ESOPs for CPA Firms Corey Rosen National Center for Employee Ownership

1. ESOPs for CPA Firms Corey Rosen National Center for Employee Ownership

2. Started in 1974 11,000 companies in 2013; 10.3 million participants $870 billion in assets (estimated 2008) Used for Succession Planning Financing Growth Employee Rewards Matching 401(k) Deferrals Tax Benefits for Selling Shareholders Company Employees ESOPs

3. Common Myths About ESOPs • Too complex and costly • Employees must end up with control • Only for C corporations • Best for certain kinds of businesses • ESOPs usually don’t work • Not more complex and are both less costly and more flexible than selling to third party • Board appoints trustee to vote the shares • C or S corporations qualify • ESOPs are found in every kind of business • Default rate on ESOP loans well under .5%

4. Basic ESOP Requirements • Company must be an S or C corporation or convert to one • An ESOP is an ERISA-governed benefit trust that must be designed to invest primarily in employer securities. • An ESOP must own stock with the highest combination of voting and dividend rights or be convertible into such shares • The ESOP trust is subject to non-discrimination rules of ERISA • The trust, not the employees, is the legal owner of the shares

5. Can an Accounting Firm Have an ESOP? • Most accounting firms are configured as limited liability partnerships or professional corporations, which don't allow employee ownership beyond the principals. Only S or C corporations can have ESOPs. • Some accounting firms either are or converted to S or C before becoming an ESOP. • States require that owners be members of the profession, but in 40 states, an ESOP can own a minority of the shares and in Minnesota and North Carolina can own more than that. In 40 states, if the ESOP trustee is an accountant, then the state allows accounting firms to have ESOPs.

6. Why an ESOP? • Creates a way for owners of closely held companies to provide for ownership transition in the most tax effective way available. • Allows companies to be transferred to employees using corporate profits, not employee after-tax dollars, on a schedule comfortable to the owner(s). • ESOPs can buy some or all of the stock, from one owner or more • Properly structured ESOPs can improve competitiveness. • S ESOP companies can avoid taxation on profits attributable to the ESOP’s ownership percentage.

7. ESOP Basics (Details to Follow) • Defined contribution plan under ERISA • Company sponsored and paid; employees very rarely buy shares • Funded instead by company contributions to an ESOP trust; contributions allocated among plan participants based on relative pay or more level formula • All full-time employees are usually covered by the plan, subject to service and vesting rules • Paid out in flexible terms on termination

8. Using an ESOP to Buy Out an Owner

9. How An ESOP Buys Out an Owner • Company sets up an employee benefit trust • Contributes cash to buy shares or • Borrows money through the plan to buy shares • Employees do not buy the stock. • Contributions are tax deductible, even when used to repay a loan (principal and interest), up to 25% of eligible pay.

10. How Much Will the ESOP Pay? • Price must not be higher than fair market value on a financial basis as determined by an independent, outside appraisal firm. • Negotiations over sale terms can only be to produce a better price than that set by the appraiser. • The ESOP cannot pay synergistic value. • Minority ownership sales are valued at less per share than control sales.

11. Elements of Valuation • Most important is some multiple of future free cash flow or, similarly, discounted future cash flow over an appropriate number of years. • Comparable company sale data and, if applicable, public company comparison data will be factored in. • Asset value is usually the least important factor, but valuable non-performing assets may add to value.

12. Benefits to Seller • If ESOP owns 30% or more of the company after the sale in a C corporation, seller can defer tax on gain on the sale if reinvested in qualifying stocks and bonds. If this is not possible, sale still qualifies as capital gain. • If the company is an S corporation, deferral is not possible, but capital gains deferral is not available, but other tax benefits are. • ESOP can buy some stock now, some later. • Sale accomplished in pre-tax dollars

13. Rules for Owners in Section 1042 • Stock must have been held for at least three years to be eligible. • Only privately held C corporations qualify. • 30% rule means ESOP must own 30% of all the stock after the transaction; synthetic equity (such as options) is considered as outstanding stock in making this calculation. • Direct family members, sellers, and 25% owners cannot get an allocation of shares in the ESOP subject to the deferral of taxation. They can, however, if the seller opts not to take the deferral.

14. Eligible Investments • Sellers have 12 months after the sale to reinvest in “qualified replacement property” (QRP). • QRP must be securities of domestic operating companies not making more than 25% of their income from passive investment (no mutual funds, government bonds, for instance). • Gain on sale of any QRP is taxed using original basis of stock in company with the ESOP.

15. Sales in a S Corporation • The tax deferral is not available. • The profits attributable to the ESOP, however, are not subject to federal, and usually state, income tax. • Subject to the anti-abuse rules discussed later, the seller, 25% owners, and family members can get ESOP allocations. • Distributions made to other owners must be made pro-rata to the ESOP, but can be used to buy additional shares.

16. Funding Options • Banks can loan money to the company, which reloans to the ESOP, which uses the cash to buy the owner’s shares. • Sellers can finance the transaction with a note, but can only get a tax deferral on what they reinvest in first 12 months (see more in next slide). • Company can contribute cash each year to the plan, either to buy shares that year or to build a cash reserve to make a larger purchase later on, perhaps in combination with debt. • In limited circumstances, some portion of funds in existing defined contribution plans may be used to help fund the ESOP (but fiduciary issues arise).

17. Seller Financed Sale to Employees • Seller takes a note for the shares with multiple employees. • Employees repay the loans individually according to the note’s terms. • Interest payments are deductible, but not principal. • Interest rates and terms must be arms length or difference is taxable.

18. Leveraged ESOPs • Plan can borrow money to buy existing shares or new shares to fund growth. • Company contributes cash to the ESOP to repay the loan and takes a tax deduction. • Shares go into a “suspense account” and as they are paid for get released to employee accounts.

19. Key Points to Remember • The company, not the employees, fund the plan. • The acquisition of shares is a non-productive expense, so the company must have the earnings to absorb it. • ESOPs are the only way a company can use pre-tax dollars to buy out an owner.

20. Contribution Limits • Generally, 25% of compensation of employees covered by the plan • If there is an ESOP loan, in a C corporation, interest payments and dividends don’t count towards this limit; in a S corporation, they do. • Not more than 100% of pay or $51,000 (in 2013) can be added to an employee’s account each year from all defined contribution plans.

21. Participation, Vesting, and Allocation • Employees have individual accounts. • Company contributes cash to buy stock, contributes stock, or has plan borrow to buy shares. • Accounts are subject to vesting over not more than 6 years. • Generally, at least all-full-time employees with 1,000 hours in a year must be included in the plan. • Allocations can be based on relative pay or a more level formula. They cannot be discretionary or merit based.

22. Distribution • Employees get distributions not later than one year after death disability, or retirement, or • Five years after the end of the plan year for other terminations. • Can be paid out in installments up to five years. • Employees with 10 years in the plan who are 55 or older can diversify part of their stock accounts.

23. Distribution Payments • Company must assure employees get fair market value for the stock, but can put cash into the plan to do this. • Employees have a put right for shares distributed to them. • Distributions are taxed the same way that other distributions from defined contribution plans are taxed.

24. Governance • Limited employee voting rights • Plans governed by a trustee appointed by the board • Often an ESOP committee to assist in the process.

25. Costs • First year costs typically $40,000 and up. • Ongoing costs can be as low as $15,000 or so, depending on size of the company, changes in the law, and other factors. • ESOPs more expensive than other plans, but much less expensive than selling a business in other ways.

26. S Corporation Issues • The ESOP’s share of taxable income is not subject to federal and, usually, state income taxes. 100% S ESOPs pay no federal and, often state income tax. • ESOP is one shareholder. • Sales to an ESOP do not qualify for tax deferral. • Contributions limits can be somewhat lower because interest, as well as principal payments on the loan count towards the limits.

27. Anti-Abuse Rules • “Anti-abuse” rules make it impossible to use ESOPs to benefit just a few employees. One effect of these rules is that ESOPs are impractical in S companies with fewer than about 12-15 employees. • Generally, individual employees who have more than 10%, or families that own more than 20%, of the “deemed-owned” ESOP shares (a measure that includes any synthetic equity they hold, such as options) cannot own more than 50% of the total equity in the company.

28. Other Plan Applications • As an additional benefit • Buying out an owner in a closely held company • Acquiring new capital • Selling or buying divisions of companies

29. Selling Directly to Employees Instead • Employees can purchase shares at a negotiated value. • Purchase is done in after-tax dollars. • Company can pay taxable bonuses to employees to help pay for the purchase. • Company can make non-recourse arms-length interest rate loans to help fund purchase. • Seller pays capital gains tax on the sale.

30. Getting Equity to Employees Outside the ESOP • Employees can individually be granted equity rights. • Stock options • Phantom stock and stock appreciation rights • Restricted stock. • Bonus shares.

31. Who Is a Good ESOP Candidate? • Generally at least 15-20 employees • Adequate free cash-flow to take on costs of buying out the shares • Management willing to share information and work-level decisions with employee owners • If buyer has synergistic seller options, is the buyer willing to accept a somewhat lower net price?

32. Basic ESOP Accounting Rules: Compensation • Employer contributions to repay an ESOP loan are counted as compensation expense and repayment of interest.  • The repayment of interest is measured as it would be for any other loan. Compensation expense is more complicated. At its simplest, compensation expense would equal the amount of principal paid on the loan in any year. • ESOP companies, however, may use dividends to repay loans or allocate shares based on the principal plus interest model. So the formula below is now standard practice: (Shares allocated for the period / total shares purchased) x Original Principal+ Interest Expense - Dividends

33. Balance Sheet Accounting • On the asset side, there may be an increase in cash or other assets resulting from the ESOP's purchase of new shares, with the money from this purchase going towards some corporate purpose. This would not be the case if the ESOP is used to buy stock from an existing shareholder. The assets of the plan, however, are not reported as assets of the plan sponsor, nor is a note receivable from the plan should the plan sponsor be lending money to the ESOP. The plan sponsor, however, must show the issuance of shares, or the sale or treasury shares, to the ESOP on its balance sheet. • All ESOP debt, regardless of whether the company guarantees it or not, shows up as debt of the sponsor. • When the debt is recorded on the balance sheet, an equal and offsetting debit is recorded in the equity section as a "contra equity account." It has to appear here because the ESOP loan does not show up as an asset in the asset section. This contra equity account is eliminated as the ESOP debt is paid. The amount of the release is equal to the number of shares released from the ESOP suspense account and allocated to participants.

34. What Value Is Used to Account for Released Shares? • Released shares are accounted for at the fair market value at the time of release, not what the company originally paid for them, even though the tax treatment of the ESOP is based on the original cost. • When the stock value declines companies can use the higher cost basis for the shares, but only for tax reporting purposes and only if the plan provides that the employer can choose to use either the fair market value of the stock allocated or the actual contribution made by the employer. The employer can't change approaches from one year to another; it has to be in the plan document and used on a consistent basis.

35. Non-Leveraged ESPO Accounting • If the company contributes new shares of stock, the value of the shares at the time of the contribution is counted as a compensation expense. The par value of the shares is credited to common stock par value, while paid-in capital is credited at the difference between par value and current fair market value.If the contribution is in cash and used to buy existing shares, the value of the contribution is charged to compensation expense, while cash is credited with the value of the contribution.Footnote disclosures in either case should identify the plan and the employee groups covered, describe the company's contribution policy, and identify how much was contributed when.

36. Business Opportunities for Accountants • Like all ERISA plans, ESOPs are subject to plan audit rules • Audits required for plans with 100 or more participants • Audits look at where rules on eligibility, allocation, and distribution are are being met and whether plan document is being followed • Check to see if plan is top heavy • Review appraisal to make sure it complies with accounting standards (but auditor does not have a role in questioning the actual value)

37. Helping Owners Evaluate an ESOP • Assess if the amount needed to make the acquisition is fundable about of future earnings • Help owner assess tax consequences of various sale approaches (seller notes versus bank notes, partial sales versus 100% sales, etc.) • Make sure that payroll is large enough so that needed contributions are within legal limits • Compare after-tax consequences of an ESOP sale to a sale to another buyer

38. Additional Resources from the NCEO • Selling Your Business to an ESOP • An Introduction to ESOPs