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 $10,000,000
Value of 60% majority stock sale $6,000,000
Corp. profits needed to net sale price $10,000,000
Corp. income tax at 40% (35% + 5%) $4,000,000
Net corp. profits available for stock purchase $6,000,000
Sale proceeds to seller $6,000,000
Capital gains tax at 29.2% (fed. & avg. state) $1,752,000
Net sale proceeds to seller $4,248,000
Total Taxes/Fees $5,752,000
Management Buy-Out
Company value $10,000,000
Value of 60% majority stock sale $6,000,000
Bonus to execs’ needed to net sale price $9,740,000
Exec’s personal income tax 39.4% (35% + 5.4%) $3,740,000
Net corp. profits available for stock purchase $6,000,000
Sale proceeds to seller $6,000,000
Capital gains tax at 29.2% (fed. & avg. state) $1,752,000
Net sale proceeds to seller $4,248,000
Total Taxes $5,492,000
Third Party Sale (Stock)
Company value $10,000,000
Value of 60% majority stock sale $6,000,000
Pre-fee proceeds to seller $6,000,000
Typical sale transaction fee at 8% $480,000
Gross proceeds to seller $5,520,000
Capital gains tax at 29.2% (fed. & avg. state) $1,752,000
Net sales proceeds to seller $3,768,000
Total taxes & fees $2,232,000
ESOP Sale: C Corp
Company value $10,000,000
Value of 60% majority sale $6,000,000
Pre-fee proceeds to seller $6,000,000
Typical transaction fee at 2.5% $150,000
Gross proceeds to seller $5,850,000
Capital gains tax at 29.2% (fed. & avg. state) $0
Net proceeds to seller $5,850,000
Total fees & taxes $150,000
Method “Net” to SellerTotal Taxes &
Fees
Percent of Total to Seller
Corporate Redemption $4,248,000 $5,752,000 42%
Management Buy-Out $4,248,000 $5,492,000 44%
Third Party Sale (Stock) $3,768,000 $2,232,000 63%
ESOP – C Corp $5,850,000 $150,000 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
Adopts
How It Works: Step 2
CONTRIBUTION
Company
ESOP Trust
Stock or Cash
Selling Shareholders
Buys Shares
Leveraged ESOP
How an ESOP Works: Step 1
The Company
ESOP Trust
Adopts
How an ESOP Works: Step 2
LenderLoan
Loan
Company
ESOP Trust
How an ESOP Works: Step 3
LenderLoan
Loan
CompanyIRC § 1042
ESOP Trust
Cash
Selling Shareholder
Stock
Cash
How an ESOP Works: Step 4
LenderLoan
Payment
Loan
Cash
Payment
CompanyIRC § 1042
ESOP Trust
Cash
Selling ShareholderCash
Stock
How an ESOP Works: Step 5
LenderLoan
PaymentCompany
IRC § 1042
ESOP Trust
Selling Shareholder
Stock
EmployeesBeneficial
Ownership
Payment
Loan
Cash
Cash
Cash
How an ESOP Works: Step 6
LenderLoan
PaymentCompany
IRC § 1042
ESOP Trust
Selling Shareholder
Stock
Employees
Interest
Payment
Loan
Cash
Cash
Cash
Cash
Death, Disability, Retirement, Termination and Diversification
Sinking Fund
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)
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
Eligible Ineligible
Common Stock Municipal Bonds
Convertible Bonds US Govt. Bonds
Corporate Fixed Rate Bonds Mutual Funds
Corporate Floating Rate Notes Foreign Securities
REITs, Bank CDs
Leveraged QRP Strategy
Cash
Portfolio Floating
Rate Notes
Margin Account
Liquid Cash
Proceeds From Sale
(1042) Balance Income with Interest
QRP can be margined to 90%
Leveraged QRP Strategy
Proceeds
From Margi
n Loan
New Home
Cars
BoatStocks
Bonds
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
“Directed” Trustee
Appoints
Control Can Remain “Undisturbed”
Board of Directors
VotesOwners with stock outside
the ESOP
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
TotalOutstanding
Shares
Shares InsideESOP
SharesOwned Outside
ESOP(Family/Mgmt)
PercentageOwned Outside
ESOP(Family/Mgmt)
0 100 90 10 10%
20 80 70 10 13%
20 60 50 10 17%
20 40 30 10 25%
20 20 10 10 50%
10 10 0 10 100%
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
• Educational “ESOPs 101” Presentation• Initial Review of Financials & Fact Finder• Preliminary Valuation• Preliminary ESOP Analysis
Investigative Phase Part 1
• Additional Data Gathering• Feasibility Study• Final Client Approval to Proceed to Next
Step
Investigative Phase Part 2
• ERISA Plan Design• Transaction Design• Engage Other Team Members• Financing• IRC§ 1042 Analysis & Execution
Implementation Phase
• Employee Communications• Management Incentive Plans• Repurchase Liability & Funding• Advanced Planning• Determination Letter
Post Closing Phase
Team Quarterback
Through Entire Process
BTA Team
Leader
Plan DesignERISA
Counsel *
Estate Planning
Stock Valuation*
Employee Communicatio
n
Company CPA *
Repurchase Obligation
Corporate Counsel
TPA*
Trustee*
Banker
Insurance Investments*
*Outside service provider
Team Approach