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ESOPs 101

ESOPs 101. Presented by: Roy A. Farmer. Business Transition Advisors. Full Service ESOP Plan Implementation Services Preliminary Analysis Feasibility Studies Plan Design Transaction Design Financing Repurchase Liability Studies Employee Communications Post Transactional Services.

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ESOPs 101

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  1. ESOPs 101 Presented by: Roy A. Farmer

  2. Business Transition Advisors • Full Service ESOP Plan Implementation Services • Preliminary Analysis • Feasibility Studies • Plan Design • Transaction Design • Financing • Repurchase Liability Studies • Employee Communications • Post Transactional Services

  3. Team Approach Plan Design ERISA Counsel * Banker * Insurance Investments * Corporate Counsel * BTA Team Coordinator Repurchase Obligation Estate Planning Stock Valuation * Company CPA * Employee Communication * Outside service provider

  4. 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

  5. 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

  6. 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

  7. 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

  8. Applications of ESOPs • Two Primary Applications • Liquidity for Closely Held Stock • Business Owner Transition Planning • Also Used In • Partner Buy Outs • Owner Diversification • Divorces

  9. Uses of ESOPs • “Golden” Handcuffs for Employees • Share Equity with Employees • Provide Enhanced Benefits to Employees

  10. 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

  11. Options • Your options depend upon the objectives and time horizon • Company Stock Redemption • Management Led Buyout • Third Party Sale • Sale to an ESOP

  12. Selling Shareholder Options

  13. Selling Shareholder Options

  14. Selling Shareholder Options

  15. Selling Shareholder Options

  16. 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%

  17. How It Works The Company Company Adopts an ESOP Trust ESOP Trust

  18. How It Works Loan The Company Lender Payment PAYMENT LOAN CASH ESOP Trust

  19. How It Works Loan The Company Lender IRC § 1042 Payment PAYMENT LOAN CASH Cash ESOP Trust Selling Shareholder

  20. How It Works Loan The Company Lender IRC § 1042 Payment PAYMENT LOAN CASH Cash Stock ESOP Trust Selling Shareholder Cash Beneficial Ownership Employees

  21. How It Works Loan The Company Lender IRC § 1042 Payment PAYMENT LOAN CASH Cash Stock ESOP Trust Selling Shareholder Cash Beneficial Ownership Sinking Fund Employees Death, Disability, Retirement, Termination and Diversification

  22. IRC § 1042 Requirements • Must Be a “C” Corporation • ESOP Must Own Minimum of 30% • Shareholder Must Have Owned Stock for 3 Years • Shareholder Must Purchase Qualifying Replacement Property (QRP) with 12 Months After Transaction

  23. Common Stock Convertible Bonds Corporate Fixed Rate Bonds Corporate Floating Rate Notes Qualified Replacement Property (QRP) Eligible Public or Private* Ineligible • 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

  24. One Possible QRP Strategy Portfolio of 40+ Yrs Floating Rate Notes Sale of Stock to Qualified ESOP Trust Cash Income from Bonds Quarterly Income

  25. Leveraged QRP Strategy Portfolio Floating Rate Notes Proceeds from Sale Cash Balance Income with Interest Margin Account QRP can be margined to 90% Liquid Cash

  26. Leveraged QRP Strategy Proceeds From Margin Loan New Home Cars Boat Stock Bonds

  27. 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

  28. Corporate Governance Privately Held Company • IN AN ESOP: • Board of Directors Appoints the ESOP Trustee • The Trustee Votes the Stock

  29. Control Can Remain “Undisturbed” Owners with Stock Outside the ESOP Votes Board of Directors Appoints “Directed” Trustee

  30. 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

  31. Corporate Governance Privately Held Company • The ESOP is a “passive shareholder” • Employees are not shareholders and do not gain Statutory Minority Shareholder Rights

  32. 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

  33. 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

  34. 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

  35. WIN-Win-Win For Everyone • Business owners • Employees • Corporations • that are more advantageous • than any other single vehicle

  36. BTA’s Role • Next Steps: • Feasibility Analysis • Presentation to the Client • Sufficient Information to Determine Direction • Move to Full Implementation

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