Transcript Slide 1

The Unique Alternative to the Big Four®
ESOP Features You May Not Have Considered
Michigan Chapter of The ESOP Association
Annual Conference
September 25, 2014
Presented by:
Pete Shuler - Crowe Horwath LLP ([email protected])
Justin Stemple – Warner Norcross & Judd ([email protected])
The Unique Alternative to the Big Four®
Preface
 Please fill out a session evaluation form and drop it off at the table outside of the
main room
 Your feedback on topics and presenters is important and will be used to develop
subsequent programs
 Take a moment to silence your cell phone
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The Unique Alternative to the Big Four®
Coordination with 401(k) Plan
 Look for *Coordination with 401(k) Plan* noted throughout presentation
 Must be the same
 HCE definition/assumptions
 Limitation Year definition
 Top-heavy contribution coordination
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The Unique Alternative to the Big Four®
“Generous” Entry and Allocation Provisions
 Maximum wait to enter:
 Service – 12 months (with 1,000 hours), then enter on the following semi-annual entry
date
 Age – 21
 Maximum allocation provisions
 Work 1,000 hours during the plan year
 Be employed on the last day of the plan year
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The Unique Alternative to the Big Four®
“Generous” Entry and Allocation Provisions
 Why would you want to be more generous?
 Can help resolve issues with maximum permissible contribution (25% of eligible payroll)
by increasing the eligible payroll
 Can help resolve issues with maximum annual allocation each participant can receive
by spreading the allocation across more participants
 Can get employees focused on the ESOP more quickly – they don’t have to wait up to
18 months to enter and up to three years before they get a statement
 What is the downside?
 Current employees who had to wait a year to enter may not be happy
 Most turnover occurs early in employment and with younger employees
 Spreads the allocation a bit (less for each existing participant), but not as much as you
may think
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The Unique Alternative to the Big Four®
Dual Eligibility
 Different contributions may have different eligibility rules
 Why would you want that?
 Can allow new hires to starting contributing to the 401(k) quickly but require longer
service to receive ESOP contributions
 Different eligibility rules for “fixed” work schedules v. non-fixed/irregular work
schedules
 Immediate for fixed; 1 year and age 21 for non-fixed
 Attempts to address part-time employees without delaying all employees
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The Unique Alternative to the Big Four®
Exclusions From Eligibility
 Certain exclusions have no impact on nondiscrimination testing
 Collective bargaining group members
 Non-employees
 Nonresident aliens without any US earned income
 Other nondiscriminatory categories may be excluded
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
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Division
Facility
Subsidiary
Job classification
Students/interns
 No hours-based exclusions
 Part-time
 Temporary
 Seasonal
 Non-benefitting employees
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The Unique Alternative to the Big Four®
Service-based Allocation
 Two methods of allocation for employer contributions are approved without
additional testing
 Compensation-based
 Per capita
 Other methods are generally permissible as long as they don’t discriminate in
favor of “highly compensated employees”
 Test must be performed annually to ensure that the allocation is “nondiscriminatory”
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The Unique Alternative to the Big Four®
Service-based Allocation
 Example
ABC Company
Employee Stock Ownership Plan
Eligible
Participants
John Smith
Joe Green
Ed Brown
Mary Johnson
Edna Williams
Total
Wages
50,000
30,000
40,000
120,000
75,000
315,000
Years of
Service
10
15
12
1
5
43
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Points
Wages Service
50
100
30
150
40
120
120
10
75
50
315
430
Total
150
180
160
130
125
745
Allocation ($100,000)
Wages
Points
15,873
20,134
9,524
24,161
12,698
21,477
38,095
17,450
23,810
16,779
100,000 100,000
Allocation %
Wages Points
16%
20%
10%
24%
13%
21%
38%
17%
24%
17%
100%
100%
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The Unique Alternative to the Big Four®
Service-based Allocation
 Why would you want to use a service-based allocation?
 If the desire is to reward participants based at least partially on their service, servicebased allocation works
 Lot of flexibility in designing the formula, as long as the allocation is nondiscriminatory
 What is the downside?
 Desire may be to reward employees based on current compensation, not service
 Could adversely impact recruiting
 Nondiscrimination testing must be passed

If highly compensated employees have the most service, test may not pass
 Repurchase obligation impact

Could put more shares into the accounts of participants who are closer to diversification and
retirement
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The Unique Alternative to the Big Four®
Compensation-based Allocation
 Most common allocation method is pro rata by compensation
 Most common compensation definition is gross W-2 (includes pre-tax deferrals)
 Withholding wages and Section 415 compensation are also pre-approved
 Pre-approved exclusion of taxable fringes: “reimbursements or other expense
allowances, cash and noncash fringe benefits, moving expenses, deferred
compensation, and welfare benefits” – must be in the plan
 Other exclusions permitted if non-discriminatory




Bonuses
Overtime
Commissions
Others?
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The Unique Alternative to the Big Four®
401(k) plan-based Allocation
 Matching allocation
 Safe harbor allocation

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

Nonelective
Matching
QACA
Eligibility rules/compensation definition
Safe harbor notice(s)
401(k) must provide for safe harbor to be satisfied in the ESOP
 *Coordination with 401(k) plan*
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The Unique Alternative to the Big Four®
Correction/Avoidance Options for Section 415 Excess
 Section 415
 Limits “annual additions” participants can receive under all company retirement plans to
lesser of their 100% of pay or $52,000 (adjusted for inflation annually)
 Annual additions are generally employee deferrals and Roth contributions, employer
contributions, and reallocated forfeitures

Catch-up contributions (currently $5,500) are not counted for 415 purposes
 Correction methods
 Return employee deferrals/Roth contributions to the individual
 Forfeit associated matching contributions
 Reallocate excess amounts to those who have not yet hit the 415 limit
 *Coordination with 401(k) Plan*
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The Unique Alternative to the Big Four®
Correction/Avoidance Options for Section 415 Excess
 Return employee contributions/forfeit associated match
 For participants at least age 50, deferrals that would have been returned can be
recategorized as catch-up contributions, if catch up contributions have not yet been fully
utilized. This means they stay in the 401(k) plan.
 Participant receives their own contributions back, less any taxes
 Positively impacts the average deferral percentage test if the participant is a highly
compensated employee
 Downside – Employees don’t like to get their deferrals back
 Reallocating excess
 Generally the avoidance of a failure, not a correct
 Because the 415 limit is not hit, due to change in allocation, no deferrals are
recharacterized
 Any excess is reallocated to those who have not yet hit the limit, so more allocations for
lower paid people
 Downside – not financially beneficial for those who hit the limit
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The Unique Alternative to the Big Four®
Forfeitures
 Timing
 Immediate upon distribution
 Five breaks in service
 Use of forfeitures
 Expenses if cash forfeitures
 Reallocate
 Reduce next contribution
 “Lost” participants
 http://www.dol.gov/ebsa/publications/2013ACreport3.html
 No “Mr. Forfeiture”
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The Unique Alternative to the Big Four®
Paying ESOP Loan with Contributions v. Dividends
 Sources of funds for the loan payment determines how the shares released by
the loan payment are allocated
 If employer contributions are used to fund the loan payment, the shares released are
allocated based on compensation/points
 If dividends/income distributions are used to fund the loan payment, at least a portion of
the shares released are allocated based on stock account balance


Dividends earned on shares in participant accounts are always allocated on stock account
balance
Dividends earned on suspense accounts shares can be allocated in different ways, but generally
either on stock account balance or in the same manner as the contribution
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The Unique Alternative to the Big Four®
Paying ESOP Loan with Contributions v. Dividends
 Not always a choice:
 Limits on contributions can necessitate the need for dividends/income distributions to
fund the loan payment

Example - $2 million loan payment, but only $1.5 million can be contribution. $0.5 million
dividend can be used to fund the remainder


404 Limit is 25% of eligible compensation
415 Limit – dividends can be used to avoid a failure
 If there are non-ESOP shareholders, and they receive dividends/income distributions,
the ESOP must receive these as well

Generally used to repay the loan
 Similarly, some preferred stock (C-Corps only) requires a dividend

Generally used to repay the loan
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The Unique Alternative to the Big Four®
Paying ESOP Loan with Contributions v. Dividends
 But if there is a choice:
 Use of dividends/income distributions will result in skewing the allocation towards
participants with larger balances – longer-term participants



If too much dividend is used, new participants may get little of the share release
Can impact 409(p) testing (generally adversely)
Can impact the repurchase obligation by putting more shares in the accounts of participants who
are closer to diversification and retirement
 Keep in mind that FMV test must be passed
 Additional deduction for C-Corps, not for S-Corps
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The Unique Alternative to the Big Four®
Pass-through Dividends
 Dividends paid directly to participants based on their ESOP shares
 C-Corps only
 Can be paid directly from the company to the participant or through the ESOP no later
than 90 days after plan year end
 Can include allocated and suspense account dividends
 Not considered a distribution, so:





No notice and consent requirement
No mandatory withholding
Not eligible for rollover
No early withdrawal penalty
Reported on 1099-DIV not 1099R
 Benefits


Allows participants to get current income from the ESOP
Can make the ESOP more meaningful, especially to younger participants
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The Unique Alternative to the Big Four®
Dividend Reinvestment Election
 Very similar to pass-through dividends except that participants can elect to:
 Receive a pass-through dividend, or
 Have their dividend stay in the ESOP and be reinvested in employer stock
 Can be based on vested shares only or on total shares, but all dividends on
which participant is given an election are immediately 100% vested
 May be offered to active participants or to all participants
 Reasonable opportunity to make election prior to dividend payment or
distribution
 Opportunity to change election at least annually and when dividend
allocation/payment affected by plan document
 Default elections allowed
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The Unique Alternative to the Big Four®
Prepaying the ESOP Loan
 Share release for most ESOPs is calculated as follows:
Current year principal and interest (P&I) payments
÷
Current Year P&I + All Scheduled Future P&I
*
Suspense Account Shares at Beginning of the Year
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The Unique Alternative to the Big Four®
Prepaying the ESOP Loan
 Prepaying the ESOP loan means making more than the scheduled payment in a
year or years
 Results in shares being released and allocated faster to participants
 Why would you want to prepay?
 Gets more shares into the accounts of participants in the ESOP at the time of the
prepayment
 Why wouldn’t you want to prepay?
 Since shares are released faster, there are fewer shares for participants down the road
 Affects repurchase obligation by loading up accounts
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The Unique Alternative to the Big Four®
Prepaying the ESOP Loan
ABC COMPANY
EMPLOYEE STOCK OWNERSHIP PLAN
LOAN AMORTIZATION AND SHARE RELEASE SCHEDULE
NO PREPAYMENT
Principal and Interest Method
Fixed Interest Rate: 3.00%
Date of Note: 12/31/13
Original Number of ESOP Shares: 100,000
Payment
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Totals
Due Date
12/31/2013
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
Principal
268,832.90
276,897.89
285,204.83
293,760.97
302,573.80
311,651.01
321,000.54
330,630.56
340,549.48
350,765.96
361,288.94
372,127.61
383,291.44
394,790.18
406,633.89
5,000,000.00
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Interest
150,000.00
141,935.01
133,628.08
125,071.93
116,259.10
107,181.89
97,832.36
88,202.34
78,283.42
68,066.94
57,543.96
46,705.29
35,541.47
24,042.72
12,199.02
1,282,493.53
Total
Payment
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
6,282,493.53
Balance
Denominator
5,000,000.00
4,731,167.10
4,454,269.21
4,169,064.38
3,875,303.41
3,572,729.61
3,261,078.60
2,940,078.05
2,609,447.49
2,268,898.01
1,918,132.05
1,556,843.11
1,184,715.50
801,424.07
406,633.89
-
6,282,493.53
5,863,660.63
5,444,827.73
5,025,994.83
4,607,161.93
4,188,329.02
3,769,496.12
3,350,663.22
2,931,830.32
2,512,997.41
2,094,164.51
1,675,331.61
1,256,498.71
837,665.80
418,832.90
Shares
Allocated
6,666.6667
6,666.6667
6,666.6667
6,666.6667
6,666.6667
6,666.6667
6,666.6666
6,666.6667
6,666.6666
6,666.6667
6,666.6666
6,666.6667
6,666.6666
6,666.6667
6,666.6666
100,000.0000
© 2013 Crowe Horwath LLP
Remaining
Shares
100,000.0000
93,333.3333
86,666.6666
79,999.9999
73,333.3332
66,666.6665
59,999.9998
53,333.3332
46,666.6665
39,999.9999
33,333.3332
26,666.6666
19,999.9999
13,333.3333
6,666.6666
-
23
The Unique Alternative to the Big Four®
Prepaying the ESOP Loan
ABC COMPANY
EMPLOYEE STOCK OWNERSHIP PLAN
LOAN AMORTIZATION AND SHARE RELEASE SCHEDULE
PREPAYMENT
Principal and Interest Method
Fixed Interest Rate: 3.00%
Date of Note: 12/31/13
Original Number of ESOP Shares: 100,000
Payment
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Totals
Due Date
12/31/2013
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
12/31/2014
Principal
Interest
Total
Payment
468,832.90
282,897.89
291,384.83
300,126.37
309,130.16
318,404.07
327,956.19
337,794.87
347,928.72
358,366.58
369,117.58
380,191.11
391,596.84
403,344.75
112,927.14
5,000,000.00
150,000.00
135,935.01
127,448.08
118,706.53
109,702.74
100,428.84
90,876.71
81,038.03
70,904.18
60,466.32
49,715.32
38,641.80
27,236.06
15,488.16
3,387.81
1,179,975.59
618,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
418,832.90
116,314.96
6,179,975.59
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Balance
Denominator
5,000,000.00
4,531,167.10
4,248,269.21
3,956,884.38
3,656,758.01
3,347,627.85
3,029,223.78
2,701,267.59
2,363,472.72
2,015,544.00
1,657,177.42
1,288,059.84
907,868.73
516,271.89
112,927.14
-
6,179,975.59
5,561,142.69
5,142,309.79
4,723,476.88
4,304,643.98
3,885,811.08
3,466,978.18
3,048,145.27
2,629,312.37
2,210,479.47
1,791,646.57
1,372,813.66
953,980.76
535,147.86
116,314.96
Shares
Allocated
10,013.5169
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
6,777.2582
1,882.1265
100,000.0000
Remaining
Shares
100,000.0000
89,986.4831
83,209.2249
76,431.9667
69,654.7085
62,877.4503
56,100.1921
49,322.9339
42,545.6757
35,768.4175
28,991.1593
22,213.9011
15,436.6429
8,659.3847
1,882.1265
0.0000
© 2013 Crowe Horwath LLP
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The Unique Alternative to the Big Four®
Account Segregation/Conversion
 Conversion of terminated participants’ accounts to cash prior to their distribution
payment
 Can occur in year of termination or any later year, whether or not the participant is
eligible to receive a distribution
 Generally done through recycling of shares, although could be done through
redemption (with an updated valuation)
 Best to convert all shares, not just the participants vested shares
 Segregation/conversion feature needs to be in the plan document


Cannot be discretionary, but the decision to put money into the ESOP to convert shares is up to
the company each year
Need to have a provisions for partial conversion, if company does not want to put full amount in

Generally pro-rata or based on termination date
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The Unique Alternative to the Big Four®
Account Segregation/Conversion
 Why would you want to convert shares?
 Gets shares (and future appreciation of those shares) into the hands of your active
participants who can still affect the value of the company
 Gets risk of owning the shares out of the hands of terminated participants who no
longer have a stake in the company
 May not want terminated participants who now work for competitors to see your stock
price
 In a rising stock price environment, accelerates cash needed for the repurchase
obligation but reduces the amount paid to the participant overall
 Why wouldn’t you want to convert shares?
 Accelerates cash flow needs
 Fiduciary obligation to invest the proceeds of the conversion


Can’t just stick it in cash
*Coordination with 401(k) Plan* if proceeds to be transferred to the 401(k)
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The Unique Alternative to the Big Four®
Account Segregation/Conversion
ABC Company ESOP
Trust Balances at the close of the allocation period:
$
ABC Stock
Other Investments
Total
400,000 $
100,000 $ 500,000
80.0%
20.0%
Participant Balances (pre-reshuffle/segregation):
Active
Participant A
$
Active
Participant B
$
Terminated
Participant C
$
130,000 $
78.8%
250,000 $
96.2%
20,000 $
26.7%
35,000 $ 165,000
21.2%
10,000 $ 260,000
3.8%
55,000 $
75,000
73.3%
145,556 $
88.2%
254,444 $
97.9%
$
0.0%
19,444 $ 165,000
11.8%
5,556 $ 260,000
2.1%
75,000 $
75,000
100.0%
Participant Balances (post-reshuffle/segregation):
Active
Participant A
$
Active
Participant B
$
Terminated
Participant C
$
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The Unique Alternative to the Big Four®
Rebalancing
 IRS Definition: “The mandatory transfer of employer securities into and out of
participant ESOP accounts, usually on an annual basis, designed to result in all
participant accounts having the same proportion of employer securities.”
 Each year, the ESOP accounts are rebalanced so that each participant has the
same percentage of his/her account investment in employer stock and other
investments
 For example, if the ESOP overall has 90% stock and 10% cash, each participant will
have 90% stock and 10% cash after the rebalancing is completed
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The Unique Alternative to the Big Four®
Diversification
 Statutory Diversification
 Enhanced diversification
 Longer period
 Higher percentage
 Mandatory diversification
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The Unique Alternative to the Big Four®
Beneficiaries
 Designation of Beneficiary Form
 Default if no named beneficiary?





Estate?
Surviving Spouse?
If no spouse, what next?
Divorce?
Disclaimers?
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The Unique Alternative to the Big Four®
QDROs
 Qualified domestic relations order (“QDRO”)
 Alternate Payee
 Spouse, former spouse, child, or other dependent
 ESOP distributions v. Family Law/QDRO processor
 QDRO distribution provisions
 When, how much, how paid
 QDRO Procedures
 Sample QDRO
 ESOP
 Other qualified retirement plans
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The Unique Alternative to the Big Four®
In-Service Distributions
 When?
 Age 59 ½?
 Normal Retirement Age?
 How much?




May accelerate repurchase obligation
May reduce total amount paid
Mitigates incentive to quit to gain access to ESOP account
Acts as additional diversification tool
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The Unique Alternative to the Big Four®
Distributions
 Form
 Lump sum of cash
 Installments of cash
 Lump sum of stock

Redeemed by the company



Lump sum
Installments – note / adequate security
Recycled by the ESOP


Lump sum
Installments – note / adequate security
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The Unique Alternative to the Big Four®
Distributions
 Timing




Immediate
After plan year end
Up to five year delay
Financed securities delay
 Mandatory cashouts
 $1,000 direct payment
 $1,000-$5,000 IRA rollover
 Distribution Policy
 Distribution forms
Audit | Tax | Advisory | Risk | Performance
© 2013 Crowe Horwath LLP
37
The Unique Alternative to the Big Four®
Questions?
Thank you!
Audit | Tax | Advisory | Risk | Performance
© 2013 Crowe Horwath LLP
38
The Unique Alternative to the Big Four®
Postscript
 Please fill out a session evaluation form and drop it off at the table outside of the
main room
 Your feedback on topics and presenters is important and will be used to develop
subsequent TEA programs
Audit | Tax | Advisory | Risk | Performance
© 2013 Crowe Horwath LLP
39