Liquidity Strategies for Government Contractors Tower Club

Liquidity Events for Government Contractors in the Wake of the Fiscal

Cliff Compromise

The Tower ClubFebruary 2013

Employee Stock Ownership Plan

• Definition. An employee stock ownership plan (“ESOP”) is a defined contribution employee benefit plan. An ESOP is designed to be invested primarily in “employer securities” and unlike other employee benefit plans, may borrow money from “disqualified persons” / “parties in interest”.

• Purpose. Shareholders of government contractors may utilize an ESOP as a liquidity strategy, to address management succession issues, and attract, retain, and incentize employees.

• Demographic. Privately held corporations with more than 20 employees, payroll in excess of $1MM, and an enterprise value of in excess of $5MM. The corporation must have borrowing capacity and cash flow sufficient to amortize transaction debt. The shareholders are seeking to diversify a portion or all of their wealth while simultaneously retaining control as long as desired. The shareholders are seeking a tax-advantaged exit strategy.

ESOPs & The Fiscal Cliff Compromise

• Takeaway: The Fiscal Cliff Compromise made ESOPs an even more attractive liquidity strategy.

• Ordinary Income Marginal Tax Rates. Bush-era marginal tax rates were made permanent and a new 39.6% marginal tax rate is imposed on ordinary income of highest earners.

• Capital Gain Tax Rates. Bush-era capital gains rates were made permanent and a new 20% capital gains rate is imposed on adjusted net capital gain that would have otherwise been taxed at the new 39.6% marginal rate if it were ordinary income.

• Qualified Dividend Income. Bush-era rates made permanent and a new 20% rate imposed on qualified dividend income that would have otherwise been taxed at the new 39.6% marginal rate if it were ordinary income.

• Net Investment Income Tax. A new 3.8% surtax is imposed on “net investment income”.

Leveraged ESOP Transaction

Step 1: Senior Lender loans funds to Government Contractor in exchange for a promissory note (“Outside Loan”).

Step 2: Government Contractor loans these same funds to an employee stock ownership trust in exchange for a promissory note made by the trust and payable to the order of the Corporation (“Inside Loan”).

Step 3: Trust uses funds to purchase qualifying employer securities from Shareholder(s).

Leveraged ESOP Transaction

STEP 1

STEP 2

STEP 3$ $

$

PR

OM

ISS

OR

Y

NO

TE

CA

PIT

AL

S

TO

CK

PROMISSORY NOTE

Illustration

• After the Fiscal Cliff Compromise, a sole shareholder of a C corporation government contractor with revenue of $10MM and taxable income of $1MM. The government contractor pays approximately $340,000 in federal corporate income taxes and approximately $60,000 (assumes Virginia rate of 5.5%) in state corporate income taxes for an aggregate annual tax liability of approximately $400,000.

• In the context of a stock sale, the shareholder would incur long-term capital gains tax liability of approximately $1.5 MM

• Assumes purchase price of $7.5 MM;• In the context of an asset sale, the corporation would incur a corporate income tax

liability of approximately $3 MM ($7.5 MM X 40%).• Assumes 35% federal corporate income tax rate; 5% state corporate income tax

rate; assets taxed at long-term capital gains rates.• The corporation would distribute $4.5 MM to the shareholder, who would incur a

capital gains tax liability of approximately $900 K.

Illustration (Continued)

• The same shareholder sells his stock to a newly-formed ESOP for fair market value, or $7.5 MM.

• An eligible shareholder may make a 1042 election to defer long-term capital gains tax imposed on the sale proceeds.

• The corporation will make tax-deductible contributions and/or dividends to the ESOP to enable the ESOP to amortize its debt under the Inside Loan. These contributions and the characteristics of the Inside Loan may be calibrated to significantly diminish or even eliminate future corporate income tax liabilities.

• The participants (employees) receive a tax-deferred retirement benefit.

S Corporation Benefits

• 100% ESOP-owned S corporation operates free of federal (and most state) income taxes by virtue of the sole shareholder being a tax-exempt trust.• Cash flow is enhanced by 40% and may be used to accelerate

amortization of transaction debt (including seller-financing) or to finance corporate acquisitions

• Synthetic equity may be used to attract, retain, and incentivize key employees. Value of synthetic equity increases by virtue of accelerated amortization of transaction debt.

• Shareholder receives fair market value for stock.• Shareholder of S corporation stock is ineligible to elect 1042 deferral.

However, S election may be revoked pre-transaction to facilitate 1042 election.

• Participants (employees) receive a tax-deferred retirement benefit.

Special Considerations for Government Contractors

• Cost Reimbursement. Federal Acquisition Regulation 31.205-6 and Cost Accounting Standard 415 provide that a government contractor’s costs incurred in connection with an ESOP may be allowable costs that may be assigned to cost-plus government contracts.

• SBA Rules. Small Business Administration regulations address when a government contractor (i) must recertify its small business size (ii) may continue its 8(a) or Service-Disabled Veteran-Owned statuses in the context of a leveraged ESOP transaction (up to 49%) (iii) may receive a loan guaranteed by the Small Business Administration.

• SCA / Davis Bacon Act Employees. The Service Contract Act or Davis Bacon Act may affect the timing of contributions and vesting of benefits.

• ESOP Financing. The Federal Assignment of Claims Act governs when a government contractor’s rights to payment under a federal government contract may be collaterally assigned to a financial institution to secure a loan to the government contractor.

Comparative Analysis of Common Liquidity Strategies

Leveraged ESOP Transaction•Return: Shareholders receive fair market value for equity.•Tax Efficiencies:

• Shareholder may defer and even eliminate long-term capital gains tax liabilities.

• Government contractor (i) may operate free of federal and most state income taxes or (ii) significantly diminish tax liabilities through tax deductible contributions and dividends.

• Employees receive a tax-deferred retirement benefit. •Liquidity: Liquidity is a function of the debt capacity of the government contractor and the percentage of equity being sold. •Diversification: Shareholder diversifies wealth to the extent shareholder receives cash at close. Seller-financed leveraged ESOP transaction exposes shareholders to risks associated with financial performance of the government contractor. •Control: Shareholder may retain control for so long as desired.

Comparative Analysis of Common Liquidity Strategies

Liquidation•Return: Liquidation value may be significantly lower than fair market value.•Tax Efficiencies: The amount realized by the shareholders at liquidation will be taxed at ordinary income marginal tax rates.•Liquidity: Creditors of the government contractor have priority over shareholders over asset sale proceeds.•Diversification: Shareholder completely diversifies wealth, but liquidation value may be significantly lower than fair market value. •Control: Shareholder loses control over assets (which are sold) and government contractor (which is liquidated).

Comparative Analysis of Common Liquidity Strategies

Buy-Sell Agreement•Return: The return to the shareholder is often a function of a buyout formula.•Tax Efficiencies: The amount realized by the shareholder is taxed at capital gains rates.•Liquidity: Liquidity will be a function of the buyout formula which may not equate into fair market value.•Diversification: Diversification will be a function of the buyout formula and may result in little, if any, diversification of wealth.•Control: A shareholder will likely lose control upon exercise of rights under a buy-sell agreement.

Comparative Analysis of Common Liquidity Strategies

Third-Party Sale•Return: Third-party synergistic buyer may offer maximum return to a shareholder.•Tax Efficiencies: Amount realized from a stock sale is taxed at capital gains rates; Amount realized from an asset sale is a taxed at a blend of ordinary income marginal tax rates and capital gains rates.•Liquidity: May offer maximum liquidity subject to earn-out and other contingencies which may significantly reduce liquidity. •Diversification: Complete diversification to the extent cash proceeds are received; Partial diversification to the extent promissory notes or capital stock are received.•Control: Shareholder likely loses complete control.

Comparative Analysis of Common Liquidity Strategies

Management Buyout•Return: Shareholder receives fair market value for equity.•Tax Efficiencies: Gain realized by shareholder taxed at capital gain rates.•Liquidity: May offer maximum liquidity in the case of a private-equity led MBO; otherwise, MBO may require seller-financing which may significantly reduce liquidity. Diversification: A private-equity led MBO may result in complete diversification, whereas a seller-financed MBO will result in partial diversification.•Control: Shareholder loses control.