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ESOP Formation and Business Succession Planning

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ESOP Formation and Business Succession Planning

An employee stock ownership plan or ESOP can be a powerful succession planning tool for business owners to consider for their ownership transition planning. ESOPs are highly regulated and require careful planning for implementation but also have the potential to offer meaningful tax benefits to the selling shareholder and the corporate sponsor of the ESOP. An ESOP can also provide significant employee benefits on a tax favored basis for employees. We will review the types of companies that are ideal candidates to consider an ESOP as well as poor candidates for an ESOP and review highlights of the process of evaluating and planning an ESOP transaction.

Transcript

- [David] Good afternoon. This is David Johanson. I'm a senior and equity partner with Hawkins Parnell & Young. We have approximately 11 offices throughout the United States. And we conduct business in virtually all of the United States. I have been working with employee stock ownership plans since the mid 1980s, almost 40 years. I'm gonna be talking with you today about a topic that I am intimately familiar with after that almost 40 year career, ESOP Formation and Business Succession Planning. This presentation is part of the Quimby Group, and will hopefully help you satisfy some continuing legal education requirements and potentially may help others in deciding whether or not an ESOP is right for you or your corporation. An ESOP is simply an employee benefit plan. It's designed to invest primarily in company stock. An ESOP trust, which is part of the ESOP, the ESOP being the plan document that sets the terms of eligibility, vesting, contributions, distributions, and other regulatory provisions. ESOP trust is the actual entity that holds the ESOP plan assets and typically those plan assets are again primarily invested in company stock. The ESOP- and ESOP is subject to the applicable provisions of both the Internal Revenue Code of 1986 as amended, and the Employee Retirement Income Security Act of 1974 as amended. I'll call that ERISA during this presentation. I also may refer to the Internal Revenue Code of 1986 as amended as the Code or the IRC. The studies have shown, and I'm not convinced these studies are correct, they've been conducted by the National Center for Employee Ownership, and the NCO as that organization is called, typically reviews Forms 5,500 filings for ESOPs on eFAST and then creates these statistics. I'm not convinced they're accurate, not 'cause I'm questioning that organization, but I think there probably is not complete compliance with the Form 5,500 filing requirements, and there are potentially other ESOPs that just simply exist out there that we're not aware of. That said the NCO projects that there's currently based upon 2019 information approximately 6,500 ESOPs nationwide. Of that portion, the NCO is designated 602 of those is being sponsored by publicly traded companies and the others are sponsored by closely held companies. According today NCO, and this review of the 5,500 filings over/or an excess of 10.2 million current employees are covered by ESOPs. Total Plan Assets, again, which most of which are invested in company stock is about 1.67 trillion. Valuations of ESOP companies will clearly be down going forward, at least in many cases because of the publicly traded company analysis that is typically done and establishing the value for ESOPs and publicly traded company market for stocks is down by anywhere from 10 to 30% this year. An average of approximately 254 new ESOPs are created each year since 2014, according to the NCO, based upon its review of these Forms 5,500. It's really not a lot quite frankly, in light of the way the population has grown since ESOPs became very popular in the 1980s. I wonder why ESOPs are not more prolific sometimes, but I think that's because they go in cycles. You go from, you know, each year a number of ESOPs have started and as many ESOPs that are started sometimes are going out the back end, they're terminated, the ESOP company is sold to a third party, et cetera. And so you see not a lot of growth year on year in ESOPs. That said, they are a remarkable alternative exit strategy for business owners to consider. You have a number of different strategies that can be used for transition of ownership. One is sell to a strategic buyer, that's gonna get your highest price for sure. Another is a sale to a financial buyer that's not gonna be your best value, that's gonna be probably a middle of the road value, and then you can sell to an ESOP. An ESOP valuation is typically not as high as a sale to strategic buyer, and it is under the ERISA adequate consideration regulations. And ERISA's requirements, you can't sell to an ESOP for more than fair market value, and that fair market value has to be established by an independent ERISA fiduciary or a trustee based upon an independent valuation of the business. So you're not gonna get the highest and best value if you wanna sell to an ESOP. That said, there are a number of advantages to selling to an ESOP that make it worth considering for ESOP plan sponsors and company owners. The transaction costs involved in a deal with a strategic or financial buyer are generally substantial because investment bankers and investment brokers seek success fees. However, such sales can offer purchase price multiples that are substantially inexcessive traditional fair market value. As I indicated earlier, ESOP sales have regulatory price limitations but typically don't involve these substantial success fees for investment bankers or financial advisors. That said, there are some very large ESOP transactions with large close sailed companies that tend to generate substantial fees for investment bankers to help find money to fund the deals and investment brokers. The next topic I'd like to cover is alternative exit strategies factors that you might consider in evaluating whether or not to accomplish a sale to an ESOP for business success planning purchases. First purposes, first purchase price, we already kind of went into that and I explained the differences between the various alternatives. Second, tax considerations. I think you'll find that ESOPs tend to be much more successful in terms of accomplishing tax savings for the corporation to sponsor the ESOPs, and tax savings for the selling shareholders who sell to an ESOP. They also tend to be helpful for the employees who can gain a tax free benefit, and it can appreciate no tax consequences over their lifetime with the company in a tax sheltered environment. So that's, I put the checkbox or a tick box there for an ESOP as one of the best strategies for evaluating business succession planning. Forms of consideration with the ESOP, typically the only one you've got is sale of stock. You can't do an asset sale with an ESOP, so typically. So that means that if you want to avoid, if the buyer wants to avoid liability, you can't ask you to form an ESOP and then basically, buy the stock in the form form of a asset transaction. Now, you could set up an ESOP, the company owners could sell their stock to the ESOP and then the Board of Directors that ESOP company could sell the assets to a third party, that's a way you could do it. Many of our corporate clients in ESOP plan sponsors over the years have accomplished ESOP transactions because they've wanted to get all their eggs out of one basket, and they were trying, they've been trying to address liquidity concerns, 'cause company stock is typically not very liquid, and if you own a company it's probably a lot of times very profitable. However, all your eggs are in one basket and if the market turns in a particular direction, adverse direction for your company, you don't have any diversification. So an ESOP can be used to diversify your investment in one company into investment in other assets, marketable securities, real estate, so on and so forth. And that is a typical goal of a transaction Legacy. ESOPs also tend to be play very high on the legacy side because ESOP plan sponsors the people who sell their stock to ESOP are usually looked at fairly favorably for having decided to create a ESOP and sell their stock to the employees essentially. You might have your own personal retirement goals and they may or may not be accomplished with an ESOP. Typically an ESOP takes fairly long period of time. You can't do, typically you can't do a hundred percent transaction up front. You can certainly try to do that. However, that's not always feasible for various reasons. You can't make enough contributions to these ESOP trusts because of the limitations on those contributions under the Code, or the value is too much and you can't accomplish a transaction that large at the outset because if you do, the company can't afford to repay the debts that's incurred to buy the stock, either that's incurred from the selling shareholders or an outside third party. Time to close of the various transactions. I know M&A transactions can happen fairly quickly. You do wanna build in a period of months, I would say a minimum of three, four months to accomplish ESOP transaction. 'Cause if you don't do that you could be challenged on the regulatory side by the Department of Labor who has regulatory authority over ESOPs, and they could come in and investigate and say, hey, this transaction that you did 10 years ago wasn't done properly. You didn't hire the right fiduciary, you did the deal too quickly. There were some conflicts here that were involved. And, so it's important to create a proper ESOP advisory team, ESOP fiduciary, independent fiduciary or a trustee, independent appraiser and financial advisor and independent legal counsel and spend the time to conduct the due diligence in the transaction so that it stands the test of time with the regulatory agencies in the class action bar, which typically goes after ESOPs pretty heavily in the litigation world. What are the advantages of selling to an ESOP C corporations? The selling shareholders can defer recognition of gain on sale of stock due a C corporation ESOP. They also can, dividends can be declared on the stock that's held by the ESOP, and those are deductible dividends to the corporation that's sponsors the ESOP, and those dividends then can be used to repay the debt that's the debt from the selling shareholders that's incurred for ESOP to buy the stock in the first place. From a C corporation perspective, tax savings are prolific with an ESOP. You can use tax deductible contributions to the ESOP to repay the both the principle and the interest on the debt that's incurred to buy the stock. You could sell, the company could sell stock to the ESOP and generate capital for expansion and acquisitions. There are two Internal Revenue Code provisions that you can look to in this respect. Section 40483 of the Code allows you to a corporation that properly establishes an ESOP to contribute 25% of eligible compensation to the ESOP each ESOP trust each year. Now you have to look at other defined contribution plans as well when you focus on that, so the 401K and any profit sharing plans. On top of that, there's a special leverage DSUP provision under section 40489 of the Code, corporations can contribute 25% of eligible compensation under that provision as well, that can be used to make payments so that corporation can make the contribution to the ESOP trust. ESOP trust can use that to make payment on exempt loans that are incurred to buy stock from the ESOP in the first place. And this 25% limit doesn't include interest payments, so you can get further deductions for that and also the 404K tax deductible dividends route is above and beyond this 25% limit. So in the first year of a leverage DSUP effectively you could double the limit on tax deductible contributions for a C corporation ESOP and contribute over 50% of eligible compensation to the ESOP. Use that to reduce your otherwise taxable income and if your tax rate is, you know, 15 or 20% both corporate, federal and state, that could be a very substantial tax benefit, might be even higher than that 20 or 25%. That could be a very effective way to save tax dollars and use those to fund the ESOP transaction that transitions ownership from the founding shareholders to the employees. And S corporation is kind of the panacea of ESOPs. You typically have the ability to pass through taxable income to the ESOP trust, which is tax exempt. And that means that if to the, based upon the percentage ownership that's held in the ESOP trust of the company, let's say the ESOP trust owns a hundred percent, and the ESOP trust is tax exempt and the company earns $10 million of taxable profits during the year, those get passed through to the ESOP trust in the form of scheduled K1, that $10 million otherwise taxable income will not be taxable 'cause the ESOP is a tax exempt trust under the Internal Revenue Code. So theoretically you could create a tax for profit tax exempt entity, corporate entity now, because it's got the ESOP trust owning a hundred percent of its stock, same thing could happen if ESOP owned 70% just wouldn't get the full benefit. 30% of the taxable income of the corporation would be taxed to the corporation and 70% would not, in the example I just gave. Only the deduction for employer contributions under Section 40483 of the Code is available for S corporation ESOPs. You cannot- selling shareholders to an S corporation ESOP cannot take advantage of the tax on sales of stock to the ESOP that I'm gonna talk about in a few minutes. S corporation distributions may still be declared to the ESOP trust based upon the stock owned by the ESOP trust. However, the S corporation distributions are not deductible like the deductible contributions to a C corporation ESOP, and you can't take advantage of Section 404K tax deductible dividends as well. The lack of deduction, tax deductions, is not material because the S corporation income is not taxable to the ESOP shareholder and you can create substantial benefits in that respect. I've seen many closely other companies become very large and tax efficient and profitable by converting to an S corporation from C corporation ESOP. Both C corporation and S corporation ESOPs have a positive, generally positive impact on corporate cash flow. Employer contributions and excessive contributions to address debt service to the ESOP trusts may be more, may be made in the form of company stock as well. Many ESOP transactions involve a conversion of an S corporation to a C corporation to allow a IRC Section 1042 tax deferral transaction for the selling shareholders, followed by maintaining that S corporation status for five years after the transaction occurs, and then converting back to an S corporation at the end of the five years to take advantage of these S corporation tax benefits that I've been talking about for the last few minutes. A C corporation involved in an ESOP transaction that is not terminated in an S selection may immediately thereafter elect S corporation status. So if you weren't an S corporation before and you converted to- and so you were a C corporation, you can do your transaction with the ESOP, do the tax deduct, or excuse me, the tax exempt or tax-deferred transaction under Section 1042 of the Internal Revenue Code for the selling shareholders, and then immediately terminate, convert from the C corporation and elect an S corporation status. And that's only if you were a C corporation before you started the process. From an employee perspective, what are your advantages? Well you get a fairly large retirement benefit with substantial contributions and capital appreciation without deductions from your wages. Typically, employers don't ask employees to defer their money into the ESOP in order to buy stock from the selling shareholders. That's very unusual for that to occur. So if I'm a $50,000 a year employee, I may get 25% of that of my compensation contributed to the ESOP trust on my behalf each year to basically essentially purchase stock for me. That's in addition to my 50,000. So it's not coming out of my 50,000 of earnings, it's on top of the 50,000 earnings I already have. So I now would become essentially a $62,500 employee based upon that contribution each year. One of the great things about ESOPs in my mind is that it aligns the interests of management and employees through ownership interests. It's a powerful tool for recruitment and retention. Management, the company and the employees and the selling shareholders are all on the same page, they wanna grow the value of the company 'cause that will help everybody. Rising tide raises all ships as they say. What are the typical, what's the typical profile of an ideal ESOP candidate? First on the selling shareholder characteristics side. The selling share, who typically wants to sell his or her stock for fair market value, and agrees that they don't need strategic value. The selling shareholder typically is seeking personal wealth diversification. They'd like to take some value out of the corporation on a tax deferred basis as we'll talk about here shortly. And they seek to preserve their own corporate and personal legacy in the company. They don't want the company to be sold and then have some large publicly traded company or company go ahead and terminate all their employees. They also wish to provide employees with economic benefits. I can't think of one founding shareholder who I've ever worked with who hasn't been interested in accomplishing that for his or her employees. From a sponsoring company perspective, you typically, the characteristics or his follows. The company wants to have a sufficient balance, sheer strength to absorb the acquisition debt 'cause you're basically incurring a bunch of debt to buy stock for the benefit of the employees. And that'll either come in the form out of an outside loan from third party lender or it would come from the selling shareholders extending credit to the ESOP and the corporation. The corporation typically has to have sufficient cash flow to cover all ESOP acquisition debt, other long term debt service requirements or the ESOP just will not work. You should move forward if it doesn't have sufficient cash flow, there should be a substantial analysis of cash flow to make that possible. Typically you wanna look at historical and projected operating performance as well and make sure that you got a series of historically prosperous years, and the projections for the next five years are pretty healthy. So that you can see that the corporation will generate sufficient profits and margins so that they can use that profit and those margins to pay off the debt following the soft transaction with the selling shareholders. There's gotta be a sufficient payroll in order to accomplish- do you wanna go to the restroom? It's right here. In addition to having submission payroll to meet the contribution requirements to the ESOP and fund the transaction that encouraged to buy stock from the selling shareholders. You also have to have not less than typically 15 to 20 employees. There's no upper limit, and 15 to 20 is not a magical amount, that's just the typical amount that you might want. The reason why wanna have 15 to 20 is you wanna have a large enough compensation base so that you can contribute dollars into the ESOP trust that can be used to amortize the debt that's incurred to buy stock from the sell and shareholders. You have to have management debt and establish plan for succession as well. And it's typically a good idea to have a participatory management environment. You don't wanna have a dictatorial management environment because that would likely not be a good environment for an ESOP to foster the kind of ownership culture that would help convince everybody to spend a lot of time with their efforts to grow the value of the business, the profits of the business, and the value of the business. Effective communications should exist between employees and management. And you certainly can use either a C corporation or an S corporation to establish an ESOP as well. What are poor candidates for ESOPs? Well, first of all, firm with flat or declining earnings would be a poor candidate for an ESOP. Firms with a lack of strong leadership would also be a- or companies, corporations with a lack of strong leadership also would be a place where you wouldn't wanna go with an ESOP. You definitely- if you got a strong individual leader and that individual leader is selling his or her stock to the ESOP and they're leaving, that is gonna be hard for that management team to facilitate the succession that's needed to make the ESOP company profitable after the deal closes. Also, another poor candidate for an ESOP would be one where the management or the owners, the company founders simply want to transfer the stock to the management or a select group of employees, that's not an ESOP. An ESOP is a broad based employee stock ownership plan that shares equity on a equitable basis throughout the company, and that typically is not what happens when the owners of the company decide I want these three or four people to own this stock. That's not a broad based employee ownership structure. Code Section 1042 is another section that you'd really wanna spend a lot of time focusing on if you wanted to accomplish any ESOP transaction because it is what has generated most of the interest in ESOPs over the last almost 40 years. This law was put in place in 1984 as a result of the efforts by Senator Russell Long. Senator Russell Long was a democratic senator from Louisiana. His father was Huey Long. And Russell Long really got the- really got interested in employee ownership. He studied with or, not studied with, but he became familiar with Louis Kelso and... Louis Kelso, was what some people consider the founding father of ESOPs. Anyway, Russell Long put in place a series of legislation in 1984 that allowed a selling shareholder to an ESOP who had- Who had sold stock to an ESOP and met certain requirements to defer tax consequences on the sale to the ESOP as long as they met these requirements. The election defers taxation of gain from the stock sale to ESOP trust, to the extent the qualified selling shareholder reinvests in stocks or bonds of other domestic operating companies over a period of of 15 months, three months before the sale and 12 months after the sale. The selling shareholder has to invest in stocks or bonds of domestic operating companies other than the ESOP that sponsor. The, excuse me, other than the corporation that sponsors the ESOP. That property that stocks or bonds of other domestic operating corporations is qualified replacement property or QRP. QRP has a carryover basis from the stocks sold to these ESOP trusts in the first place, and a stepped up basis, it passed to the selling shareholders ears under current tax law. This means that if the founding shareholders sell stock to ESOP and defer their taxes on the sale under Section 1042 of the Internal Revenue Code. And then they sell the stocks or bonds they buy in order to defer their taxes under Section 1042, they're gonna have a recapture of capital gain. And that recapture of capital gain is going to basically be based upon the original basis that the founding shareholder had in the corporation that founded the ESOP in the first place. So let's say for example, I had a corporation that I built over a period of 50 years and I originally had a stock basis or a, yeah a basis in that company the stock that I owned in that company of a million dollars, and I sold that stock for $10 million to the ESOP and then I rolled the proceeds from the sale to the ESOP, the $10 million into stocks or bonds of US operating companies. If I do that then and I sell the stocks or bonds of the US operating companies, let's say that $10 million grows to 20 million, I would have a capital gain based upon the 20 million, less than 1 million of basis I originally had or a 19 million tax capital gain. Now there are certain circumstances in which that does not apply and I'll talk about that in a few minutes, but President Biden's tax reform proposals leave the benefits of Section 1042 of the IRC at a significant risk as it as it would only defer taxes not eliminate taxes, because the step up in basis could not occur at death as it currently exists. The step up in basis would go away. And so in that example that I just gave, let's say I've sold stock to ESOP for 10 million. I bought stocks or bonds and they grew to 30 million and then I die. I don't get a step up in basis under President Bidens new laws. So at death my heirs are taxed on 30 million, less than $1 million basis or a 29 million capital gain. Let's hope that particular tax bill does not get passed 'cause that's not very favorable for Section 1042. QRP remember I talked about stocks or bonds of domestic operating companies. QRP cannot include US government, municipal securities, foreign securities, mutual funds, or interest in limited partnerships, REITs, passive investment companies, or stock of an ESOP plan sponsor. There are ways to get around that limitation, and I'll talk about how you can monetize in and invest in those assets a little bit later in this presentation. Under Section 1042 of the Internal Revenue Code, the transactions that occur have to meet the following requirements in order for the selling shareholders to defer their taxes on the sale in the first place. First, the selling shareholder must have otherwise have long term capital gains without the 1042 election. Second, the seller must have held the stock, sold to the up for at least three years prior to the sale. Now one thing there is, if you have an LLC before you start with this process and you transfer the- convert the LLC to a corporation, you could transfer those assets of that LLC to a corporation and then get stock. When you do that, as long as do that properly, you could have attacking of the holding period of the capital assets that you transferred to the corporation to create the C corporation. And so if you held those assets for at least three years prior to the conversion from an LLC to an C corporation, you might be able to meet this three year requirement that way. Stock that's sold to ESPO must be qualifying important securities. They can't be a readily tradable on an established securities market. They must be common stock with the best dividend and best boating rights or converted preferred stocks. Seller must not ever received the stock sold through a qualified employee benefit plan, exercise of a stock option or purchase under an ESPP. And the fourth requirement is that the seller must acquire the QRP, the stocks or bonds of US operating companies during a 15 month period. Three months pre-closing in 12 months following the stock sale to ESOP. Post sale ESOP trust must own at least 30% of the plan sponsor's equity on a fully diluted basis. This is a key requirement of the 1042 tax deferred transaction requirements that allow the selling share holders to defer their capital gains on the sales. There are some restrictions on allocations under the ESOP. If a selling shoulder takes advantage of Section 1042, the Internal Revenue Code, those restrictions and allocations are typically a substantial detriment to family members or ESOP sellers who wanna continue to be employed by the ESOP company, 'cause they won't be able to be participants in the ESOP. This is important now that the stepped up basis at death, that's key to 1042 planning may be at risk and tax reform. So what are the restrictions? There's a 50% excise tax on the ESOP plan sponsor if you allocate any of the stock that's sold to the ESOP in a 1042 transaction, during a 10 year period of time after the sale to the seller who makes the election under Code Section 1042 to the sellers family members and to any person owning more than 25% of the plan sponsor stock at the date of the sale to these up there is an exception for allocations to children and grandchildren of the selling shareholder. They may receive 5% of the aggregate of allocations, but if you violate this, it's a 50% excise tax, and then there's tax consequences to the people who receive these allocations. Post-closing, let's, you know, we can either use, I think we'll use a 10 million transaction 'cause I think a hundred million is probably not that typical out there. The slides do have a hundred million dollar example. Let's say that a corporation wants to use 10 million of profits to finance purchase of equity from selling shareholders. So it's a $10 million transaction. ESOP is a vehicle for future tax deductions. You get equity incentives on a broad basis to the employees and business succession is underway. Let's also assume this is a 10, this is a hundred percent transaction, so it's the entire equity of the business. Typically what would happen is if you didn't have bank financing, the ESAP trust would issue a 10 million promissory note to the selling shareholders, and the selling shareholders would transfer a hundred percent of the issue in outstanding shares of company stock to the ESOP trust. The $10 million worth of proceeds from the sale basically would accrue to the selling shareholders. Now you could do a installment sale reporting of that, but that's limited to 5 million. So essentially you'd have to pay tax advanced taxes on the receipt of the- you could defer 5 million through the installment sales and then you'd have to pay advanced taxes on the other $5 million of proceeds from the sale of stock to the ESOP, even though you're not gonna get 'em for a period of years. Selling shareholder may be able to negotiate warrants from the corporation that sponsors ESOP in connection with providing this $10 million of selling shareholder financing on the sale of stock to the ESOP. That's something you have to be extremely careful with. Should get a financial advisor to give an advisory opinion to the ESOP that says, that's fair to the ESOP from financial point of view, you really need to, when you're doing this, you need to make sure that financial advisor determines what the appropriate, reasonable, commercially reasonable price should be for the selling shareholders granding that financing extension to these, based upon looking at comparable transactions in the public market. Without a Code Section 1042 election, there'd be 2.38 million of tax consequences on the $10 million QRP transaction. Again, the slides may show a hundred million dollar transaction, but I'm cutting that back to 10 million 'cause I think that's more realistic. With a Code section 1042 election, $10 million in qualified replacement property can potentially be purchased in the form of stocks or bonds of US companies to defer the taxes, to heirs for further, excuse me, to further taxes on to the selling shareholders on the sale of stock, $10 million worth of stock to the ESOP. This potentially passes dares on a stepped up basis if that continues. The elimination of the stepped up basis is in the Biden administration tax proposals. We'll see if that gets through. You should note that the tax reform proposals on capital gains present potentially large changes to sellers as we'll discuss on the next few slides. Again, realize gain, under current law, let's say it's 10 million under the proposed tax reform, it's 10 million. The highest marginal tax rate for federal long term capital gains right now is maybe increased in 2022 and beyond, but it's 20% right now. That's out of the 10 million, that would be 2 million. Under proposed tax reform that could be as high as 40%. Federal Act Size taxes under the Affordable Care Act or the Obamacare are 3.8%. So that would be another roughly $380,000 of taxes. So the total taxes without a 1042 tax deferred election to the selling shareholder ignoring state taxes would be 2.38 million. Under tax reform, they could be more than 4 million, 3.96 million, 40% of the 10 million for the highest marginal tax rate for federal long term capital gains, and then ACA tax, or Obamacare tax, 3.8%. That puts you over 4.3 million of taxes out of the 10 million of proceeds in the sale. And this also doesn't count state tax implications. They range from zero in some states like Nevada, Florida, other states that have, oh, Texas. And then they range as high as 13 plus percent in California. So that would take another 1.3 million away in the $10 million transaction. So if you look at this from a selling shareholder perspective, if you don't defer your taxes on section 1042, you could have probably almost 35% or $3.5 million of taxes on a $10 million transaction even without proposed tax reform. I talked about installment sale reporting already under Code section 453. Installment reporting is the default method. That means that if the selling shoulders extend credit to the ESOP for $10 million, technically they can defer their taxes on that sale until they receive each payment on the loan, and it's included each year in the year of receipt. Seller can opt out of installment reporting under Schedule D and pay their taxes on the entire gain up front. That would be a planning opportunity if you thought capital gains rates were gonna raise substantially with tax reform. Remember I talked about 5 million caveat, you can't use Code Section 453 to defer the sale proceeds on the 10 million transaction that's limited to 5 million. So you'd have to, the selling shareholders would be hit with the tax consequences on the other 5 million up front. Essentially, you can't defer it under the installment sale method. Please remember that you could do a partial Code Section 1042 election and a partial installment sale. So for example, in my $10 million example, the selling shares could defer $5 million of the sale proceeds by buying stocks or bonds of US companies equal to 5 million and they could report the rest of the gain on an installment sale basis. Again, you should look at that very carefully because there are limitations under Code Section 453 with the 5 million caveat that I talked about. Let's talk about roles and responsibilities of various parties in the ESOP transaction. ESOP trustee is appointed by the ESOP plan sponsors Board of Directors. ESOP trustee does elect those Board of Directors going forward. ESOP trustee does approve certain major corporate transactions that require shareholder vote. You oversee the valuation process and set the annual share value. The Board of Directors of a ESOP company, they typically handle corporate business via board meetings and they're typically board committees like an audit committee, there might be a an executive compensation committee, there might be a corporate governance committee, there might be an ERISA fiduciary committee. The Board of Directors typically appoints these committee members. What we recommend to our corporate clients is that they typically have an ERISA fiduciary committee. That committee is made up of members of typically of outside independent members. And you can focus the ERISA, the limited ERISA fiduciary duties of the Board of Directors on that ERISA fiduciary committee. So for example, you could have two people out of a five person Board of Directors be on an ERISA fiduciary committee and their duty would be to have a limited monitoring of the ESOP trustee. And typically that monitoring doesn't involve micromanaging, it just means that they make sure that that ESOP trustee is ticking the right boxes and that their experience is the correct experience to play the role of an independent ERISA fiduciary. Management of the company, is another player and they typically handle the day to day operations of the ESOP or excuse me, of the company, not the ESOP. The ESOP implementation and transaction team for the corporation typically involves a financial advisor, corporate attorneys, a CPA, corporate attorneys like ourselves, a CPA who's experienced with ESOPs, a bank officer if you're borrowing money from a- a lender to fund the transaction, and then an ESOP record keeper who keeps track of the allocations to the ESOP participants' accounts, and then prepares account statements to share with ESOP participants every year. From the selling share side, the team typically involves attorneys, financial advisors and maybe a CPA. And then the ESOP trustee or fiduciary has its own independent appraiser and financial advisor and its own independent legal council. That's critical for any well run ESOP transaction. By using a sell side financial advisor independent of the ESOP financial advisor, the valuation process for the ESOP is isolated from information shared with the selling shareholders. And I think that's really critical 'cause the DOL does critically examine whether or not the selling shareholders had any involvement in that valuation process up front or any influence on the independent appraiser and financial advisor. Although the projections, financial projections are not a guarantee, the future, the rationale for the financial projections should be fully vetted by the corporation at the time and its Board of Directors at the time of the transaction, and them being issued to the ESOP trustee and the ESOP independent appraiser and financial advisor. There shouldn't be any contractual restrictions on corporate governance and all, for example, the selling shareholders shouldn't be able to stay on the ESOP. The ESOP companies Board of Directors, that should be determined by the ESOP trustee going forward. All compensation rights, executive compensation rights of the selling shareholders should be clearly defined at the outset of the transaction. And bonuses to the selling shareholders post-ESOP transaction should typically only be based on the performance of the company and based- and the company exceeding the projections at the time of the ESOP transaction. How do we implement an ESOP? Well, first we have to look at eligibility requirements, which, are there any foreign employees, for example, who are not eligible? Any young employees who are not old enough to be eligible. Typically the age is 18 or 21 doesn't have to be. There's securities, tax and labor, and the employment law considerations to consider in foreign jurisdictions. Maybe easier in dealing with foreign employees to simply create a phantom ESOP to benefit them. You could also create the phantom ESOP to benefit the relatives of the selling shareholders who take advantage of section 1042 tax deferral. Vesting is another thing that needs to be considered. Typically there's a three year cliff vesting schedule where you're a hundred percent vested after three years of service or a two to six year graded vesting schedule. There's not too much other than that available. There's distribution rules that are set forth in the ESOP. Typically those distribution rules are extended out over a period of time because the company has to make a market for the company stock when the invested employee leads the company and wants to sell his or her stock back to the company and retire. So that typically the distribution process doesn't start for until the end of the sixth plan year, following the plan year in which the employee terminates, and then could be extended six installment payments over five years after that. That's all part of the design of the ESOP. Other considerations in implementing the ESOP, determine financing needs. Can we get seller financing? Will the seller give the ESOP $10 million of credit if it's $10 million deal? Can we, do we have assets that we can pledge to get outside bank financing? How much equity does the selling shareholder want to sell to these? It's really important that you document a negotiation of the terms of the sale between the independent ERISA fiduciary or trustee, and the selling shareholders, have a written record of that. Make it clear that the negotiations have occurred and the given the take that's occurred. Attorneys typically prepare the transaction documents, the ESOP loan documents, the stock purchase agreement, and then you gotta find a method of communicating all these things to the ESOP participants. I've talked about the valuation standards for ESOP companies, ERISA Section 318 defines that as adequate consideration. The Board of Directors and the trustee of the- or independent fiduciary of the ESOP must know the valuation requirements for fair market value 'cause the board uses that fair market value determination by the trustee, good faith determination based upon an independent appraisal. They use that to report the value to the employees every year. And then on top of that, you have to really have a look at who's gonna actually determine the fair market value in good faith based upon the independent appraisal. Higher ESOP trustee or independent fiduciary that's had substantial experience in doing this before the definition of fair market value is set forth in section 318 of ERISA, and the adequate consideration regulations price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell. And both parties are able, as well as willing to trade and are well-informed about the asset in the market for such asset. Funny thing is, after almost 35 years, the DOL has not finalized their proposed regulations. Recently Congress has demanded that they do that, so we'll see if that happens soon now. Couple of recent developments I wanna share with you before we get close to wrapping up here. ESOPs remain the subject of the Department of Labor's National Enforcement Project and the DOL agency, Employee Benefits Security Administration is fully expected to continue to actively investigate ESOPs regarding valuation issues. This is, I've probably handled 300, 400 of those investigations over the 40 year career and they're very extensive, very detailed, involve a lot of time and money, and it's really quite sad how much time it takes, because most of the time companies are handled their ESOPs quite well. But the DOL has had a be in its bonnet about ESOPs for many years. Former Boston Mayor Marty Walsh, now serves as the Biden Administration Secretary of Labor, he's a strong proponent of labor unions. Having served as an executive for many years of the laborers union. I've to say enforcement activity has not been a priority in light of the Biden administration focus on many other problems right now, but they definitely have a guy who can continue the historical focus on ESOP regulatory efforts in Marty Walsh. I talked earlier about the tax proposals that, are basically, could take away some of the advantage of the stepped up basis on inherited assets. We're not sure if that's gonna happen, so I don't, you know, that's a potential. I will tell you that the tax advantages of Section 1042 transaction remain very valuable. You can do this monetizing process that I haven't really talked about all that much, in which you can monetize in to buy the necessary stocks and bonds or actually bonds to defer your taxes under Section 1042. Typically you can borrow 85% of the purchase price of those bonds. So that essentially if you've got, let's say you do a $10 million deal and you've got $2 million of assets that are readily available to loan from the corporation to the ESOP, the corporation could loan those funds to the ESOP, selling shareholder could take or the ESOP could take those funds and buy the stock from the selling shareholder. Selling shareholder could take that $2 million of initial sale proceeds and buy $10 million worth of qualified to replacement property or floating rate notes, bonds of US corporate bonds of domestic operating companies. And that would defer this sale proceeds on the $10 million sale. Then you could put in place a $10 million note from the corporation to the selling shareholders, which could be paid, let's say over 10 year period of time. So the selling shareholders could get one million dollars of principal each year tax free from the corporation. No tax consequences, no strings attached, invested in whatever you want. Real estate REITs, US municipal securities, limited liability companies, another corporation, so on and so forth. You could even invest it in the corporation that you just sold quite frankly. And that is a really good mechanism for avoiding some of the taxes that are on slide 29 here, which shows some of the aggressive tax positions of recent tax reform proposals by the Biden administration. ESOPs can provide substantial income tax savings to selling shareholders. With a 1042 election, legislation is pending to allow that deferral to occur to be available for selling shareholders to a S corporation ESOP company. These tax savings will increase if President Biden's proposed increase in capital gains taxes are enacted. However, the savings will be negated if the- some of the savings will be negated if the step up in basis at death is eliminated as is currently proposed in the Biden estate tax reforms. Opportunities for planning through tax reform is addressed by- before tax reform is addressed by Congress, appear to be present through probably 2022, then the midterm elections and then may go well into next year, 'cause we may wait and see what happens with the balance of power in Congress. If balance of power stays with the Democrats and as it's likely, you know, if they gain power over the Senate, or they already have power over the Senate, or the Democrats retain power over the Senate, they re maintain power over the house and President Biden remains in place, it may be possible for tax reform to occur next year. So you should seriously consider any sub now rather than down the road when the rules may change in an unfavorable manner. Just a few concluding remarks. If after you carefully consider the thoughts that I've shared with you here today and you think that an ESOP might make sense for a Board of Directors to implement, these are the touchstones I'd leave you with on slide 31. Establish and document procedural prudence in all decisions along the way, whether or not it's corporate decisions or ERISA fiduciary decisions. Educate key decision makers about their corporate and their ERISA fiduciary standards, so I think that's really important. Consult with experts, hire legal accounting, valuation fiduciary, ERISA fiduciary. Hire what you need in order to make sure the transaction's handled in a proper manner. Maintain adequate directors and officers in ERISA fiduciary liability insurance. The plaintiff's bar is very active these days. It's very likely that you will be in a position that, you know, you could have a DOL investigation at some point. You know, 90, 95% of the transactions that occur out there involving ESOPs are, you know, typically not subject to DOL investigations and/or plaintiff's litigation, but when you are subject to those things, having adequate DNO and ERISA fiduciary insurance is important. The typical case that goes to trial involving private plaintiff's class actions and/or Department of Labor investigation and following lawsuit, typically will run minimum of two to 3 million to defend over a period of seven to eight years. So you can get $5 million of insurance and protect yourself against that. Read and understand the ESOP plan documents, the transaction documents, the loan documents, the stock purchase agreement. Don't, you know, you can't go in empty mind or, excuse me, pure heart, empty mind doesn't work, that's been established to be not a standard that works under ESOP transactions. Be careful, ESOPs are not for the faint of heart, but they have a lot of benefits as I've talked about today. I think they're really, they can be really great. You can align the interest of everybody, the selling shareholders, the Board of Directors, the management of the company, the rank and file employees of the company. All can be aligned if an ESOP is properly handled and communicated. And if you create a nice cooperative employee ownership culture, it's amazing what you might be able to accomplish. I've enjoyed speaking with you today. I hope that accomplishes what you wanted. I look forward to my next opportunity to present for Quinn B and I appreciate they're giving me the forum to speak with you today about one of my favorites topics, ESOP formation and related business succession planning. Have a great day. Cheers.

Presenter(s)

DJ
David Johanson
Partner
Hawkins Parnell & Young, LLP

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