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Employee Stock Ownership Plans:

Is it the Right Fit for Our Company

in the United States

April 30, 2015 Presented By:

Alexander L. Mounts Partner, Krieg DeVault LLP One Indiana Square, Suite 2800

Indianapolis, IN 46204 (317) 238-6335 [email protected]

Moderated By:

Kristen Chittenden

Is your company publicly traded?

Yes No

Do you have an ESOP or an ESOP

component to your 401(k) plan?

Yes, an ESOP

Yes, an ESOP component to my 401(k) plan No, neither

What is an “Employee Stock

Ownership Plan”?

•  Tool of CORPORATE FINANCE/

SUCCESSION VEHICLE

•  Tax-qualified RETIREMENT PLAN

•  Invests “primarily” in EMPLOYER STOCK

•  Numerous Federal tax incentives encourage

implementation

Private Company ESOPs

Advantages of C and S Corporation ESOPs

Flexibility

•  Market for shareholders’ stock

•  Unlike most buyers, serves as source of funds to purchase minority blocks

•  Low marketability discount (typically 5%) on value of shares (private company)

•  Succession planning vehicle for gradual transfer of ownership to next generation (often combined with transfers of ownership to

management – “sweat equity”)

•  “Financial” buyer with long term perspective

•  Easily combined with “401(k)” plan – use of “matching” contributions to fund ESOP; some transactions allow employees to transfer 401(k) funds to ESOP

•  Investment option for employees.

•  Additional fiduciary protection since ESOP are designed to invest primarily in company stock.

Advantages of ESOPs

Tax – C Corporation

•  If certain requirements in Code Section 1042 are met, selling shareholder(s) can defer (or even eliminate) taxable gain on sale

•  All contributions to ESOP (including those used to repay loan) are tax deductible

•  Cash dividends are deductible if used by ESOP to:

–  repay loan,

–  distributed to participants, or –  Used to buy more shares

•  Allocations to participants’ accounts are tax deferred; distributions eligible for tax-free rollover

•  Special tax treatment of “net unrealized appreciation” on distribution of stock

Advantages of ESOPs

Tax – S Corporation

•  ESOP’s share of company’s income is not subject to tax

•  Contributions to ESOP are tax deductible (important if ESOP owns less than 100%)

•  ESOP’s share of “tax dividends” can be used to repay loan, satisfy repurchase liability or pay expenses

•  Allocations to participants’ accounts are tax deferred; distributions are eligible for tax-free rollover

•  Special tax treatment of “net unrealized appreciation” on distribution of stock

Effect on Employees

(Well Communicated ESOPs)

•  Pride of ownership culture

•  Recruiting/retention tool

•  Increased commitment and enthusiasm

•  Material increase in value of corporation*

*See Key Studies on Employee Ownership and Corporate Performance at https://www.nceo.org/articles/

Disadvantages of an ESOP

•  Cost and number of service providers

•  Complexity

•  Communication

•  Repurchase liability (private company)

•  Less diversification of retirement assets (private company)

•  Fiduciary responsibility/liability

Fifth Third Bancorp v. Dudenhoeffer

•  Case involving a public company ESOP.

•  The Supreme Court ruled that there is no presumption of prudence to protect fiduciaries of plans designed to invest in company stock, and specifically ESOPs.

•  While the decision eliminated the presumption of prudence rule, it replaces it with a pleading requirement that plaintiffs

demonstrate the fiduciary acted imprudently.

ESOP Valuation Requirements

•  Publicly traded companies use the current stock value.

•  IRC Section 401(a)(28)(C) – “ . . . All valuations of

employer securities which are not readily tradeable on an established securities market . . .” must be the subject of an independent appraisal

•  ERISA Section 3(18) – if there is no “…generally

recognized market…” for the shares (i.e., they are not

traded on a “national securities exchange”), they must be the subject of a valuation which meets the requirements

ESOP Valuation Considerations (private

company)

•  ESOP Valuation vs. “Multiple of Book” – How should ESOP shares be valued?

–  Independent appraisal firm qualified and experienced with ESOP valuations

–  Appropriate methods of valuing companies –  Weighting of methods

–  Use of publicly available information regarding non-publicly traded companies

•  Financial performance

•  Merger and acquisition activity

–  Effect of cash and stock dividends on value

How does Company Stock get in an

ESOP in a Public Company?

•  Purchase in the market or from the company with employee deferrals, profit sharing contributions or matching contributions.

•  Matching or profit sharing contributions made in the form of shares of stock.

Basic Structure of a Private Company

ESOP Transaction (Bank Financing)

4. Cash

Employer _Bank

1. Bank Loan

2. Pledge of Collateral

Step 1

Basic Structure of a Private Company ESOP

Transaction (Bank Financing)

Employer 3. Loan Payments Bank

1. Contributions Dividends

Step 2

Stock

Company

Basic Structure of a Private Company ESOP

Transaction (Seller Only Financing)

“Short Term” Subordinated Note & Warrant

Redeem Shares

“Long Term” Note Subscribe

for Newly Issued Shares

Step 1

ESOP

1

2

Basic Structure of a Private Company ESOP

Transaction (Seller Only Financing)

Note Payments

Contributions (Including 401(k) “Match”) Distributions

Note Payments

Step 2

Stock ESOP

Examples of Benefits of “S” Corporation

ESOP Structure

Net Income of $5,000,000 with No ESOP

Corporate Tax -0-

Individual Shareholder Tax:

on $5,000,000 @ 45% = $2,225,000

Total “Tax Dividends” = $2,225,000

Net Income of $5,000,000 with 50% ESOP

Corporate Tax -0-

Individual Shareholder Tax:

on $2,500,000 @ 45% = $1,125,000 ESOP Shareholder Tax on $2,500,000 = $0 Total Tax Dividends = $2,225,000

ESOP’s Share = $1,125,000

Net Income of $5,000,000 with 100% ESOP

Corporate Tax -0-

ESOP Shareholder Tax on $5,000,000 = $0 Additional cash flow = $2,225,000

ESOP “Myths”

•  “Control” will be lost/trustee will become involved in governance

•  Employees or trustee must have seat on Board

•  Management structure will change; the ESOP will become involved in management

•  Stock valuation, compensation and/or corporation’s financial statements must be disclosed (private company)

•  Corporation will be less attractive to potential buyers

•  Corporation cannot “go public” later

•  An ESOP that buys less than 51% of stock cannot pay a

Characteristics of Well-Designed and

Implemented ESOPs

•  “Sanity check” approach to implementation

a.  Stock valuation b.  Feasibility

c.  Financing

d.  Commitment of key managers

•  Independent, experienced advisors to ESOP

a.  Counsel

b.  Financial Advisor c.  Trustee

•  Well-educated ESOP “Committee”

•  Well-prepared feasibility analysis

a.  Projections based on history

b.  “Cushion” for economic downturn

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•  Carefully designed ESOP distribution provisions

a.  Forms (e.g. lump sums vs. installments) b.  Times (after loan paid vs. current)

•  Non-dilutive “sweat-equity” plan for key management (or outright buy-in)

•  Employment and non-compete agreements for key management

•  Effective employee communications program (“Employee as Owner”)

Characteristics of Well-Designed and

Implemented ESOPs

The “1042 ESOP Rollover”

•  The business owner can elect to defer the

recognition of long-term capital gain on the sale

of C corporation stock to an ESOP if certain

requirements are satisfied:

–  Owner must sell “qualified securities” - “best common stock” of a non-publicly traded C corporation

–  Holding period must be at least three years at time of sale

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The “1042 ESOP Rollover”

•  Immediately after sale, ESOP must own at least:

–  30% of the total number of shares of each class of stock, or

–  30% of the value of all outstanding stock of the corporation

•  Selling shareholder, members of family and 25 percent or greater shareholders cannot receive allocations of shares on which gain is deferred

Disclaimers

•  These slides are for educational purposes

only and are not intended, and should not be

relied upon, as legal or accounting advice.

•  Pursuant to Circular 230 promulgated by the

Internal Revenue Service, please be advised

that these slides were not intended or written

to be used, and that they cannot be used, for

the purposes of avoiding federal tax penalties

unless otherwise expressly indicated.

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