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Nevada Society of Certified Public Accountants 3 rd Annual Southwest Tax Conference December 7, 2011 Employee Stock Ownership An Introduction to ESOPS.

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Presentation on theme: "Nevada Society of Certified Public Accountants 3 rd Annual Southwest Tax Conference December 7, 2011 Employee Stock Ownership An Introduction to ESOPS."— Presentation transcript:

1 Nevada Society of Certified Public Accountants 3 rd Annual Southwest Tax Conference December 7, 2011 Employee Stock Ownership An Introduction to ESOPS John A. Kober Morgan, Lewis & Bockius LLP 1717 Main Street, Suite 3200 Dallas, TX 75201-7347 214-466-4105 John R. Maxfield Holland & Hart LLP 555 17 th Street, Suite 3200 Denver, CO 80202 303-295-8341

2 Outline Identify when ESOP opportunities are the right business transition solution Educate attorneys and CPAs Starts with goals of the current owners 2

3 Selected Uses of an ESOP Provide business continuity A tax-advantaged corporate finance tool Build a stronger corporate culture Provide liquidity for existing shareholders (without necessarily relinquishing control) Create a charitable giving tool Part of a poison pill, restructuring or acquisition strategy Asset diversification for the existing shareholders An estate planning tool for the existing shareholders Spread ownership among most employees 3

4 “Partial” ESOP As Alternative to Taxable Recapitalization/Redemption and IPO Taxable Recapitalization/ Redemption Company Stable Company Privately Held Shareholders Desire Liquidity No Current Need for Capital for Growth Transaction Provides Partial Liquidity Shareholder Group Retains Control Dividend Tax Rate Debt/Private Equity/Sale Lease Back Real Estate Tax Inefficient for Company Dilution Only if Private Equity/Mezzanine Investor Involved ESOP Company Steady Growth Company Often Closely Held (may be a professional Service Company) Shareholders Desire Liquidity Strong Ongoing Management Team Perpetuation of Culture No Current Need for Capital for Growth Transaction Provides Partial Liquidity Shareholder Group Can Retain Control Financial Buyer Valuation Metrics Tax Incentives Enhance Transaction Economics Estate Planning Benefits Family/Succession Planning Benefits IPO Company Steady or High Growth Company Significant Use for Growth Capital Desires Significant Capital Markets Access Sophisticated Operational and Financial Management Transaction Creation of Liquid Market in Company Shares Depending on Public Float Achieve Public Fair Market Valuation Access to Growth Capital Diversification of Shareholder Base Regulatory and Compliance Requirements 4

5 Sample ESOP Transaction 1.An ESOP Trust is formed 2.Bank lends money to the Company 3.Company lends money to the ESOP Trust 4.Stock is purchased from the Shareholder by the ESOP Trust at the current fair value of the shares purchased. ESOP holds stock for employees and periodically notifies employees how much they own and how much it is worth 5.Company makes tax deductible contributions to the ESOP which the ESOP uses to repay the company for the stock it purchased. 6.Company makes annual payments on the debt to the Bank until debt is retired 7.Employees receive credit for the stock that has been “paid for” and separation from service (i.e. retirement, termination) employees receive stock or cash in an amount equal to their vested account balance which is directly impacted by the change in the fair value of the stock at the time of separation Existing Shareholder(s) Company ESOP Trust Bank 1 2 stock $$ or stock 4 3 $$ 7 Employees Loan $$ 5 $$ 6 Payment $$ 5

6 ESOP Financing: Where Does the Money Come From? Most ESOP transactions are leveraged – Externally through independent sources of financing – Internally using cash on the company’s books – Using seller financing – These can work independently or in combination Financing categories – Senior bank financing is the least expensive “slice” – Cash flow loans – Asset-based loans – Subordinated (“Mezzanine”) debt can get quite expensive – Seller financing can be structured as either senior or subordinated How much of each category depends on the situation 6

7 Ideal Candidate Attributes Closely held corporation (C or S) Profitable with strong and steadily increasing cash flow Corporate culture suited to employee ownership Owners seek liquidity and/or diversification Company has borrowing capacity Strong ongoing management bench Substantial payroll Stable employee base 7

8 The ESOP Owned S Corporation After 1998, ESOPs may own stock in S corporations – Earnings of an S corporation are taxable to the shareholders based on their ratable shareholdings – ESOP ownership is attributed to the Trustee (not the participants) – treated as a single shareholder – ESOP Trustee is exempt from income tax under IRC Section 501(c) – To the extent of the ESOP’s ownership, corporate earnings are tax free Must meet the S corporation ownership rules and there are anti-abuse rules to follow 8

9 The ESOP Owned S Corporation Tax Reporting for 100% ESOP Owned S Corporation Company Shareholder - ESOP Trust Tax Liability $ 0 State & Federal Government Taxable Income 9

10 Advisors ESOP Company Owners/ Shareholders CPA Valuation Company Third Party Administrator Attorney ESOP Consultant Lender CPA Attorney Estate/Family Planning Advisor Attorney Investment Advisor Trustee 10

11 Sample ESOP Implementation Interview and retain advisors – Preliminary evaluation and design (including feasibility study) – Legal – Trustee – Valuation firm Financing Legal and financial due diligence ESOP and NQ plan design Negotiations Corporate revisions Documentation Closing Communication 11

12 The Ownership Culture Reward Ownership proven to impact company performance – 70 percent report revenue increase – 64 percent report profitability increase – Default rate on bank debt is two thirds the rate of non-ESOP companies – 60 percent of ESOP companies report productivity increases – 80 percent of ESOP companies indicate the ESOP is a major benefit in recruiting new employees – Retirement plan contributions are double the amount of non-ESOP companies 12

13 Other Benefits to Company Cultural maintenance or enhancement Keep current management in place Current owner(s) stay involved and possibly maintain control Effective deductibility of both principal and interest repayment 100% ESOP-owned S Corps can effectively become tax exempt business 13

14 Benefits to Selling Shareholder(s) Liquidity and diversification Tax deferral opportunity (C Corp only) Owners may retain control Can be used for estate planning – including potential for enhanced liquidity, date of death basis step-up in “QRP” and/or reduced value for gifting purposes due to leverage incurred (can apply to company shares, seller notes and warrants) Enhanced charitable giving opportunities 14

15 Shareholders How a Typical ESOP Company is Organized BOD Officers Mgmt Employees Board owes duty of care & loyalty to shareholders ESOP participants have beneficial ownership interest ESOP trustee has fiduciary responsibility Shareholders & trustee vote for Board 15

16 Corporate Governance – Is This Important from Tax Standpoint Family Assets Independent Directors S – CorporatiVs. C- Corporations Seller Contractual Rights Tax Abuses Entity  Corporation  LLC  Partnership Synthetic Equity Capital Gains Treatment  Redemption – True Sale  1042 ESOP Purcahse Leverage  Debt  Equity S-Corporation  Corp  Individual Trustee of ESOP 16

17 Potential Barriers to a Successful Transaction Selling shareholders goals: – Looking for a strategic valuation or has an unrealistic expectation for the company’s value – Wants to concentrate ownership in the hands of a few individuals – Requires best practices for corporate governance which is a change for some family owned businesses 17

18 Potential Barriers to a Successful Transaction Company characteristics: – Startup or early growth phases of life cycle – Successor management is inadequate or nonexistent Must be able to understand complex ESOPs issues – Company has no additional debt capacity – Too few employees – Transaction due diligence and costs may be too high – cannot cut corners! – May complicate subsequent company sale 18

19 Sample ESOP Transaction - Take 2 Shareholder notes 5-10 years at 3.53% interest plus warrants 80% Shares 20% Shares 2 15 -25 Year Note Sale to the ESOP ESOP Loan 1A2 Share Redemption 1B1A1B SARs for key management 19 Cash

20 What Happens to Contribution 1. Company makes annual contributions or dividends to the ESOP 2. Trustee uses contributions to repay the ESOP loan Participant Accounts ESOP Trust Unallocated Account The Company 3. As loan is repaid, stock is allocated 20

21 ESOP Care and Feeding Annual valuation Plan document maintenance Participant communication Corporate formalities Can be difficult to eliminate – Terminate – Heightened fiduciary standards if ESOP is seller 21

22 Variations on Leveraged ESOP Selling shareholder finances ESOP borrows directly from lender Company redeems all (or most) stock from shareholder, then sells to ESOP (or contributes over time in contributory ESOP) 22

23 Summary of the Meeting with the Senate Finance Committee Family Assets Tax Enhancements Jobs Creation Community Wins S – Corporations Vs. C-Corporations Types of Transactions Tax Abuses Valuations Success of Company Tax Revenues Senate Finance Committee ESOP Leverage Advisors 23

24 Administrative Conference of the United States Reconstituted in 2010 Independent Federal Agency Designed to Study Administrative Processes of the Federal Government Recommend Specific Proposals to Improve Procedures Appointees 24

25 Questions? 25 5267751

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