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 10million dollars, selling 60% based
on the following methods:
•
•
•
•
Corporate Stock Redemption
Management Leveraged Buy-Out
Third Party Sale
ESOP
Corporate Redemption
Company value
Value of 60% majority stock sale
Corp. profits needed to net sale price
$10,000,000
$6,000,000
$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%
Gross proceeds to seller
Capital gains tax at 29.2% (fed. & avg. state)
Net proceeds to seller
Total fees & taxes
$150,000
$5,850,000
$0
$5,850,000
$150,000
Method
“Net” to Seller
Total 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
Adopts
ESOP Trust
How It Works: Step 2
Company
C
O
N
T
R
I
B
U
T
I
O
N
Stock or Cash
ESOP
Trust
Buys
Shares
Selling
Shareholders
Leveraged ESOP
How an ESOP Works: Step 1
The
Company
Adopts
ESOP Trust
How an ESOP Works: Step 2
Lender
Loan
Company
L
o
a
n
ESOP
Trust
How an ESOP Works: Step 3
Lender
Loan
IRC §
Company
1042
C
a
s
h
L
o
a
n
ESOP
Trust
Stock
Cash
Selling
Shareholder
How an ESOP Works: Step 4
Lender
Loan
IRC §
Company
1042
Payment
L
o
a
n
C
a
s
h
ESOP
Trust
P
a
y
m
e
nt
C
a
s
h
Stock
Cash
Selling
Shareholder
How an ESOP Works: Step 5
Lender
Loan
IRC §
Company
1042
Payment
L
o
a
n
C
a
s
h
ESOP
Trust
C
a
s
h
P
a
y
m
e
n
t
Stock
Cash
Selling
Shareholder
Employees
How an ESOP Works: Step 6
Lender
Loan
IRC §
Company
1042
Payment
L
o
a
n
C
a
s
h
ESOP
Trust
Sinking
Fund
Death, Disability, Retirement,
Termination and Diversification
P
a
y
m
e
n
t
C
a
s
h
Stock
Cash
Selling
Shareholder
Employees
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)
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
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
Leveraged QRP Strategy
Proceeds
From Sale
Cash
(1042)
Portfolio
Floating
Rate Notes
Margin
Account
QRP can be margined to 90%
Liquid Cash
Balance
Income with
Interest
Leveraged QRP Strategy
New
Home
Bonds
Proceeds
From
Margin
Loan
Stocks
Boat
Cars
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
Control Can Remain “Undisturbed”
Owners with
stock outside
the ESOP
Votes
Board of
Directors
Appoints
“Directed”
Trustee
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
Total
Outstanding
Shares
Shares
Inside
ESOP
Shares
Owned Outside
ESOP
(Family/Mgmt)
Percentage
Owned 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
Team
Quarterback
Through Entire
Process
Investigative
Phase Part 1
• Educational “ESOPs 101” Presentation
• Initial Review of Financials & Fact Finder
• Preliminary Valuation
• Preliminary ESOP Analysis
Investigative
Phase Part 2
• Additional Data Gathering
• Feasibility Study
• Final Client Approval to Proceed to Next
Step
Implementation
Phase
•
•
•
•
•
ERISA Plan Design
Transaction Design
Engage Other Team Members
Financing
IRC§ 1042 Analysis & Execution
Post Closing
Phase
•
•
•
•
•
Employee Communications
Management Incentive Plans
Repurchase Liability & Funding
Advanced Planning
Determination Letter
Team Approach
Plan Design
Insurance
Investments*
ERISA
Counsel *
Estate
Planning
Banker
BTA
Team
Leader
Trustee*
Stock
Valuation*
Employee
Communication
TPA*
Corporate
Counsel
Repurchase
Obligation
Company
CPA *
*Outside service provider
Contact Information
Roy Farmer
Managing Director
(208) 761-3612
rfarmer@bta.us.com