Employee Stock Ownership Plans ESOPs 101

Transcription

1 Employee Stock Ownership Plans ESOPs 101 Presented by: Daniel M. Zugell, CLU, ChFC, LUTCF Senior Vice President B T A I N C.

2 VALUE PROPOSITION What if your clients were able to Sell all or a portion of their company to a ready and willing buyer at full Fair Market Value Indefinitely Defer all capital gains taxes Leave behind a completely Tax-Exempt company to the next generation

3 BTA S EXPERIENCE Providing services in all 50 states Drawing on over 100 years of combined team experience In the last 5 years BTA has worked with: 25,345 employees 882 stockholders Market values of over $3.8 BILLION DOLLARS!

4 WHAT IS AN ESOP? Employee Stock Ownership Plan A tax qualified defined contribution employee retirement plan Overseen by the IRS and the Department of Labor like 401(k) plans Qualified Plan under IRC Sections 401(a) and 4975(e)(7) Unlike other qualified plans, an ESOP must invest primarily in stock of the sponsoring company

5 MAJOR TAX INCENTIVES 1. Indefinite Deferral/Elimination of capital gains taxes normally due on a sale of a business 2. Dollar for dollar corporate deduction on every dollars worth of stock sold to the ESOP 3. Profits of an ESOP company may become 100% federal and state income tax exempt 4. Significant estate planning transfer discounts

6 $20,000,000 VALUE Management Buy-Out/ Corporate Redemption $33,332,000 Earnings Required ($13,332,000) Corporate Tax $20,000,000 ($5,840,000) Capital Gains Tax $14,160,000 Net to Seller $19,172,000 Taxes Paid ESOP $20,000,000 Earnings Required $20,000,000 Deduction - $0 Corporate Tax - $0 Capital Gains Tax $20,000,000 Net to Seller $0 Taxes Paid Assuming 40% Combined Federal & State Tax Rate Assuming 29.2% Combined Federal & State Capital Gains Tax Rate

7 ESOP CANDIDATE PROFILE Owner wishing to cash out all or portion of business Payroll of $1,000,000 or greater Strong succession management $5,000,000 or more business value 20 + Employees

8 ESOP Basic Structure ESOP borrows money from bank and/or seller note The ESOP uses the borrowed funds to purchase stock from sellers Company makes annual tax-deductible contributions to the ESOP ESOP uses contributions to repay debt Employees are allocated shares over a year period Employees cash out stock balance when employment ends Company must make market for exiting employees stock

9 STEP 1 HOW AN ESOP WORKS ADOPTS Company ESOP Trust

10 STEP 2 HOW AN ESOP WORKS LOAN LOAN Lender Company ESOP Trust

11 STEP 3 HOW AN ESOP WORKS LOAN LOAN Lender Company ESOP Trust CASH STOCK CASH (C Corp) IRC 1042 Selling Shareholder

12 STEP 4 HOW AN ESOP WORKS Lender LOAN PAYMENT Company LOAN PAYMENT CASH ESOP Trust CASH STOCK Selling Shareholder

13 STEP 5 HOW AN ESOP WORKS Lender LOAN PAYMENT Company LOAN PAYMENT CASH ESOP Trust BENEFICIAL OWNERSHIP CASH STOC K EMPLOYEES Employees Selling Shareholder

14 STEP 6 HOW AN ESOP WORKS Lender LOAN PAYMENT Company LOAN PAYMENT CASH ESOP Trust CASH INTEREST CASH STOCK Death, Disability, Retirement, Termination, Diversification EMPLOYEES Sinking Fund Employees Selling Shareholder

15 IRC 1042 Selling shareholder may elect to indefinitely defer federal capital gains on sale proceeds regardless of basis Similar to real estate provision IRC 1031 and life insurance IRC 1035 Must reinvest proceeds into Qualified Replacement Property (U.S. stocks and bonds) Special ESOP financial vehicles are available to facilitate deferral and access to cash

16 100% S CORP ESOP Profits are NOT subject to Federal or State corporate income tax to the extent ESOP ownership Taxation is passed through to shareholders in proportion to ownership An ESOP is tax exempt, therefore no tax is paid on percentage owned by the ESOP Corporation does not have to distribute income

17 TAXATION OF S CORPORATIONS Before ESOP The Company CPA Prepares Form K-1 K-1 Goes to the Owner The Shareholder Files 1040 Pays Tax

18 TAXATION OF S CORPORATIONS After Sale to ESOP The Company CPA Prepares Form K-1 K-1 Goes to the Owner ESOP Shareholder Files 5500 Pays NO Tax Note: No distributions needed, cash stays in the company

19 TAXATION COMPARISON Pre-ESOP Post-ESOP (100% S Corp Sale) Company Value 20,000,000 Company Value 20,000,000 Taxable Income 4,000,000 Taxable Income 4,000,000 Taxable Income 15 Years 60,000,000 Taxable Income 15 Years 60,000,000 Taxes (40% Fed/State) (24,000,000) Taxes (40% Fed/State) (0) After Tax Cash Flow $36,000,000 After Tax Cash Flow $60,000,000 ESOP tax savings = $24,000,000 Tax savings usually cover the entire stock sale

20 CORPORATE GOVERNANCE Shareholders elect the Board of Directors Board of Directors appoints the Officers Officers responsible for day-to-day operations

21 BOARD OF DIRECTORS Appoints Current Owner Votes Board of Directors Directed Trustee

22 FINANCING THE SALE Bank financing Seller financing Combination of bank and seller financing Significant incentives for seller

23 FINANCING STRUCTURE Need to finance 100% % L E N D 2-3 X E B I T D A 3-5 % S U B O R D I N A T E D L E N D E R ( M e z z a n i n e ) S E N I O R B A N K D E B T % % T O T A L E Q U I T Y

24 RECOMMENDED STRUCTURE BTA often recommends the seller take a note for everything above senior debt Seller is entitled to a Market Rate of Interest Market Rate of Interest is NOT what the senior lender (bank) is charging Market Rate IS what a secondary lender (mezzanine) would have charged to lend money in the same subordinated position

25 CONSIDERATIONS Generally, senior lender does not allow the seller to have a higher rate of interest than the bank Corporate cash flow may suffer if required to pay actual market rate of 10%-12% Seller pays hefty ordinary income tax on interest In lieu of current market rate of interest, seller may take a lower rate (3%-5%) plus a substantial future equity stake of the Company (25%-40%)

26 RECOMMENDED STRUCTURE B L E N D E D M A R K E T R A T E S E L L E R T O A C C E P T % 3-5 % P l u s W a r r a n t s S E L L E R N O T E % T O T A L E Q U I T Y L E N D 2-3 X E B I T D A 3-5 % S E N I O R B A N K D E B T % T O T A L E Q U I T Y

27 TOTAL OUTCOME EXAMPLE Company Value $20,000,000 Bank Down Payment 8,000,000 Seller Note - Principal 12,000,000 Seller Note 4.5% Interest 4,524,000 Warrants (25%) * 7,790,000 Approx. Total Proceeds $32,314,000 *Assumes company value grows at 3% annually over 15 years

28 WARRANTS: $20M EXAMPLE If the Company only pays off its debt and doesn t grow at all, the value should return to $20,000,000 Warrants exercise price is very minimal The additional net value of the warrants (35%) of the company would be worth approximately $6,650,000 If the company grows to $30,000,000, the net warrant proceeds would be $10,150,000 Upside potential is un-capped Paid in addition to $20,000,000 sale price plus interest

29 POSSIBLE OUTCOME SUMMARY Retain control indefinitely Salary/Healthcare/Phone/Clubs/Car/Board Fees ESOP Participation Estate planning/charitable gift/transfer benefits Company s profits become income tax-free

30 ESTATE PLANNING OPPORTUNITIES Warrants are generally worth little at issuance Warrants can be transferred to the next generation with little or no estate or gift tax consequences Seller subordinated note is also subject to significant discounting for estate/gift tax purposes Use of GRATs, GRUTs CRTs or IDITs may reduce the value to near zero for estate and gift tax purposes

31 PLANNING NEEDS

32 CROSS DISCIPLINARY ASSET MANAGEMENT Mandatory reinvestment of sale proceeds into U.S. Securities within 12 mos. to maintain IRC 1042 tax deferral S E L L E R 401(k) takeover while re-structuring N O T E qualified plans to include ESOP EE rollovers from ESOP to IRAs Estate Planning/FLP/Gifting S E N I O R NQDC/Equalization for Aineligible N K D E family B T Sinking fund to pre-finance mandatory buy back of participant shares

33 CROSS DISCIPLINARY INSURANCE Life insurance on seller who S E Lalso L E R guaranteed loan; death benefit assigned to lender Nfor O duration T E of loan Potential institutional grade life insurance to pre-finance mandatory buy back of exiting participant shares Buy-Sell financing for death S E Nand I Odisability R on non-esop shares A N K D E B T Estate tax neutralization policies

34 CROSS DISCIPLINARY Bankers, Accountants, Attorneys, Financial Advisors, Valuators Generally, the acquireds corporate advisors are replaced by the acquirers corporate advisors S E L L E R An ESOP does not involve Noutside O T E interests Generally, a sale to an ESOP retains all current corporate advisors Additionally, the ESOP becomes S E N I O Ra client requiring substantial initial and ongoing services A N K D E B T Good for the economic fabric of the community

35 CROSS DISCIPLINARY BANKING Retail Banking Retain/strengthen retail S Eclient L L E R with ESOP N O T E Lose retail client (checking, bus. services) if sold Lose EE deposit accts and loans to EEs Commercial Lending S E N I O R Significant lending opportunity of ESOP purchase price A N K D E B T Lose existing loans/locs if sold Lose future loans if sold

36 Case Study #1

37 BACKGROUND Electrical & Civil Contractor S Corporation with approximately 300 employees Company value $56,000, shareholders, several family members involved in the business

38 GOAL Founder and shareholder with more than 50% ownership looking for an exit strategy Also looking for liquidity and a tax effective way of passing control to family members Interested in retaining & motivating existing employees while having a tool to attract new employees

39 SOLUTION Establish an ESOP All shareholders will sell 100% of their stock to the ESOP In exchange for selling stock sellers will receive cash and notes Company will borrow $12,200,000 in senior debt to fund the payoff of shareholder s Accumulated Adjustment Account balances and the remainder will be used towards the stock sale

40 BENEFIT TO CLIENT Owners received $9,600,000 cash at closing for payoff of AAA notes and stock sale down payment Some shareholders were cashed out entirely, others received cash and seller notes 15 year seller notes totaling $44,500,000 at a 4.5% interest rate (life of loan interest = approx. $13mm)

41 BENEFIT TO CLIENT Shareholders received 1,500,000 warrants to divide between seller note holders At the end of the seller note period the projected value of warrants is estimated to be $40,000,000 As a 100% S Corp ESOP owned company, 100% of future profit will not be taxed from that point forward Over the next 15 years the corporate tax savings are estimated to be over $67,000,000

42 BENEFIT TO ADVISOR Asset management of proceeds: $107,100,000 Insurance sales: $3,750,000 annual premium Repurchase Obligation ILIT (Second to Die) Key Person SARS/Phantom pre-funding

43 Case Study #2

44 BACKGROUND Engineering Company in AZ Long time full service bank customer S Corporation $14,500,000 business value 25 employees w/ 1.5MM payroll 64 year old owner in fair health Key manager willing to run business but cannot afford to buy it outright

45 GOAL Begin transition of ownership to key executive immediately (chips off the table) Transition control to key executive within 5 years Gain estate liquidity Reward long-term employees Secure business continuation Reduce taxes when possible

46 SOLUTION Implement ESOP for 95% of shares Sell 5% to key exec w/in 5 yrs. or death Borrow $3,000,000 from bank as senior 5 yr. debt at 4.0% ($13,5mm offered by bank) Seller finance $10,775,000 (balance) as subordinate 10 yr. debt payable at 4.0% but effective mezz. rate of 16.2% Additional payment is made for difference when loan is paid off in the form of warrants

47 BENEFIT TO CLIENT Estimated corporate tax savings of over $17,032,000 over next 10 years Employees receive significant additional retirement benefits Owner received immediate cash of $3,000,000 and notes totaling $10,300,000 over 10 years ($13,300,000) Seller gets an additional $7,500,000 in 10 years when warrants are exercised

48 BENEFIT TO ADVISORS Bank Loan: $3,000,000 ESOP loan (could have been up to $13,355,000) Asset Management: Immediate $3,000,000 assets under management Future $10,355,000 plus interest of assets to manage from seller note over next 10 yrs Estimated additional $7,500,000 to manage in 10 years from warrant proceeds

49 BENEFIT TO ADVISORS Insurance Sales $250,000 annual premium into corporate owned life ins to pre-finance repurchase obligation $50,000 annual premium for new manager/key person after one year of service Discussions regarding joint & survivor life insurance to be placed into Irrevocable Trust for Estate planning purposes

50 PROCESS STEPS 1. Complimentary client ESOP Complimentary ESOP financial review (3 years of income statements, balance sheets and fact finder) 3. Preliminary Valuation/Preliminary Analysis 4. Feasibility Study 5. Implementation

51 Daniel M. Zugell Senior Vice President Phone (724) Website