Transcript Slide 1

Analysis of Possible ESOP
Minority Leveraged
Stock Purchase
March 17, 2010
PRIVILEGED AND CONFIDENTIAL
Schuck Law Group
Law Offices of Edwin G. Schuck, Jr.
500 South Grand Avenue, 19th Floor
Los Angeles, California 90071-2609
(213) 683-5376 Direct
(626) 485-8959 Mobile
(213) 683-5366 Fax
[email protected]
Executive Summary
● Existing shareholders can take significant cash out now
at existing low capital gains rates or with permanent tax
deferral and tax-free liquidity - unsold residual is then
held and grown to sell with ESOP later at a higher value.
● The sale-to-ESOP transaction is highly tax-incentivised
compared to alternative structures.
● A transaction can be structured to achieve a 100% ESOPowned S corporation owning a fraction of the business
● A sale to a third party three years later will allocate sale
proceeds to pay off the original ESOP purchase debt and
then only to released ESOP-held stock; the balance will
go to the existing shareholders.
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WHY USE A LEVERAGED ESOP TRANSACTION TO
SELL A MINIORITY INTEREST:
● Selling shareholders can take cash “off the table” now
while continuing to grow the company for later sale at a
higher value.
● Sale gain can be tax-deferred (permanently) or will be
taxable at current low federal capital gains rate (before
Obama increase).
● Later sale (say, three or more years after the leveraged
ESOP transaction) can be to a third party strategic or
financial buyer or to the ESOP or in a redemption by the
company in a second-stage leveraged transaction.
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WHAT IS AN
EMPLOYEE STOCK OWNERSHIP PLAN (ESOP)?
 An ESOP is a qualified trustee defined contribution
employee retirement plan designed to invest
primarily in employer stock.
 Employees indirectly own stock in the employer to
the extent the stock is allocated to their accounts and
vested.
 ESOPs are unique among qualified benefit plans in
their ability to borrow money, allowing “leveraged
ESOP’s” to legally fund the purchase of employer
stock from existing stockholders.
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Employee Stock Ownership Plan (ESOP)
 ESOPs are unique among tax-qualified benefit plans in
their ability to own stock in an S corporation without
paying UBIT, thus avoiding all federal income tax at both
the corporate and shareholder levels (California taxes an S
corporation’s net income at 1-1/2%).
 ESOP companies usually experience productivity gains
from making employees shareholders, according to
research by the NCEO (National Center for Employee
Ownership).
 An ESOP leveraged buyout can be structured to allow
selling shareholders to obtain liquidity yet maintain
control of their company, even if the ESOP owns a majority
of company stock. This is done with a “directed trustee.”
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Typical Structure of a
Leveraged ESOP Transaction
Leveraged ESOP Purchase of Existing Stock
Outside
Loan
Company
Lender
Inside Loan
Shareholders
Stock
Cash
ESOP
Trust
STRUCTURAL STEPS:
• The company incorporates and creates an ESOP and an ESOP Trust.
• The company borrows funds from a bank or other outside lender (“outside loan”) and re-lends the
proceeds to the ESOP Trust (“inside loan”).
• The ESOP Trust uses the borrowed funds to purchase company shares from the existing shareholders.
The purchased shares are held by the ESOP in a suspense or “contra equity” account until released
when contributions or dividends are received by the ESOP.
• The selling shareholders can elect to defer capital gain on the sale yet still achieve tax-free liquidity.
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Structure of a
Leveraged ESOP Transaction
Repayment of ESOP Financing
Lender
Outside Loan Repayment
Tax Deductible
Dividends & Contributions
Company
Inside Loan Repayment
ESOP
•
The company services the new outside debt by making tax deductible contributions to the ESOP. The ESOP uses the
company contributions to repay the inside loan to the company and the company then makes debt service payments to the
outside lender.
•
Because the contributions to the ESOP are tax deductible, the new outside debt is, in effect, repaid with before-tax dollars
– in other words – the principal repayment to the bank is effectively tax-deductible.
•
As the company makes annual ESOP contributions and the principal of the inside loan is thereby repaid, the purchased
shares are released from the suspense account and allocated to the employee accounts in proportion to their respective
compensation.
•
Dividends paid on C corporation stock owned by the ESOP are also deductible when the dividends are used to repay the
inside loan; shares in the amount of the dividends are then released from the suspense account and allocated to employee
accounts.
•
Dividends must be “reasonable”. A 10% dividend if structured correctly can be reasonable.
•
The dividend deduction is not available for corporate AMT.
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Leveraged ESOP
Contribution and Deduction Limits
 Annual deductible contributions cannot exceed 25% of aggregate eligible
compensation of all eligible employees – an employee’s compensation
considered cannot exceed $245,000 in 2010 (subject to annual COLA
increases).
 If 25 % of such “covered payroll” is not sufficient to zero out C
corporation taxable income, some or all of the difference can be made up
with a reasonable deductible dividend on the ESOP-held stock.
 Also, an additional 25% of “covered payroll” can be a deductible
contribution if not used to repay the inside loan.
 The “annual addition” to each participant’s account for all qualified plans
cannot exceed $49,000 in 2010 (subject to annual COLA increases).
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Incorporate and Make the S Election if Tax
Deferral is not Important
 If the Company incorporates and makes the S election (or if an existing S
corporation holding company is used), the 1042 rollover tax deferral will
not be available, but the existing low federal capital gains rate (plus
California’s ordinary income rate) will apply to the sale gain.
 However, if desired the S election can be made immediately after the
1042 sale (as a C corporation) thus preserving the 1042 rollover deferral.
 For a 100% ESOP-owned S corporation, deduction limits for
contributions to the ESOP will not be relevant because there will be no
federal tax at either the S corporation or ESOP level.
 For a less-than-100% ESOP-owned S corporation, distributions to the
non-ESOP shareholders of the S corporation to pay quarterly taxes must
also be made pro-rata to the ESOP. Such distributions can be used by
the ESOP to repay the inside loan.
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Why Do Companies Use a Leveraged ESOP?
 A leveraged ESOP transaction is a readily available highly tax-incentivized
alternative to an IPO, a strategic or financial sale or a leveraged
recapitalization.
Summary of Four Principal Tax Incentives
 Deduct both principal and interest on sale debt financing
 Deduct dividends (but not for AMT) paid on purchased C corporation stock
held by ESOP.
 Tax-deferred sale of stock to ESOP that provides 90% + liquidity and
ultimately escapes capital gains tax entirely.
 The S-election is available to an ESOP-owned company so that, where there
is 100% ESOP ownership, no federal income taxes are paid at either the
corporate or the shareholder level (there is a 1-1/2% California tax on S
corporation taxable income).
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ESOP Company Can
Deduct Principal, Interest and Dividends
 Increased Cash Flow:
 Principal (and interest) payments on ESOP loans are
effectively tax deductible as ESOP contributions.
 Dividend payments on ESOP-held C corporation
shares are tax deductible – must be “reasonable”.
Thus, an ESOP company deducts loan interest, loan principal
and dividends paid on C corporation stock (but not for AMT)
from taxable income.
 Resulting enhanced after-tax cash flow provides company a
greater debt capacity.
● ESOP-owned S corporations do not pay federal income tax at the
corporate level or at the ESOP-shareholder level. Any non-ESOP
shareholders pay tax on their pro-rata flow-through income.

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C Corporation
Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions
 Non-C-corporation shareholders of a C corporation in existence for three years
selling all or a portion of their stock to an ESOP will typically be able to defer
capital gains tax indefinitely if qualified replacement property (“QRP”) is
purchased with the sale proceeds within one year. This is an election under
Section 1042 of the IRC and so is called a “1042 rollover”.
 A partnership or LLC in existence for three years can incorporate tax-free as a C
corporation in order to obtain the 1042 deferral. An S corporation can revoke
the S election to obtain the 1042 deferral and re-elect S status five years later if
then desired.
 The selling shareholders can achieve tax-free liquidity of 90% + of the selling
price by buying QRP that is specially issued “floating rate notes” (FRNs) with
the sale proceeds and borrowing against them (“liquidity loan”).
 The FRNs are issued by AA or AAA-rated public companies and are designed so
that their face amount is always near their fair market value. Banks will
typically lend up to 90% + of FRNs’ face value when they are pledged as
collateral in a margin loan.
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Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions (cont’d)
 The interest cost on 90% of face amount is about the same
(nominally plus or minus) as interest income on 100% of
the face amount of the FRNs. Currently there is a small
negative.
 Properly structured, the seller’s proceeds in the form of the
purchased FRNs may eventually be transferred to the
seller’s estate with a tax basis that is “stepped-up” to the
original sale price (if the estate tax remains reinstated after
2010). The estate then sells the FRNs at no taxable gain and
repays the liquidity loan, effectively eliminating forever the
deferred tax associated with the original sale of the stock.
 The 1042 rollover election applies only if the ESOP owns at
least 30% of the company’s stock immediately after the
sale.
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Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions (cont’d)
 Private equity and/or mezzanine debt can be raised to fund
the buyout or to fill the “gap” that may not be lent by a
senior (bank) lender in a first-stage buyout.
 Also, the selling shareholders can partially finance the sale
of their stock to the ESOP by taking back a subordinated (to
the bank senior debt) “seller note.”
 Other sources of financing may be tax-free investments in
the ESOP from employee accounts in other company
qualified plans such as 401(k) or profit sharing plans.
 If the 1042 rollover is elected, three years must elapse
before the ESOP can re-sell the purchased stock (or a 10%
excise tax will be imposed on the company).
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Summary of Leveraged ESOP Aggregate
Tax Savings for C Corporation Shareholders
Per $10 of Sale Proceeds in a 1042 Rollover
Non-ESOP
ESOP
ESOP TAX
SAVINGS
After-tax Proceeds to
Shareholder (@ 25%
combined capital gains rate)
$7.5
$10.0
$2.5
After-tax Cost to Company
(@ 40% combined tax rate)
(10.0)
(6.0)
4.0
Total ESOP Tax Savings
Per $10 of Sale Proceeds
$6.5
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Deferral of Capital Gains for Selling Shareholders
EXAMPLE
Seller Defers Capital Gains Tax –
1042 Rollover – 31% Sale to ESOP
ESOP
Transaction
Non-ESOP
Transaction
$205,000,000
$205,000,000
Less: Existing Debt
(5,000,000)
(5,000,000)
Equity Value
200,000,00
200,000,000
31%
31%
50,000,000
50,000,000
0
(12,500,000)
50,000,000
Invested in QRP
37,500,000
Enterprise Value
Multiplied by % Acquired
(Less 20% Minority Discount)
Cash From Sale
Less: Combined Capital Gains Tax
@ 25% (assuming -0- stock basis)
After-Tax Proceeds
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1042 Leveraged ESOP Transaction – Bank Debt and Seller Note
$40MM
Senior Debt
Outside Loan
Company
ESOP
31%
Stock Purchase
Residual- Selling
Shareholders
69%

$50MM
1042
Sellers
The Company borrows up to $40MM from the outside BANK lender, borrows as little as
$10MM from the selling shareholders and re-lends the $50MM to THE ESOP. The ESOP
uses the $50MM loan proceeds to purchase 31% of the company’s stock from the selling
shareholders.
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ESOP-Owned S-Corporations
100% S - Corp Transactions

If the ESOP owns 100% of the common stock, the company can elect S-Corp tax status and avoid paying
federal (and most state) income tax completely (California imposes a 1-1/2% income tax at the S
corporation level).

Enhanced after-tax cash flows facilitate:

•
1. Additional debt repayment, resulting in a more rapid “deleveraging” of the company
•
2. Capital expansion projects
•
3. Additional growth opportunities, including acquisition.
•
4. Lower prices for company’s goods or services – more competitive
By rapidly reducing its debt balances with before-tax cash flow, a company can rapidly generate additional
value for its equity holders.
S Election Eliminates All Federal
and Most State Income Taxes
Year 1
Year 2
Year 3
Year 4
Year 5
Pretax Income
$30,000,000
$30,000,000
$30,000,000
$30,000,000
$30,000,000
Tax Savings @ combined 40% rate
$12,000,000
$12,000,000
$12,000,000
$12,000,000
$12,000,000
5-year Tax Savings to S Election
$60,000,000
On $150,000,000 of Net Income
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 Company incorporates as a C corporation with two classes of voting





common stock, Class A and Class B.
The Class B stock can pay a special dividend independently of the Class A
stock.
The Class B stock is sold to the ESOP for its appraised fair market value.
If less than a majority of common stock is sold, the selling price will
reflect a “minority discount” (say, 20%); if more than 50% is sold, there
will be no such discount.
Company shareholders can sell 31% as a first-stage transaction. If the
company is worth $200 million, a sale of 31% with a 20% minority
discount would yield about $50 million.
Some or all of the purchase price can be funded with bank debt; the
balance can be funded with junior mezzanine and/or seller debt.
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 Company Partner’s total payroll is about $3 million; 25% is




about $750,000.
A 10% dividend on about $50 million of stock is about $5
million.
Thus, total annual deductions would only amount to about
$5.75 million – likely not enough to zero-out C corporation
taxable income at EBITDA levels at or above $20 million.
An additional 25% of “covered compensation” deduction is
available if not used to pay down the inside loan – but this
would add only another $750,000 in deductions.
Thus, this is likely not a tax-attractive structure for Company.
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 There is an alternative way to structure the sale so that the C corporation
double-tax problem is avoided:
 A substantial portion of Company’s business (say, 31%) is separately
incorporated by its individual owners and the shares sold 100% (as a C
corporation) to an ESOP, after which the S election would be made,
resulting in a 100% ESOP-owned S corporation but achieving the 1042
rollover on the sale, if desired.
 The ESOP-owned corporation would then be a 31% member of a joint
venture LLC with Company as a 69 % member.
 The 69% of the LLC ultimately retained by existing members would
pay tax on pro-rata flow-through income as at present.
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Alternative 100% ESOP-Owned S Corporation Structure
Existing
Members
1
2
Distribute and
incorporate 31%
of assets and liabilities
Form ESOP and sell new
corporation to ESOP
31%
XYZ
Partners
LLC
ESOP
Company
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Alternative 100% ESOP-Owned S Corporation Structure (cont’d)
3
Existing
Members
ESOP
Create
Joint Venture LLC
entity and drop down
or dedicate all assets
and liabilities
4
New corporation
makes S election
100%
Corporation
LLC
Company
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SUMMARY
ESOP Benefits to Employees
 ESOPs can be used effectively to increase employee morale.
 Employees have an equity stake in the company and therefore share in




the growth and increase in company value.
Appreciation in equity and contributions to the ESOP are not currently
taxable – taxable only when distributed.
ESOP distributions to employees may be rolled over into an IRA to
further defer taxes.
Company’s cash flow is improved, translating to improved company
stability.
If a partial ESOP company is later sold (say, three years after the
leveraged ESOP transaction), the employees will get a share of the
proceeds in respect of stock that has been released from the suspense
account by then (the sale proceeds in respect of the unreleased stock
revert to the non-ESOP shareholders – after paying all remaining
outside debt).
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SUMMARY
Leveraged ESOP Transaction Deal Points:
 Leveraged Transaction
 Possibly Multiple Financing Sources
 ESOP Can Own Special Dividend-Paying Stock
 Private Equity (or Mezzanine Debt) Can Be Used
 Profit Sharing Plan Money Can Be Used
 “Seller Notes” Can Be Used
 Management Retention Incentive Contracts are
Encouraged by Bank Lenders and ESOP Trustees
 A 100% ESOP-Owned S Corporation May Present THE
IDEAL STRUCTURE
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