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ESOPs as an Alternative Business Succession Structure

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ESOPs as an Alternative Business Succession Structure

In this one-hour CLE course, attorney David Johanson, will provide an overview of employee stock ownership plans (ESOPs) as an option for succession planning. This course will explore best practices for developing ESOPs that maximize the potential in succession planning, benefit the participants, and follow all ERISA requirements. This course will review the best practices of using an ESOP for succession planning and discuss potential traps attorneys should look out for when developing a plan.

Transcript

Good morning or good afternoon if you're on the East Coast or in the middle of the country. I'm doing this this morning from the West Coast, and first time I've done a Happy Halloween ESOP presentation. I'm looking forward to talking with you about ESOPs as an alternative business succession strategy or structure. And if you have questions as you go, certainly, please ask them. We've got a chat box and I'll try to respond to them. I've got the chat box open. My name is Dave Johansen. I'm a senior partner at Hawkins, Parnell, ampersand Young and I have been doing this for not quite 40 years and have accomplished probably close to a thousand ESOP transactions during that period of time. ESOPs are not a panacea for everything that's good in life, but they if they are structured properly and implemented properly and maintained properly, they can add great benefits for selling shareholders, companies and employees. Esop is a tax qualified employee benefit plan. It's not funded through deductions from employee wages. It can be, but it is typically not done that way because that creates a bunch of securities law issues. So typically it's employer tax deductible contributions to the Esop that fund these up. The Esop must be designed to invest primarily in qualified employer securities. Esop trust is the actual legal owner of the shares of company stock. You may hear me refer to it as the Esop. Esos eligible employees and their beneficiaries are the beneficial owners of the company stock. They're not the legal owners of the stock. Trustee has the right to vote the shares and has the right, under certain circumstances to sell the stock, so on and so forth. Just a quick introduction to Suppes, and this surprises me because it hasn't changed much over the years. I've been doing this since the mid 80s. There are approximately 6500 ISPs nationwide. There's only about 10% of those are sponsored by publicly traded companies, according to a study by the NCA. The National Center for Employee Ownership data based on 2020 forms 5500. They're just the reporting forms that are filed with the IRS and Department of Labor about Esops. They basically say there were 13.9 million current and former employees who participated in Esops back then, with a total plan assets of over $1.8 trillion. What the study by the CEO said back then was that there were 225 new Esops created in 2020, covering approximately 41,000 participants. Again, this is just statistics. Data collected from these four form 5500. Form 5500 also is a little bit of a misnomer as well, because it includes certain information that make the Esop financials not look all that well for leveraged new Esop companies. So I wish the government would take some time to change that, but they haven't done so yet. What is an alternative exit strategy? What? What? Excuse me. I'll say that a different way. What alternative exit strategies are available to business owners or a transition of ownership? First of all, you could sell company stock to a buyer. That buyer could be a strategic buyer. A strategic strategic buyer may be someone who really wants to get into your business and sees a strategic benefit for them to do so, such that one plus one equals 3 or 4. And that may be why that strategic buyer is willing to pay that much. Financial buyers. Private equity companies typically are involved in buying stock or assets from an Esop company as well, or from a company as well. That's typically not going to be your highest price. The strategic buyer is. Or you could sell to an Esop trust or an Esop. That's what we're going to be focusing on today is that third alternative. But let's compare. Factors to consider in evaluating alternative exit strategies. Let's compare for a second a sale to a strategic or financial buyer and a sale to an Esop trust or an Esop. The I will tell you that if you're looking to maximize the purchase price. Uh, you can exceed fair market value in a sale to a strategic or financial buyer because of the goals of those buyers. And that tips the balance. That balance at least purchase price in favor of doing a strategic or a transaction, or a financial buyer transaction with a private equity company sale to an Esop trust subject is subject to a number of regulatory limitations, including ERISA and the Adequate Consideration regulations. And you can't pay more than fair market value. That's to protect the employees, the government, the excuse me, the Employee Benefits Security Administration and the US Department of Labor, Secretary of Labor, have been required to propose final regulations dating back to the almost the start of ERISA. They proposed the Secretary of Labor and the Dol proposed adequate consideration regulations back in May of 1988. Where now what is it almost 36 years later, and they haven't finalized those regulations. I question why they haven't. One of the reasons being is that they're there, the regulatory agency that governs Esops. And they essentially whoops, sorry about that program slid. They may not be doing it to have a strategic advantage in their investigations of esops in transactions. Other factors to consider. Let's consider some other factors that may tip the balance in favor of the Esop trust or Esop transaction. Generally, you're taxed if you sell to a strategic or financial buyer. You may be subject to success fees, substantial success fees from a broker or financial advisor, or a investment banker. And the buyer might not want to continue the legacy that you built in your business. Those are some of the negatives that tip the balance in favor of the Esop Trust sale. With an Esop, if it's structured properly. And I'll go over that today during our approximately one hour together, if it's structured properly, you can potentially defer your capital gains taxes on the sale of stock to an Esop trust. You don't have to pay any broker's fees. You may continue on with your company and continue the legacy that you've built. And you also may be able to complete a partial sale consistent with your retirement goals. So you could do 30% up front with a 70% transaction down the road. And you can do it gradually. And that may be something that appeals to a business owner who's built their company over a period of 30 to 40 years, which is typically the types of people that we're working with in these transactions. What are the tax advantages of selling to an Esop? First of all, for a selling shareholder, there's an ability under section 1042, the Internal Revenue Code of 1986 for qualifying sales to a C corporation Esop to be deferred, the capital gains to be deferred. And right now, under current tax law, to make that a complete tax avoidance, if the selling shareholder holds the stocks or bonds they buy in lieu of the company stock that they sold to the Esop with the proceeds from the sale. And they hold those till death. They get a step up in basis and then never pay any taxes on the sale to these up after 2027. There is an election. This election under section 1042 extends to S Corporation Esops, but only up to the extent of 10% of the purchase price. So that's an added tax incentive that's been added recently. These tax incentives that I'm talking about have been in the Internal Revenue Code since 1984, since the time I started working on Esops. And so it's it's interesting to see that they've basically just stayed static and or improved over that over that period of time since 1984, which is almost 40 years. There are substantial tax deductions available to a corporation that sponsors an Esop. Most of the companies that we're working with can create sufficient tax deductible contributions that are contributed to the Esop, that are used to repay debt that's incurred to buy stock from selling shareholders, either external debt or internal debt, and those tax deductible contributions and or dividends. You can use dividend deductible dividends as well are pre tax dollars for the corporation. It can essentially wipe out legitimately the company's taxable income in a particular year. You can do. Up to 25% of eligible compensation. So if you count the compensation base of your employees, let's say you have $10 million of compensation for all your employees who are eligible to participate in the Esop. You could contribute $2.5 million to the Esop that's used to repay the debt that's incurred to buy the stock, and that would be tax deductible by the corporation. You can double that amount in the first year of the operation of the Esop. Also, because there's a leveraged Esop component and a non leveraged up component under section 404 A of the Internal Revenue Code. Furthermore, you can the company can issue tax deductible dividends on the stock that's held by the Esop trust that's purchased with debt. And those dividends can be used to repay the debt. And if they are, those are tax deductible dividends as well. And that's beyond the eligible compensation. On top of that, any interest expense that's incurred in this leveraged Esop can also be contributed to the Esop trust by the plan sponsor and deducted on the plan sponsors corporate tax return. So you can see there's many benefits there. You do have to switch to a C corporation to get some of these benefits, as with the dividends. But a well structured Esop can take into consideration these tax deductible contributions and essentially make it possible to sell your stock to your company's Esop with pre-tax dollars, instead of after tax dollars for the corporation participating employees. They don't have any taxes on their Esop benefits until after their employment ends, and they receive a distribution from the Esop and then the Esop trust. And then they roll that distribution over into an IRA or eligible retirement plan, or they just spend that money during retirement. So it's great for employees as well as it as it relates to tax consequences. What are the other advantages of selling to an Esop? The company's reputations with its with its customers and or the broader market or community may benefit from saying that your employee owned 100% employee owned, or partially employee owned. It may be an employee recruitment and retention benefit. Provision of what may be substantial retirement benefits without deductions from wages is really quite nice for the employees perspective. They still get their regular compensation, wages and benefits and bonuses, and they get this substantial Esop contribution on top of that. And what you're trying to do with an Esop is align the interests of management, the selling shareholders and the employees through employee ownership. And that is a way that you can basically use this Esop concept to align all three interests so that everybody benefits. If the value of the stock rises after you accomplish these up transaction and the profits rise, because those profits can be used in a tax deductible manner to pay off the selling shareholder debt and or outside debt, and also create equity incentives for the employees at the same time. There are. There are also demonstrated studies. The National Center for Employee Ownership has done them. The Esop Association have done them. Rutgers has a number of studies that have shown that the productivity of. Employees of Esop owned companies tend to improve with the creation of an Esop, and cost saving measures are also accomplished. What's a profile of an ideal? Uh, Aesop candidate. And by that I mean corporate. Let's first talk from selling shareholder perspective. Um. There's a desire from the selling shareholder to sell their stock for not more than fair market value, but they can sell for a fair market value and comply with applicable law. And they understand that they're not going to receive strategic value, which would be the highest value. They're seeking the selling shareholders are typically seeking. Um, personal wealth diversification. They want to take some money out of some funds, out of their corporation through the form of an Esop transaction, and diversify that into other areas real estate, treasury bonds, marketable securities, so on and so forth. And that is a typical goal of a selling shareholder in an Esop transaction. Uh, if you'd like to take some value out of the corporation and tax deferred basis, that's something you can do with an Esop. As I've talked about. So that also is a characteristic of a situation in which you typically would see a tax deferred benefit being interesting to a selling shareholder to an Esop trust. Most of the owners that we've worked with over the last 30 to 40 years seek to preserve some form of corporate legacy. They built a company that they really believe in. They really like that company. They like the employees who helped them build the value in that company. They want to reward those employees. And so they create an Esop to share some of the equity of the company with the employees. And finally, you know, if an Esop is handled properly, there's a substantial economic benefit. We've had one closely held company that we've worked with over a period of years that simply did a, A. $10 million transaction. Series of $10 million transactions equal in $10 million about 30 years ago. And during that period of time, they've probably paid out in benefits, economic benefits to departing and retiring employees equal to 15 to $20 million with pre-tax dollars. And so that's been a phenomenally successful example of an Esop on a smaller scale size, but really just phenomenally successful. Let's look at the corporation and employee characteristics as well, because those are important as well. And let's look at what probably makes sense for the profile of an ideal Esop candidate. First, you got to have a sufficient payroll to meet the contribution requirements to pay off the debt that's incurred to buy the stock from the selling shareholders in the first place. That payroll is of the employees who are eligible participants in the Esop. So for example, if you only have five employees, you might not have that much in annual compensation that limits the amount you can. The company can contribute to these trust and use to repay debt that's incurred to buy stock from the selling shareholders. So it's just a rule of thumb, may not be a panacea in all situations, but you probably got to have a minimum of 15 to 20 employees and there's probably no upper limit. But if you have less than ten employees, you're starting to get to the point where the payroll base, the eligible payroll base, is just not sufficient to accomplish a transaction of any size that might help a selling shareholder entice a selling shareholder into create an Esop and selling his or her stock to that Esop. Management depth and established plan for succession is also something that you really want to see with the corporation. Do we have someone other than the founding shareholder or shareholders who can help run the business and establish a plan for business succession at the business? Is there a participatory management environment, or is the management environment restricted to just key employees and not involving other employees in the business? That's also a fact pattern that probably is helpful if it's a participatory management environment instead of a top down kind of an environment. There should be effective communications between employees and management. If you don't have that again, the ESF probably is not going to be well received or well communicated, quite frankly, to the employees. Either an S corporation or a C corporation can be used to implement an Esop. There are some great tax advantages for an S corporation Esop because in theory, an S corporation Esop has an Esop as a shareholder if its Esop trust. If the Esop trust owns 100% of the stock of the corporation of an S corporation, we know that there's no shareholder level tax at the corporation or there's no corporate level tax at the corporation, and there's no shareholder level tax because the shareholder, the trust is tax exempt under section 501 of the Internal Revenue Code. So you can use an S corporation. There are certain tax deferred benefits involving a C corporation that are very attractive, which make a lot of companies consider switching from a S corporation to a C corporation and then switching back after five years, because you have to wait five years and then accomplish a situation where you're in a 100% owned S Corporation Esop situation where you can have that totally tax free environment for the corporation, both at the corporate and the shareholder level that I just described. That was that that's a panacea that we thought would never happen. And I still remember when President Bush signed that law into effect finally, way back when it's been over 22 years. And that is that's really a a valuable opportunity for. Um, companies to get substantial tax benefits involving an Esop. How does a leveraged Esop work? You might ask, and I guess I'll tell you the you can have an outside bank if you want. You don't have to. The selling shareholders can be the outside bank. They can sell. They can basically self-fund this and take a promissory note from the Esop trust as a payment for their stock. Or you can work with a lender. We've recently had a bunch of discussions with SBA, section seven, a lenders in which we've talked about Esop transactions and attempted to obtain financing. You can basically obtain a loan now from a section seven, a SBA lender. That doesn't have to be guaranteed. It's got no personal guarantee required, rather. And that money, for example, you could obtain a $5 million loan loan that money to the company or corporation. The company then loans basically loans that to the Esop trust. Esop trust in arrow to there uses the the loan proceeds to acquire the stock from the selling shareholders and then allocates that stock to the Esop stock accounts over a period of years after the company makes tax deductible contributions to the sub trust in number three there over a period of years, and declares dividends on the Esop trust. Shares of company stock that are held makes those loan payments, and then that releases shares of company stock to be allocated to participants accounts and to be vested over a period of time. Um, you don't have to use a loan. You could just use company resources and make tax deductible contributions to the sub trust and buy the stock from the selling shareholders over a period of time. But if you do have extra cash at the company and or you can generate a section seven, a SBA loan without a guarantee, it's an attractive idea to consider for purposes of setting up your Esop transaction. At the end of the day, how do the employees get anything out of this other than the paper, the stock that's allocated to their accounts over a period of years, and they get vested in by the way they get vested in that stock over a period, typically over a period of 2 to 6 years, 20% after two years, 100% after six years. And the selling, excuse me, the there's also a three year or a two year cliff vesting schedule as well. While you're 0% vested, up to two years of service and 100% vested after two years of service, 0% up to two years and 100% after two years. How do the employees receive anything out of this economically? Well, you could make dividends on the stock. The corporation could declare dividends on the stock to sell by the Esop, and those could be passed through to the employee participants. Or you could at the end of the day, what's the stock is allocated. And it's been vested. And someone leaves either death disability retirement or just they're vested and they want to leave. They could leave. The Esop could distribute cash to them, and they could roll that over to an IRA or spend the money, or they could distribute stock to them. And then the company could buy that stock back from the employees at the current then fair market value of the stock and the same thing. The cash would then be used to transfer to an IRA or a qualified retirement plan, or to spend in retirement years. So that's a basic structure of a leveraged Esop. You could accomplish non leveraged esops, as I indicated, without borrowing money from an outside lender. But this shows you how you can use a chunk of funds from an outside lender to create a larger transaction and more liquidity for the selling shareholders up front, and more equity for the employees up front that's allocated then over a period of years. I talked about code section 1042 earlier in this presentation. That section has been in the code for many years, and it typically has mirroring provisions in state tax laws so that not only can you defer your tax on the gain from the sale of stock to an Esop trust, to the extent that qualified shareholder reinvests in stocks or bonds of other operating domestic operating companies, that's called qualified replacement property or. Within 12 months after the sale or three months before the sale. But you might have a mirror image of this same tax law under state law, so that if there's a state capital gains rate, you get to avoid that or defer that as well. You are the qualified replacement property, which is typically stocks or bonds of US operating companies as a carryover basis from the stock that you sold to the Esop trust in the first place. So typically, most selling shareholders to an Esop trust have very little cash basis in the stock that they own because they created the company many years ago and have just taken money out of the business over a period of years. And there's no real basis in the stock that they own. So. Um, one of the things that President Biden has proposed, which we're a little bit concerned about, is that this step up in basis may be eliminated to the selling shareholders heirs under current tax law proposals. Uh, not under current tax law. Under current tax law, you do get a step up in basis if the QP, the stocks or bonds of US operating companies are transferred to family members and tax free transfers. And then you can. Essentially have the family members get a step up in basis upon death, never have to pay any taxes on the capital gains that were generated from the sale of stock to the Esop many years earlier. This step up in basis is proposed in Presidents Biden, Biden's 2324 budget proposal to be eliminated. Shrp excludes. Us government, municipal securities trust or foreign securities. Mutual funds interests and limited partnerships, real estate investment trusts, passive investments or the stock of an Esop plan sponsor. That said, what you can do is you can monetize into stocks or bonds of US companies if you have approximately 15% of the purchase price necessary to do so, because you can buy floating rate note debt securities, which typically don't fluctuate in value because of the floating rate interest. You can buy those which qualify as QP. You can buy them on margin. You can set it up if you put enough money into buying them with the 15% down payment, so that the interest income generated off of the floating rate notes or bonds. Qp can cover the borrowing costs on the 85% of the money that you borrowed, typically from a brokerage firm, to buy the bonds in the first place. So that that's a neutral position, and then you can take all the rest of the proceeds out of the business through the Esop transaction with tax deferred dollars. A step up in basis and no strings attached like the ones at the bottom of the slide, which excludes things that a lot of people like to buy. So it's really important that you. Excuse me? I hit the wrong button again. It's really important that you work with a qualified financial adviser at one of the independent financial advisor companies to help you structure this and get legal advice as well, or else you won't defer your taxes properly under section 1042 of the code and corresponding state laws. What are the five main characteristics of a code section 1042 tax deferral. First of all, seller must otherwise have long term capital gains without the election, can't have held it for less than a year. The stock must have held the stock for at least three years prior to the sale as well. That's a just a requirement in order to get this tax deferral, because the government doesn't want you to or the Congress doesn't want you to flip these investments quickly, sell to an Esop and then flip them. Stocks sold must be qualified employer securities. Well what's that that's not readily tradable on an established securities market, not the market that you see every day that we see trading and going up and down must be common stock with the best dividend and best voting rights of of or convertible preferred stock that's converted into common stock with those best rates. That's qualifying employer securities of the company that establishes these. Seller also must not have received the stock through some kind of qualified employee benefit plan, a retirement plan exercise of a stock option, or a purchase under an employee stock purchase plan. The seller must acquire the QP, the floating rate notes, or the stock securities within a 15 month period three months before the closing. 12 months following the sale to the Esop trust. And you might wonder why you can do that. But that's you know, they just decided that you can have that window to acquire a 15 months so you can decide what makes sense for you to acquire in terms of stocks or bonds of US operating companies. You just have to characterize them as and target them as such on your tax return. Post-sale. Esop trust also must own at least 30% of the plant sponsors equity on a fully diluted basis. So if you have a bunch of stock options that dilute the equity below 30%, that would be problematic. So you have to be careful there. The election. Under the tax deferred election under section 1042 does create some restrictions under the Esop in terms of what you can do and with respect to allocating company stock that was purchased by the Esop trust to family members or Esop sellers who continue employment with the Esop plan sponsor after you do the transaction. The impact of this restriction is particularly important now that the stepped up basis at death. That is key to 1042. Section 1042 plan may be at risk. And tax reform. There's a 50% excise tax on the plan sponsor. If you allocate stock sold to the Esop trust in a 1042 transaction during the ten year period of time to the selling shareholder who makes the election under section 1042 to lineal family members, parents, grandparents, children, grandchildren of the family, member of the selling shareholder, or any person who owns more than 25% of the company's stock as of the date of the sale to the Esop trust. All of these are restrictions and. These restrictions are important now that you may lose the step up in basis, because not only is the government preventing you from getting the step up, step up in basis and transferring that wealth to your family at the end of your life, but they're also saying, oh, you can't allocate the stock in the Esop transaction to your family members, except in a very limited degree, 5% to children or grandchildren in the aggregate. So it is pretty restricting, but it also has some great tax benefits. Let's look at. A couple of examples here of the potential tax benefits. And again you know you can use any transaction amount you want. But let's say that well let's focus on this for a minute. Right now the current tax rate level for marginal tax rate, the last dollar that you pay taxes on is 37%. The proposed adjusted level under the Biden proposal is 39.6%. Long term capital gains are currently 20%. Right now. Um. And. It's there are restrictions for people earning more than $1 million in taxable income. The proposed adjustment is 39.6. Again, the corporate income tax rate right now is 21%. The proposed adjustment under the Biden proposals is 28%. The top estate and gift tax rate now is 40%. It's proposed to be 45% under the new Biden proposals. Also, there's an exemption under the tax, estate and gift tax laws that exempts, right now, 11, almost 11.6 million for individuals and 23.6 million for couples. So if you have under those levels of assets, you can transfer your assets to your heirs without any tax. The estate and gift tax consequences on a federal level, the limits are being proposed to be reduced to 5.5 million for individuals and approximately 11 million for couples. And again, as I indicated, President Biden has proposed no step up in basis on inherited assets, which will affect virtually everybody in our our country. There are a lot of people in our country. And the transfer of wealth from one generation to the next. Um, an illustrative example of comparison of stock transactions involving sale to a strategic or financial advisor compared to a c-corporation Esop transaction, I think would be helpful right here. And we'll do it. We'll do it. We'll do two types of c-corporation transactions, one with a stock redemption, the other with a Esop stock, Esop trust stock acquisition with a ten 1042 section 1042 election tax deferral election. The let's say, the hypothetical purchase price under all three of these ideas. Strategic financial Buyer C Corporation C Corporation Esop trust transaction is all $10,000,010 million. There's no federal tax savings for the the seller in the strategic financial buyer transaction. There's no federal tax savings to the seller in a corporate stock redemption. There are in this situation roughly $2.38 million under current tax law, tax savings. If the selling shareholder elects to defer their taxes by buying stocks or bonds of US companies within the 15 month window for at least $10 million. The net cost to the company. Unless structured as a leveraged buyout would be zero. With a strategic financial buyer and that cost to the company of redeeming $10 million of stock from a selling shareholder without. 1042 would be 10 million. Whereas the net cost to the company, after factoring in Esop tax deductions is, can be approximately 7.6 million in an S Corporation Esop situation. Federal tax consequences to the selling shareholders in the strategic financial buyer transaction and a corporate stock redemption transaction would be about $2.4 million. There's zero with the code. Section 1042 tax deferral election. Net proceeds retained by the seller. Um, in a. In a strategic financial buyer transaction would be about 7.6 million. Same with a C Corp stock redemption, whereas they'd be $8.5 million after a tax deferred Esop transaction involving at 1042 election. And that also neglects to state however, that slide that you've got the 1.5 million that's invested in the QP. So you really get the full $10 million out in an Esop owned C Corporation Esop transaction. This table assumes federal tax laws and does not. And they won't change. It does not include any state taxes, which may vary. You know some states California the marginal tax rate is 13.3%. I think it's pretty high in New York as well. In some states it's only 5%. But that has to be factored into your analysis and deciding which type of transaction makes sense to you to structure. Continuing a little bit on this. The use of $10 million of pre-tax profits to finance the purchase of equity from a selling shareholders is is really attractive to a corporation because it doesn't have to pay taxes on the profits that it earns in order to buy that stock from the selling shareholders. The Esop is a vehicle that creates a substantial number of future tax deductions as well. Equity incentives to employees are inherent within the sub structure and business succession. It can be accomplished with an Esop trust transaction. With an Esop trust transaction, you could have, you know, you could have selling shareholder be owed $10 million on a promissory note or excuse me these trusts widow $10 million on an Esop promissory note to the company. And they'd also have own 100% of the issued outstanding shares of company stock. That's a net net as the company makes tax deductible contributions to the Esop. To repay that note, the value it creates to the Esop and the Esop, net equity value increases and the value of the stock held by the employees as beneficial owners increases. With the selling shareholder, you get $10 million worth of gross proceeds from the sale to the Esop trust. You may be able to negotiate warrants in connection with financing. If you don't use an outside lender, you've got to be careful there to make sure that that's examined. To be fair, from a financial point of view for the company itself. And for the rather and without a code section 1042 election, you're going to have $2.3 million, almost $2.4 million of transaction. But as I showed in the prior slide, the benefits with a code section 1042 election are basically keeping the entire $10 million of QP and 8.5 million of net stock sale proceeds. The 10 million of QP is offset by the 8.5 million of borrowing costs to achieve that 10.10 million of QP. But the net is you get $10 million of assets. In this situation, you can potentially pass that $10 million plus appreciation onto your heirs at a stepped up basis upon death, unless the stepped up basis is eliminated or materially modified in the current Biden tax proposals. Seller financing is also another way to think about some potential favorable tax consequences. You could report the sale. Let's say you did a corporate tax redemption and you didn't, or you did an Esop trust transaction and you didn't defer your taxes. Under section 1042, you could report your gain as an installment sale. That's the default method under code section 453 of the Internal Revenue Code. Each payment on the loan is included in income. A portion of each payment would be treated as income each year based upon the receipt of the proceeds and. The seller can opt out of installment reporting on schedule D and pay taxes on the entire gain up front. So if you think we're going to go from a lower tax environment to a higher tax environment, which I think most people are estimating right now, you could you could sell to an Esop for $10 million, pay taxes at today's dollars, $2.38 million or $2.4 million, and the tax rates go up to 39%. It's a win for you. And then remember, you've got the current state tax rates as well. There's a $5 million caveat with these installment sales under code section 453. Because each spouse may only hold a $5 million note before the tax based on the deferral value of the payment is taxed. So you get a eventually. There's this odd reporting that results in you losing the benefit of installment sale reporting under code section 453, losing that benefit of deferring the gain over that period of years of the promissory note. If the value of the notes between the two spouses is at least $10 million. One of the other things you can think about is you could do a code section 1042 election for a portion of the sale proceeds from the Esop trust, and you could do a partial installment sale reporting as well. Under code section 453. However, the installment sale taxes will be based on the entire selling proceeds under that situation. Another factor that we should consider in thinking about an Esop trust sale is who's who's on the implementation and transaction team. For the company. The decision maker is typically the board of directors. For the selling shareholders. It's the selling shareholders, obviously, or their personal trusts or representatives for the Esop trust. It's usually an independent trustee or or independent fiduciary. I would strongly advise you not to self trustee an Esop transaction, because there are substantial conflicts of interest that are involved in that, and it's just hard to show that you're totally independent in that kind of a transaction. So hiring an outside independent third party is advisable for that reason. Financial advisors. You typically going to have an investment banker for the company or a CPA for the sellers. You might have a financial adviser, an independent appraiser as well, or and a CPA for the Esop. You got to have an independent appraiser and financial advisor. If you don't, your transaction isn't going to pass muster under law because the independent trustee has to determine in good faith, the fair market value of stock based upon an independent appraisal of the company. And that's where all the action is when it comes to investigations of esops and potential litigation involving Esops. For the company, you're typically going to want to have corporate legal counsel involved. We played that role many times. The selling shareholders, you may want to hire somebody to represent yourself for the Esop trust. You typically would want to have independent legal counsel. It's not required but it's highly advisable. And then you may have a bank officer an Esop third party record keeper involved. What we like to see happen at the outset of most of these transactions is some form of feasibility study. Based that is typically based on corporate, historical and projected financial information, and you make certain assumptions about employee demographics and other variables. And you might want to model model one, two, or three different Esop transaction structures, evaluate the impact of costs, tax deductions, potential downsizing scenarios. After these UPS implemented. Just be careful to make sure you think about all potential ideas. And typically that's done at the company level. But it can be done at the self level as well. You've got to have a design, the plan, you have to have a trustee for the Esop or independent fiduciary, typically up legal counsel, and any independent appraiser who's independent of all parties to the transaction. As we approach the next 10 or 15 minutes, which will be the end of my presentation, I'm going to jump through these slides a little bit faster so I get through the entire deck. How do you implement an Esop? You need to determine your financing needs. Do you need a bank? Do you need mezzanine financing? Sub debt player? Are you going to use seller financing? Can you use a combination of all? What equity percentage does the selling shareholder want to sell to the sub trust? Esop advisors, meaning the trustee, the independent appraiser and the legal counsel should undertake comprehensive due diligence review of the company before you accomplish a transaction. Primarily, these are remote interviews and electronic data rooms post-Covid, but they can be in-person still. It depends on what's necessary under the circumstances. Esop trustee and the selling shareholders typically negotiate the terms of the sale, including any post transaction equity incentives for management, which should be determined to be reasonable under the circumstances. Attorneys for the corporation and the selling shareholders typically prepare the transaction documents. Then after the deal closes, you hopefully have a party and celebrate communications with employees about becoming employee owners. Valuation standards for Esop companies are very strict. I've talked already about the adequate consideration rules under section 318 of ERISA and the Adequate Consideration Regulations. The board of directors and the trustee or independent fiduciary should know the valuation requirements for fair market value before they do an Esop transaction, because this highly regulated concept and they're got the definition of fair market value, the 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. Talked about the prior adequate consideration regulations. The Dol has been directed under Secure act Secure 2.0 act to issue new regulations. The Dol committed to doing so in a letter to the Esop Association on April 12th of this year. 2023. Esop trustee is responsible the ultimate responsible party, for determining fair market value in good faith based upon an independent appraisal that said buyer should beware here, the selling shareholders should not get involved in that process, but they should make sure that they're comfortable with how that value is being determined, not interfere with the Esop trustees that have their own independent evaluation of that, because they can be what's known as knowing participants in. In an Esop prohibited transaction under ERISA, and that's just as bad as being the trustee who has to make the determination and makes a wrong determination because there's personal, at risk liability for doing so. There's continuing scrutiny involving. He's is helped by the US Department of Labor. Ebsa the Employee Benefits Security Administration. The doll remains slow in policy development efforts and the Senate confirmation of Julie Sue, which just occurred. I believe the nominee for Secretary of Labor did remain before the Senate Health, education, Labor and Pensions Committee, but I think that just came out here recently. There is an incentive or a to establish Esops under the new Secure act 2.0 Secure act. The Dol must promote employee ownership and employee participation in decision making process. This is according to that act. There is an increasing focus by the IRS on tax compliance of Esops. We don't see that as often as the Dol investigations, but we certainly do see it. The IRS announced on August 9th of 2023 that it planned on increasing the scrutiny of Esops and Esop transactions due to the complexity of Esops. As if you want to copy this presentation, you can get it and you can get some of the links that are included in this. The secured 2.0 act directs the IRS to expand. Also, the Employee Plans Correction Resolution system, which EPCs will cover additional corrections and common plan failures involving an Esop. Funding for Esop loans. I've already mentioned this, which I'm actually am quite excited about this. It's not going to work in every transaction, but it's certainly going to be available in some situations. The Small Business Administration SBA has eased the requirements for Esop loans under the SBA's section seven A program. In April and May of this year, 2023, they eliminated the requirement of a 10% equity infusion as a loan condition. Personal guarantees will only be required if the Esop trust acquires less than a controlling interest, so less than 50% or 51% rather. And companies may apply directly with seven eight lenders instead of solely through the SBA. So that eliminates a bunch of red tape. That's, to me, a really fabulous thing that happened in the secured 2.0 act and with these sub transactions. And that was in April and May of this year. Actually, the Employee Equity Investment Act s Senate 1618 was introduced in Congress in May of 2023 as well. Hopefully, we're going to now see Congress do some things again. Although the politics of Congress is is maddening to all of us, quite frankly, from all sides of the fence. The if enacted, this s 1618 would allow the SBA to provide up to 5 billion in loan guarantees for qualifying employee equity investment companies under the SBA Small Business Investment Company Program. I know some of the people who are involved in working on this. Dick May, for example, is one of them, Chris Mack, and they're they're devotees of Aesop's dating back for the last four decades as well. And I'm really eager to see how this pans out. And if it helps companies do more Esop transactions because. Essentially we've got more money available to do deals with. So that's exciting. Those are two really exciting legislative developments involving Esops. Oops, sorry. It's not cooperating here. Esops can provide substantial and significant income tax savings to selling shareholders in connection with an election under code section 1042. These tax savings will increase if the provision in President Biden's tax reform proposal in fiscal year 2024 budget that increased capital gains taxes are enacted. We go from 23.8% to 39%. That's just multiplies the tax savings that I've described to you in my presentation today. And also, however, the tax savings will be negated a little bit if the stepped up basis is in. Death is eliminated, as is proposed in the current Biden tax reform proposal in the fiscal year 2024 budget. So we're just going to have to wait and see. It's hard to see any legislation getting passed of any kind right now, given the. Extremely unfortunate circumstances for the world and Israel and and the Gaza Strip. Our our hearts go out to those people right now, quite frankly, from all sides. It's just terrible what's happening. And we wish everyone well. Um, so it's hard to see with the Ukraine war, the war that's going on in Israel and the Gaza Strip. Um, I'm just concerned that we won't. And politics in general, in an election year coming up, it's hard for me to see that any of this, the tax increases will happen or the tax elimination of tax benefits will happen. So stay tuned quite frankly. So I'd like to just wrap up now in the last 3 to 4 minutes, um, with a few concluding remarks, I think again, buyer beware. Careful analysis is required. Company's board of directors should decide whether or not to implement an Esop. Selling shareholders should have their own independent counsel in that respect and decide how they should proceed. But basically. You have to establish and document procedural prudence in all decisions that are made, even if you're not a fiduciary. So I would say if you're a member of the company's board of directors and you're only responsible, fiduciary responsibility is selecting the trustee who basically will decide what. Um, is done in terms of setting up these up and purchasing company stock on behalf of these up trust. You're you're a fiduciary there as a director. You've got personal liability there. You've got a limited monitoring, fiduciary responsibility. But even if you're not making those decisions, you should you should follow procedural prudence in all decisions involving setting up these up and accomplishing a transaction involving these sub trusts, you should educate key decision makers with respect to their corporate and ERISA fiduciary standards. So their their directors have both corporate fiduciary standards which are reasonable business judgment rule. And they also have a risk of fiduciary standards which are are much less onerous or much more onerous than corporate, the reasonable business standard that's set forth in every statute in this country for corporations. You should consult with experts at every step of the way. Legal, accounting, valuation, fiduciary as needed. All sides of the transaction should have these types of experts the company, the selling shareholders, certainly the sub trust. And at a minimum, you need an independent fiduciary or trustee for the sub trust, a independent appraiser and a. Legal counsel. That's what I strongly recommend. Also maintain adequate directors and officers and ERISA fiduciary liability insurance. I see far too many situations in which companies establish large Esop transactions, and they don't have any ERISA fiduciary liability insurance or officers and directors insurance. And, you know, if you do a if you do a $100 million transaction or $200 million transaction, and you have only $1 million of ERISA fiduciary liability insurance for directors and officers and the Esop trustee, it doesn't make sense to me, quite frankly, because you can easily help defend any kind of spurious litigation, which is the typical kind that that is involved with an Esop. You should also read and understand the Esop plan documents, the the trust agreement, the the Esop plan document, the Esop Stock Purchase Agreement, these Up loan agreements, the corporate financing documents. If you're a corporate director or an ERISA fiduciary, you should read and understand all of those. If you don't understand them, ask questions I. Um. I think there's a there's a rule in the Donovan versus Bierwirth case, which dates back almost four decades. It basically said empty head, pure heart is not a standard that satisfies your ERISA fiduciary responsibilities. So be careful. Buyer beware. That said, all in all, I think these remains one of the best business succession planning concepts available from a tax and financial incentive, and from rewarding employees and selling shareholders and companies with benefits. So I've really enjoyed this opportunity to speak with you today. Appreciate the opportunity. I don't see any open questions at all at this point. So at this point I'm going to end the sharing of the PowerPoint, and I really appreciate the opportunity to speak with you today about one of my favorite topics. After all these years, I've been involved for almost 40 years. I've created a lot of esops, I've defended a lot of Esops and a lot of fiduciaries who created Esops and Esop transactions, and proud of what I've done in that period of time and and enjoyed speaking with you today. Have a nice day. Thank you. And have a great Halloween.

Presenter(s)

DJ
David Johanson
Partner
Hawkins Parnell & Young, LLP

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