The New England Chapter 2016 Annual Fall Conference

Transcription

1 The New England Chapter 2016 Annual Fall Conference October 6-7, 2016 Portland, Maine Barbara Clough, QPA, QKA Director Newport Group Joseph Marx, CPA Vice President - Consulting Principal

2 Managing distributions and the related repurchase obligation is one of the challenges for long-term ESOP sustainability It is important to develop a strategy for how the company will meet its repurchase obligations Implications of your plan provisions, loan amortization schedule, distribution policy, share repurchase methodology, and funding sources for the ESOP need to be understood Employee benefit levels will also be affected by the choices you make 2

3 Distribution strategies and their impact on repurchase obligation, benefit levels and share value Distribution policy choices Share repurchase strategies Redeeming vs. Recycling Releveraging Benefit level Funding the ESOP 3

4 When are shares repurchased - distribution policy Delay vs. immediate Up to six year wait for start of repurchases from terminated employees Up to one year wait for start of repurchases from death, disability and retirement Lump-sum vs. installments Up to five years for all participants, with longer periods for larger account balances Segregation/reshuffling Immediate exchange of shares for cash, same impact as lump-sum with no delay 4

5 Plan document may allow earlier distribution if vested account balance is under $5,000 Under $1,000 cash less withholding $1,000 to $5,000 can be automatically rolled over Participants with account balances exceeding $1,050,000 One additional year for each $200,000 excess 5

6 The timing and form in which distributions are paid have consequences which need to be weighed when making decisions about distribution policy Many plan sponsors who pay in installments consider having minimum installment payments 6

7 Delayed distributions and installment payments More level cash requirements from year-to-year More predictable cash requirements Additional time for repurchase planning Slows down future repurchase obligations* More level benefit to participants* In periods of rising share value, participants distributions will be larger Terminated accounts will receive dividends on remaining stock * Shares are reallocated more slowly 7

8 Immediate lump-sum distributions Locks in account value at termination Terminated participants do not receive dividends Shares are held primarily by active participants Variable cash requirements from year-to-year Less predictable cash requirements Less time for repurchase planning Accelerated future repurchase obligations* Potential uneven benefit to participants* * Shares are reallocated right away 8

9 Best practice is to have statutory distribution requirements, i.e. no later than language in plan document Typically, if plan document has more liberal provisions; it can be difficult to amend May need to grandfather anyone employed when amendment occurs Distribution policy allows some flexibility relative to timing and manner of payments The distribution policy selected may impact share value based on the implied benefit levels and year-to-year variability in cash requirements 9

10 Conversion of terminated balances from stock to cash The total account balance is typically converted in the year after termination (provided plan has sufficient cash) Terminated participants do not benefit from increases in stock value or dividends Shares to new/active participants sooner It is important to keep in mind that this strategy, from a cash flow perspective, could be the same as paying immediate lump-sum distributions* * Note that accounts can also be converted over a period of years, depending on available cash in the plan 10

11 Transfer of investments to provide each participant with same proportion of employer securities Each year, plan accounts are rebalanced so each participant has the same percentage of his/her account investment in employer stock and other investments i.e. all participants have 80% stock and 20% cash 11

12 Rebalancing can be used when shares are recycled or plan has accumulated cash Helps alleviate Have vs. Have Nots Rebalancing takes stock from the long-term participants (the Haves ) for the benefit of new participants (the Have Nots ) Can be a tool to help avoid Code Section 409(p) failures Provides some diversification for all participants 12

13 Redeeming vs. recycling Releveraging 13

14 A company can alternate between recycling and redeeming from year-to-year Redeeming and recycling can also be combined Redeem all shares, then contribute stock equal to a target benefit level Contribute cash equal to a target benefit level, use the cash to recycle shares, and redeem any additional shares S distributions or dividends can also provide a source of cash for recycling; however, they are allocated differently than contributions 14

15 Some companies adopt a full or partial redemption strategy To reduce the future repurchase obligation To control the benefit level received by participants 15

16 Handling repurchase obligations with redemptions can have unintended consequences ESOP owns fewer shares, but cost of repurchasing shares may be higher* Communicating the connection between performance and value per share can become an issue* If the ESOP loan is repaid and the company does not plan to recontribute stock to the plan: Existing participants will not receive additional shares New participants do not receive a benefit from the ESOP * Value per share may rise faster than aggregate equity value 16

17 Redemption Year 1 Year 2 Year 3 Company Value $100 $105 $109 Shares Outstanding Price per Share $1.00 $1.10 $1.21 Redemption - 5 Shares $5.00 $5.50 $6.05 Ending Company Value $95 $99 $103 Ending Shares Outstanding Ending Price per Share $1.00 $1.10 $1.21 Recirculation Year 1 Year 2 Year 3 Company Value $100 $105 $109 Shares Outstanding Price per Share $1.00 $1.05 $1.09 Recycle - 5 Shares $5.00 $5.23 $5.46 Ending Company Value $95 $99 $104 Ending Shares Outstanding Ending Price per Share $0.95 $0.99 $1.04 Assumes 10% annual Company Growth 17

18 The ESOP s leveraged purchase of shares that have previously been distributed from the ESOP Purchase is financed with a loan from the company to the ESOP typically with a long amortization schedule Shares are placed in loan suspense and released over time as contributions are used to amortize the loan Advantages: Creates a source of shares to be allocated over a period of time Avoids anti-dilutive effects of redeeming Disadvantages: May be costly and time-consuming Contemporaneous valuation and fiduciary considerations 18

19 Helps to manage ESOPs for the long term by creating a source of shares that can be allocated over time Most effective in periods of unusually high repurchase obligations Avoids reallocating a large number of shares at one time Sometimes done in conjunction with a one-time special diversification/in-service distribution offering However, there are associated complexities and costs (similar to any ESOP transaction)* * Competent professional assistance is needed to implement a releveraging transaction 19

20 Administrative complexity each tranche must be tracked separately S corporations MUST consider affect on Code Section 409(p) testing Dividends used for loan repayment must follow the shares The dividend from one tranche cannot be used as payment for a loan on a different tranche 20

21 Aggregate company value declines relative to cash outflow Per share value declines (similar to recycling) vs. straight redemption Cash leaves company, future earnings are lower due to future ESOP compensation expense, shares outstanding change depends on size of re-leverage relative to shares repurchased Share value may change based on the extent to which: The company takes on additional external financing or uses cash to execute the transaction All else equal, more debt or less cash would decrease share value) The company s redemption of terminated participant shares are different than the number of reissued shares Shares sold to the ESOP do not need to mirror shares redeemed 21

22 Redeem Recycle Releverage Shares outstanding Reduced No impact No impact(*) ESOP ownership Reduced if < 100% No impact No impact Additional shares to Employee ESOP accounts No Yes Yes, over time Per share value Anti-dilution Diluted Diluted Employer contribution No Yes and dividends/s distribution Yes and dividends/ S distribution Employee group benefited most EEs with larger share balances Depends upon funding Contribution (EEs) Dividends (Participants) Contribution (EEs) Corporation s cash flow Reduce Not Reduced if =Benefit Expense Not reduced if =Benefit Expense Income tax No deduction Deduction for employer contribution Deduction for employer contribution * Assumes after redemption by the company all shares are sold to ESOP * Is a new securities acquisition loan needs an adequate consideration opinion at time of transaction 22

23 Share redemptions impact on valuation: Redemptions are not an expense and do not affect operating cash flow, but they do reduce overall cash Enterprise value remains the same, equity value is lowered, but share price remains unchanged because number of shares are reduced in proportion Share recycling impact on valuation: Contributions are an expense and reduce operating cash flow which results in reduced enterprise value unless otherwise offset Dividends are not an expense and do not affect operating cash flow but they do reduce overall cash Enterprise value remains the same, equity value is lowered Benefits vs. return on capital 23

24 Cash going into plan Contributions Dividends and S distributions Value allocated to participants included in benefit level Value of shares released Value of shares recycled with current contributions Forfeitures Contributions not used for ESOP loans or repurchase Appreciation in share value and dividends and S distributions on allocated shares really, return on equity 24

25 What is normal benefit level? Industry and geographic norms Competitors and other ESOP companies What is desired benefit level? Corporate culture Employee expectations Desired incentive/motivation What is the entire benefit cost? ESOP debt service Wages All qualified plans Non-qualified deferred compensation 25

26 When recycling stock, a company can fund the repurchase obligation with cash contributions, S distributions/ dividends, or some combination It is important to understand that these funding sources are allocated differently Contributions are allocated based on method described in plan document; typically pro-rata on eligible compensation S corporation distributions/dividends: Those paid on unallocated shares, i.e. shares in loan suspense, are typically allocated pro-rata based on eligible compensation Those paid on allocated shares, i.e. shares in participants accounts, are typically allocated pro-rata based on share balance o NOTE: This method can actually increase the value of terminated participant accounts 26

27 Some companies fund the ESOP primarily (or solely) with S corporation distributions/dividends Often occurs when the ESOP owns less than 100% Also occurs when funding exceeds Code Section 404 limits Many times S distributions are required Be careful of substantial and recurring contribution requirements May result in a Have vs. Have-Not situation which affects repurchase obligations and participant benefit levels Shares become concentrated in the account of longer-term participants New participants with little or no shares, receive little or no additional shares Can also result in compliance issues with dividend whole test 27

28 Valuation issues: S corporation distributions (C corporation dividends) to ESOP No impact on earnings Shares outstanding remain constant Aggregate company value declines Per share value declines since cash leaves company; shares outstanding remain unchanged 28

29 Reserve in Trust Reserve on Company Books Book expense Maybe No Tax deductible Maybe No Available for non-esop purposes No Yes Impact on valuation May decrease May increase Bonding Not asset of company Asset of company Bank covenants Not asset of company Asset of company Subject to contribution limits Yes No Income tax Deduction for employer contribution Deduction for employer contribution 29

30 When thinking about managing distributions and employee benefit levels, and for the sustainability of the ESOP, be sure you understand the consequences of your decisions regarding plan design, repurchase method, and funding strategy The choices you make with respect to distribution policies, share repurchase methodology, and funding strategy can be combined in a variety of ways to best manage and fund the ESOP in the long term 30

31 Phone Barbara Clough is a Director at Newport Group in the firm s national Employee Stock Ownership Plan (ESOP) administration and consulting practice. Ms. Clough is responsible for client relations, training, mentoring, and managing the ESOP team. Ms. Clough has worked closely with Plan Sponsors, accountants and legal counsel to provide guidance on plan design, legal and compliance matters, and DOL & IRS inquiries. She administers and provides annual reporting and compliance for plans ranging from 20 to 20,000 employees. Ms. Clough is a leading expert on compliance matters with extensive experience in Code Section 409(p) testing. Ms. Clough holds a Bachelor of Science degree from the University of Massachusetts. She is the immediate past chairwoman of The ESOP Association s Administrative Advisory Committee, past Administration Representative of The ESOP Association Interdisciplinary Committee, Executive Committee member of The New England Chapter of The ESOP Association, frequent author and speaker at NCEO and ESOP Association conferences. Ms. Clough is a member of ASPPA, the ESOP Association and NCEO. 31

32 Phone Joe is a Vice President of Consulting in Retirement and Investor Services of the Principal Financial Group (Principal ). He specializes in assisting companies in the analysis, design, implementation, and operation of ESOPs including repurchase obligation planning and retirement plans. He has over 28 years of experience in employee benefits and consulting on ESOPs. Prior to joining Principal in 2003, Joe was an employee benefits consultant for Ernst & Young. His experience also includes tax and executive compensation consulting for companies throughout the United States. Joe is a Certified Public Accountant. He earned his Bachelor of Business Administration degree from Niagara University, New York, where he graduated with high honors. Joe is a member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants, The ESOP Association (TEA), and the National Center of Employee Ownership (NCEO). He also sits on the Finance Committee of TEA and is Vice President of the New Jersey/New York Chapter. Joe has conducted numerous pension and benefit seminars, written articles and presented at national and regional events for TEA, NCEO, the Ohio and Vermont Employee Ownership Centers, and the NYS Society of CPAs. 32

33 This presentation is intended to provide accurate and authoritative information in regard to the subject matter covered. The accuracy of the information is not guaranteed and is provided with the understanding that Principal and Newport Group are not rendering legal, accounting, or tax advice. While this communication may be used to promote or market a transaction or an idea that is discussed in the presentation, it is not a marketing opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements. Principal and Newport Group are not affiliated. 33