ESOPs 101

ESOPs 101

Presented by:

Roy A. Farmer

Business Transition Advisors

Full Service ESOP Plan Implementation ServicesPreliminary Analysis Feasibility Studies Plan DesignTransaction Design FinancingRepurchase Liability StudiesEmployee CommunicationsPost Transactional Services

Team Approach

BTA Team

Coordinator

Plan Design

ERISA Counsel

*Insurance

Investments

*

Estate Planning

Stock Valuation

*

Employee Communicatio

n

Company CPA

*

Repurchase Obligation

Corporate Counsel

*

Banker*

* Outside service provider

Presentation Agenda

• Background & History of ESOP’s • Unique Features • Case Study – Comparisons • How a Typical ESOP Works• Owners Tax Deferral – IRC § 1042• Corporate Governance • Summary of Benefits • BTA’s Role • Moving Forward

Background and History

What is an ESOP?• 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 companies 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

Applications of ESOPs

Two Primary Applications Liquidity for Closely Held

Stock Business Owner Transition

Planning

Also Used In Partner Buy Outs Owner Diversification Divorces

Uses of ESOPs

“Golden” Handcuffs for Employees

Share Equity with Employees

Provide Enhanced Benefits to Employees

Business Owner Concerns

• Must have a “transition” plan while they are alive and healthy

• Develop personal exit strategy

• Minimize personal and corporate taxes

• Provide for Management Succession

• Diversify and have estate liquidity

• Leave a legacy

Options

Your options depend upon the objectives and time

horizon1. Company Stock

Redemption

2. Management Led Buyout

3. Third Party Sale

4. Sale to an ESOP

Selling Shareholder Options

Company Value $10,000,000Value of 51% $5,100,000Discount applied 0% $0Post Discount Value $5,100,000Profits required to redeem stock (divide by .6) 0.6 $8,500,000Tax on Profits @40% 40% $3,400,000Proceeds to Seller $5,100,000Capital gains tax 20% $1,020,000Net to Seller $4,080,000Total Taxes $4,420,000Ratio of Net Proceeds to Gross Proceeds 48%

Stock Redemption

Selling Shareholder Options

Company Value $10,000,000Value of 51% $5,100,000Discount Applied 0% $0Post Discount Value $5,100,000Bonus required to buy shares 0.65 $7,846,154Individual Tax on Bonus 35% $2,746,154Proceeds available to Pay Owner $5,100,000Owners Capital Gains Tax 20% $1,020,000Net Proceeds to the Seller $4,080,000Total Taxes $3,766,154Ratio of Net Proceeds to Gross Proceeds 52%

Management Payout

Selling Shareholder Options

Company Value $10,000,000Value of 51% $5,100,000Discount Applied 0% $0Post Discount Value $5,100,000Typical Transaction Fee (8%) 8% $408,000Net Sales Price $4,692,000Owners Capital Gains Tax 20% $938,400Net Proceeds to seller $3,753,600Ratio of Net Proceeds to Gross Proceeds 74%

Sale to a Third Party

Selling Shareholder Options

Company Value $10,000,000Value of 51% $5,100,000Discount Applied 0% $0Post Discount Value $5,100,000Estimated Transaction Fee (2.5%) 127,500Net Sales Price $4,972,500Capital Gains Tax (assuming 1042) 20% 0Net Proceeds to the seller $4,972,500Ratio of Net Proceeds to Gross Proceeds 98%

ESOP

Comparison

Stock Redemption $4,080,000

% of Sale 48%

Management Buy-Out$4,080,000

% of Sale 52%

Sale to a Third Party $3,753,600

% of Sale 74%

Sale to an ESOP $4,972,500

% of Sale 98%

How It Works

The Company

ESOP Trust

Company Adopts an

ESOP Trust

How It Works

The Company

ESOP Trust

Loan

Payment PAYMENT

CASH

LOAN

Lender

How It Works

The Company

ESOP Trust

Loan

PaymentPAYMENT

CASH

LOAN

IRC § 1042

Selling Shareholder

Cash

Lender

How It Works

The Company

ESOP Trust

Loan

PaymentPAYMENT

CASH

LOAN

IRC § 1042

Selling Shareholder

Cash

Lender

EmployeesBeneficial Ownership

Stock

Cash

How It Works

Death, Disability, Retirement, Termination and Diversification

The Company

ESOP Trust

Loan

PaymentPAYMENT

CASH

LOAN

IRC § 1042

Selling Shareholder

Cash

Lender

EmployeesBeneficial Ownership

Stock

Cash

Sinking Fund

IRC § 1042 Requirements

Must Be a “C” CorporationESOP Must Own Minimum of

30%Shareholder Must Have

Owned Stock for 3 YearsShareholder Must Purchase

Qualifying Replacement Property (QRP) with 12 Months After Transaction

Qualified Replacement Property (QRP)

Eligible Public or Private* Ineligible

•Common Stock

•Convertible Bonds

•Corporate Fixed Rate Bonds

•Corporate Floating Rate Notes

• Municipal Bonds

• US Gov. Bonds

• Mutual Funds

• Foreign Securities

• REITs, Bank CDs

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

One Possible QRP Strategy

Sale of Stock to Qualified ESOP Trust

Portfolio of 40+ Yrs

Floating Rate Notes

Quarterly Income

Cash

Income from Bonds

Leveraged QRP Strategy

Proceeds from Sale

PortfolioFloating

Rate Notes

Margin Account

Liquid Cash

Cash

Balance Income with Interest

QRP can be margined to 90%

Leveraged QRP Strategy

Proceeds From Margin Loan

Stock BondsBoatCarsNew Home

Corporate Governance

Corporate Control Shareholders Elect the Board

of Directors Board of Directors appoints the

Officers Officers responsible for day-to-

day operations

IF YOU CONTROL THE BOARD OF DIRECTORS YOU CONTROL THE COMPANY

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

Corporate Governance Privately Held Company

Trustee is the owner of the stock, not the Employees

Trustee votes the stock Participants “advise” trustee

only on Mergers, Sale or Business, Recapitalization or Liquidation

Corporate Governance Privately Held Company

• The ESOP is a “passive shareholder”

• Employees are not shareholders and do not gain Statutory Minority Shareholder Rights

100% “S” Corporation ESOP

• Pays no Federal corporate income tax

• Taxed like a partnership – net income flows through to the shareholders – ESOP, No Tax

• Exempt from prohibited transaction rules

• Doesn’t have to distribute stock

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

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 ownersEmployees Corporations

• that are more advantageous • than any other single

vehicle

BTA’s Role

• Next Steps:Feasibility Analysis Presentation to the ClientSufficient Information to

Determine Direction Move to Full Implementation