taxes & fees $10,000,000 $6,000,000 $6,000,000 $480,000 $5,520,000

$1,752,000 $3,768,000

$2,232,000

ESOP Sale: C Corp

Company value Value of 60% majority sale Pre-fee proceeds to seller Typical transaction fee at 2.5% Gross proceeds to seller

Capital gains tax at 29.2% (fed. & avg. state) Net proceeds to seller

Total fees & taxes $10,000,000 $6,000,000 $6,000,000 $150,000 $5,850,000

$0 $5,850,000

$150,000

Method Corporate Redemption Management Buy-Out Third Party Sale (Stock) ESOP – C Corp “Net” to Seller Total Taxes & Fees Percent of Total to Seller

$4,248,000 $4,248,000 $3,768,000 $5,850,000 $5,752,000 $5,492,000 $2,232,000 $150,000 42% 44% 63% 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

How It Works: Step 2

Company C O N T R I B U T I O N Stock or Cash ESOP Trust Buys Shares Selling Shareholders

Leveraged ESOP

How an ESOP Works: Step 1

The Company ESOP Trust

How an ESOP Works: Step 2

Lender Loan Company L o a n ESOP Trust

How an ESOP Works: Step 3

Lender Loan L o a n Company IRC § 1042 C a s h ESOP Trust Stock Cash Selling Shareholder

How an ESOP Works: Step 4

Lender Loan Payment Company IRC § 1042 L o a n C a s h P a y m e nt ESOP Trust C a s h Stock Cash Selling Shareholder

How an ESOP Works: Step 5

Lender Loan Payment Company L o a n C a s h ESOP Trust P a y m e n t Stock Cash IRC § 1042 C a s h Selling Shareholder Employees

How an ESOP Works: Step 6

Lender Sinking Fund Loan Payment Company L o a n C a s h ESOP Trust e n t P a y m Stock Cash IRC § 1042 C a s h Selling Shareholder Employees Death, Disability, Retirement, Termination and Diversification

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)

Eligible

Common Stock Convertible Bonds Corporate Fixed Rate Bonds

Corporate Floating Rate Notes Ineligible

Municipal Bonds US Govt. Bonds Mutual Funds Foreign Securities REITs, Bank CDs 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

Leveraged QRP Strategy

Proceeds From Sale (1042) Cash Portfolio Floating Rate Notes Margin Account QRP can be margined to 90% Liquid Cash Balance Income with Interest

Leveraged QRP Strategy

New Home Bonds

Proceeds From Margin Loan

Cars Stocks Boat

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

Control Can Remain “Undisturbed”

Owners with stock outside the ESOP Votes Board of Directors Appoints “Directed” Trustee

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

0 20 20 20 20 10

Total Outstanding Shares

100 80 60 40 20 10

Shares Inside ESOP

90 70 50 30 10 0

Shares Owned Outside ESOP (Family/Mgmt)

10 10 10 10 10 10

Percentage Owned Outside ESOP (Family/Mgmt)

10% 13% 17% 25% 50% 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

Team Quarterback Through Entire Process

Investigative Phase Part 1 • Educational “ESOPs 101” Presentation • Initial Review of Financials & Fact Finder • Preliminary Valuation • Preliminary ESOP Analysis Investigative Phase Part 2 Implementation Phase Post Closing Phase • Additional Data Gathering • Feasibility Study • Final Client Approval to Proceed to Next Step • ERISA Plan Design • Transaction Design • Engage Other Team Members • Financing • IRC§ 1042 Analysis & Execution • Employee Communications • Management Incentive Plans • Repurchase Liability & Funding • Advanced Planning • Determination Letter

Team Approach

Insurance Investments* Plan Design ERISA Counsel * Banker Estate Planning Trustee*

BTA Team Leader

Stock Valuation* TPA* Employee Communication Corporate Counsel Repurchase Obligation Company CPA * *

Outside service provider

Contact Information

Roy Farmer Managing Director (208) 761-3612 [email protected]