OEOC The 28th Annual Ohio Employee Ownership Conference A Wealth of Opportunity: Employee Ownership Fuels Growth April 24, 2014

Transcription

1 OEOC The 28th Annual Ohio Employee Ownership Conference A Wealth of Opportunity: Employee Ownership Fuels Growth April 24, 2014 Managing the Repurchase Obligation Before it Becomes Unmanageable Tina DiCroce ESOP Economics, Inc. Tina Fisher SES Advisors, Inc. Ann Caresani Porter, Wright, Morris & Arthur LLP

2 Topics we will cover Introduction to repurchase obligations and planning Factors to consider when planning early on in the life of the ESOP, and the impact of various choices on RO and the benefit to ESOP participants Distribution policy ESOP loan amortization schedule Funding sources, i.e., contributions vs. dividends/distributions Repurchase method, i.e., redeeming vs. recycling Corrective actions for mature ESOPs Addressing the have vs. have-not issue Amending the plan Case Study examining distribution policy alternatives Conclusion

3 Defining the Repurchase Obligation The repurchase obligation is a legal obligation imposed on the sponsor of an ESOP to provide cash to participants who are entitled to a distribution It occurs as a result of distributions being made from the ESOP due to: Exercise of diversification rights In-service distributions Termination of employment

4 What is a Study? A repurchase obligation study is a long-term projection of ESOP distributions and the associated cash requirements that a company will face AND An analysis of strategies for managing and funding the resulting obligations Forecasting repurchase obligations is a critical part of the process of planning for future liquidity requirements.

5 When is the right time to complete a Study? Do first study early in the life of the ESOP Review assumptions annually Update as necessary Whenever there are material changes in your business or the Company s strategic plans Assumptions or census change significantly ESOP is considering transaction that will affect repurchase obligations Otherwise, update every 2-3 years

6 Do it yourself or hire a consultant? It depends on your resources and experience Doing it in-house You can run additional scenarios and update results more readily Hands-on involvement may provide deeper understanding of RO issues A consultant brings Experience to the project Reasonableness of assumptions Data setup and review Analytical experience The ability to analyze the results and their implications for you Using a consultant does NOT mean: Here s the data, call me when you are done Your input is critical to the process

7 Factors to consider when planning early on in the life of the ESOP

8 Distribution Policy General ESOP requirements: ESOPs required to distribute participant accounts after death, disability, normal retirement, separation from service ESOPs also required to make distributions upon attainment of age 70½ and may make distributions in satisfaction of diversification requirements Timing: Death, Disability and Retirement at Normal Retirement Age must generally begin by end of plan year following the plan year in which the event occurred Termination for other reasons must generally begin by end of sixth plan year following the plan year in which the participant terminated Exceptions: Leveraged shares

9 Distribution Policy Method: Lump Sum Installments Series of substantially equal periodic installments (at least annually) over period not exceeding five years Exceptions: Large balances One additional year for each $195,000 or fraction thereof by which account balance exceeds $985,000 (as indexed limits are $210,000/$1,050,000) Form: Cash Stock Combination Participant has the right to demand distribution in the form of stock unless corporation is an S corporation or charter/bylaws restrict ownership to ESOP/current employees

10 Other Distribution Considerations Early retirement provisions In-service distribution provisions Consent requirements; limits on involuntary cash-outs Alternate payee (qualified domestic relations order) Money purchase pension plans: in-service limitations

11 Other Distribution Considerations Coordination between ESOP rules and general distribution rules which require commencement at later of termination from service, attainment of age 65 or ten years of participation Required minimum distributions age 70-1/2 or death Diversification : age 55 with 10 years of participation Diversification: publicly held companies

12 Distribution Policy Segregation: Many ESOP companies determine that allowing former employees to remain invested in stock does not align with the goals for the ESOP The plan can be designed to provide for the segregation of former participants out of stock, and into other investments The plan document must provide for this This results in an immediate cash need for the ESOP as all or a percentage of the former participants accounts must be funded in cash The timing, method, and form rules previously listed are only the outer statutory parameters that ESOPs are required to follow. Decisions must be made regarding your plan s specific distribution guidelines after prioritizing your objectives and reviewing your repurchase obligation study.

13 Impact of Distribution Policy on RO and Benefit to Participants Delays & Installments: Give the company additional time to develop the cash needed for repurchases Reduce year-to-year variations in cash requirements Can be combined in various ways Delay re-allocation of shares to current participants

14 Impact of Distribution Policy on RO and Benefit to Participants Assuming terminated participants accounts remain invested in stock: Repurchase costs are higher in periods of rising stock values Repurchase costs are lower in periods of declining stock values Postpones availability of shares on hand to allocate to have-nots

15 Impact of Segregating Accounts on RO and Benefit to Participants Stock in accounts of terminated participants is cashed out following termination event and cash remains invested in other investments until distributed Distribution policy can be maintained without having terminated participants accounts fluctuate with changes in stock value Cash requirements are equivalent to immediate lump sum distributions Frees up shares sooner for reallocation

16 ESOP Loan Amortization Schedule The term ESOP Loan generally describes the internal loan between the company and the ESOP This loan does not have to have the same repayment schedule as the related external debt In a C corporation, it can be advantageous to accelerate the ESOP loan amortization schedule to recognize tax savings on contributions (Regular contributions to ESOPs are tax-deductible up to 404(a) limit for deductibility) In an S corporation, contributions must be within deductible limits, but tax advantages are not realized at the corporate level When a loan payment is made, shares are released from loan suspense and allocated to eligible participants accounts

17 Impact of Term of ESOP Loan on RO and Benefit to Participants Accelerating payments can result in an uneven allocation of shares over time Participants employed during the years when the loan is repaid may receive a high annual benefit, which may not be replicated after the loan is repaid This can result in a have vs. have-not issue Amortizing the ESOP loan over a longer period of time spreads out the allocation of shares, which may result in a more even benefit to participants from year to year, and provides shares to new participants further into the future Allocating shares more slowly can also help the company better manage the repurchase obligations in the long-term The cash requirements related to the repurchase of shares allocated from loan suspense are spread over a longer period of time

18 Funding Sources for ESOP Cash Contributions vs. Dividends/S Distributions Contributions Cash or Stock Usually allocated to eligible participants based upon compensation, although other methods could be used C Corporation Dividends Dividends paid on employer securities held by an ESOP are deductible if paid in any of the following ways: Paid in cash directly to participants (or beneficiaries) Paid to ESOP Trust and distributed in cash no later than 90 days after close of plan year for which the dividend is paid At the election of the participants (or beneficiaries), paid to the participant or paid to the ESOP and reinvested in company stock Used to make loan payments Dividends could remain in the plan and be allocated to participants cash accounts but there is no deduction

19 Funding Sources for ESOP Cash Contributions vs. Dividends/S Distributions S corporation earnings distributions - IRC Section 404(k) which governs C corporation dividends does not apply to S corporations - no deduction, some differences in application If S corporations distribute earnings to shareholders, pro-rata portion of the earnings must be made to the ESOP Can use to make loan payments, pay out to participants, or remain in the trust as cash Allocation methods of dividends/earnings distributions: Dividends on allocated shares allocated based on stock account balances Dividends on suspense account shares frequently allocated based on compensation although other nondiscriminatory allocation methods can be used

20 Impact of Cash Contributions vs. Dividends/S Distributions on RO and Benefit to Participants Funding the ESOP solely with dividends/s corporation distributions results in: Concentration of shares in accounts of long-term participants; participants who have stock get more stock May see increased repurchase obligations due to age-related events, i.e., diversification and retirement If all shares are allocated, new participants do not receive a benefit from the ESOP, since dividends/s corporation distributions are allocated pro rata to stock balance

21 Repurchase Method: Redeeming vs. Recycling Repurchase obligations can be handled by: Having the company buy back the shares ( redeeming ), or Within the ESOP, using cash from contributions and/or dividends/ S corporation earnings distributions ( recirculating ) The repurchase method you choose affects: Number of shares owned by the ESOP Number of shares to be repurchased over time Tax treatment and cost of repurchases Size of participants accounts And potentially, the value per share of the company s stock Companies can alternate between redeeming & recirculating each year; the two methods can also be combined

22 Impact of Repurchase Method on RO and Benefit to Participants Redeeming Company buys back shares No tax deduction Shareholder equity reduced by amount of redemption No immediate change in value, but may have longterm anti-dilutive effect No addition to participant accounts Benefits Have s ESOP s ownership reduced Recycling Trustee repurchases shares, shares reallocated Can use current contributions (tax deductible) or S corp distributions, or accumulated cash balances May have dilutive effect on value Participants account balances are increased Benefits Have s and Have-not s ESOP s ownership unchanged

23 Using Repurchase Method to Manage Participant Benefit Levels Redeeming and recirculating can also be combined in various ways for example: Redeem all shares, then contribute stock equal to a target benefit level Contribute cash equal to a target benefit level Use cash in the ESOP to recirculate shares, redeem any additional shares that have to be repurchased S distributions or dividends can also provide a source of cash for recirculating S distributions/dividends paid on shares in participants accounts are allocated pro-rata to share balances, while contributions are allocated pro rata to compensation

24 Corrective actions for mature ESOPs

25 Ways to Address Have vs. Have-Not Issue Have vs. have-not issues within ESOP Concentration of shares in accounts of long-term participants Availability of shares for new participants Methods for addressing have vs. have-not issue can include: Rebalancing accounts Releveraging Amending distribution policy to provide for more rapid reallocation of shares

26 Rebalancing Used by some mature ESOPs to try to eliminate the Haves vs. Have Nots The ESOP allocations are completed in a normal fashion As the last step, the plan accounts are rebalanced so that each participant has the same percentage of his or her account invested in employer stock and other investments The terms of the rebalancing must be part of your plan document Communication issues when changing to rebalancing Chances are long term employees will give up shares

27 Releveraging Releveraging refers to the ESOP s leveraged purchase of shares that have previously been distributed from the ESOP Repurchases are handled through redemptions, shares are sold back to ESOP with loan from company The internal loan typically has a long amortization schedule The company does not need to take on external debt if cash is available Shares go into loan suspense, i.e., are unallocated initially Shares are allocated as loan is repaid from future contributions/dividends/s corporation earnings distributions Creates flow of shares for future participants Avoids lift in value per share that would result if number of shares outstanding was reduced

28 Releveraging Releveraging has become an increasingly popular way to manage ESOPs for the long term, by creating a source of shares that can be allocated over time It is typically used in periods when repurchase obligations are unusually high Avoids reallocating a large number of shares at one time There are associated complexities and costs similar to any ESOP transaction Competent professional assistance is needed to implement a releveraging transaction

29 Amending Distribution Policy to Address Have vs. Have-Not Issue Could amend distribution policy to get shares into the hands of new participants: Change the form of distribution from installments to lump sum Could also increase any lump sum thresholds Add a segregation provision, to reallocate shares more quickly Helpful in situations where terminated participants are holding onto stock Can segregate in a lump sum or installments

30 Amending Distribution Policy to Better Manage ROs If the goal is to smooth out the cash requirements related to funding the repurchase obligation: Could amend distribution policy to change form of distribution from lump sum to installments This also helps in providing a more level benefit to participants from year to year

31 Amending Distribution Policy to Better Manage ROs Internal Revenue Code Section 411 anti-cutback provisions would prohibit most changes to distribution policy, absent an exception. Section 409(o) allows changes to the distribution policy, within limited parameters. Changes may surprise employees. What goes into the plan provision, versus separate distribution policy? IRS now asks for the distribution policy with a determination letter application.

32 Limitations on Changes to Distributions Policies Procedure: must plan amendment procedure be followed? (IRS view: yes.) Reasonable frequency Nondiscriminatory

33 Limitations on Changes to Distributions Policies - Commence Can delay processing of distributions (later in year) Section 409(o): If participant elects to commence, commencement cannot be later than 1 year after the close of the plan year: in which the participant separate from service upon attainment of normal retirement age, disability or death; or which is the 5th plan year following the plan year in which the participant separates for other reason (and not rehired)

34 Limitations on Changes to Distributions Policies Form & Period Section 409(o): If changing from lump sum to installment, or changing number of installments, the payments must be substantially equal payments, and not less frequently than annual, over a period not longer than the greater of: 5 years; or account balance > $800,000: 5 years plus 1 year (up to 5) for each $160,000 or fraction thereof over $800,000.

35 Limitations on Changes to Distributions Policies Leveraged Section 409(o) - C corporation leveraged ESOP can delay distribution, but not later than the plan year following the plan year in which the loan incurred to purchase the leveraged share has been repaid, and cannot disregard other distribution rules.

36 Limitations on Changes to Distributions Policies Medium Stock or cash? Put option: participant has the right to demand distribution in the form of stock unless corporation is an S corporation or a C corporation with charter/bylaws restricting stock to ESOP and current employees.

37 Limitations on Changes to Distributions Policies Other Rules Change in distribution policy cannot disrupt compliance with other distribution rules previously covered.

38 Distribution Policy Change Example Old: lump sum as soon as administratively feasible after distributable event New: Separate from service upon attainment of normal retirement age, disability or death: commence five annual installments by last day of plan year after separation Others: commence five annual installments by one year after close of plan year which is the 5th plan year following the plan year in which the participant separates

39 Limitations on Changes to Distributions Policies Segregation Treasury Regulation Section (b)(1)(i), (ii), and (iii) definite allocation formula requirements Code Section 401(a)(28)(B) diversification requirements Treasury Regulation Section 1.401(a)(4)-4 discrimination testing for benefits, rights, and features. ERISA fiduciary requirements investment selection

40 IRS Segregation Example Required Divestiture for Participants Who Have Attained the Age of 60: The Trustee shall transfer from a Participant s account the Employer stock in such Participants account in accordance with the following schedule: Attained Age Fraction of Stock to be Transferred 60 1/8 61 1/7 62 1/6 63 1/5 64 1/4 65 1/3 66 1/ %

41 Segregation Example cont. The transfer of the stock in the Participant s account shall be made internally within the Plan or sold by the Plan. The consideration to the Participant s account shall be the fair market value of the stock as of the date of such transfer. Once the transfers take place, the Participant shall be entitled to direct the investment of the Participant s non-stock account in accordance with the provisions of 9.15.

42 Case Study

43 Assumptions Used in Case Study ABC Company ESOP effective January 1, 2010 ESOP acquired 100% of Company Loan with external lender amortized over 5 years Internal loan between Company and ESOP ( ESOP Loan ) amortized over 15 years 153 ESOP participant census Normal Retirement Age: Later of age 65 or 5 years of participation in ESOP A 20-year period was modeled 43

44 Assumptions Used in Case Study ABC Company (Cont d) Share value projected using simplified model 5% growth in debt-free Enterprise Value each year Factors in pay-down of ESOP-related external debt Turnover projected using a service-based table, published by the Society of Actuaries Projected overall average turnover rate of 8.5% Distribution Method: Shares are recycled/recirculated in ESOP ESOP Distribution Policy: Timing and method differ by scenario, as described on the following slides Terminated participants accounts are assumed to remain invested in employer stock 44

45 Assumptions Used in Case Study ABC Company (Cont.) Scenario 1 Distributions delayed until internal loan repaid Timing: For all terminations, distributions of shares are delayed until the internal loan with which those shares were acquired is fully repaid With exception of Minimum Required Distributions (Age 70 ½) and Diversification After the internal loan is repaid, commence as follows: Death, Disability, and Retirement: In year following year of termination Other terminations: In sixth year following year of termination Form: Accounts < $5,000: Paid in a lump sum Accounts $5,000: Paid in five substantially equal, annual installments Extended installments for accounts $985,000 (as indexed) 45

46 Assumptions Used in Case Study ABC Company (Cont.) Scenario 2 Same as Scenario 1 (delays and installments), except: distributions not delayed until the internal loan is repaid Scenario 3 Distributions paid right away Timing: No loan delay Distributions for all terminations: Paid in year following year of termination Form: Distributions for all termination reasons are paid in a lump sum 46

47 Results: Number of Shares Repurchased (20-Year Period) 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Scenario 1 Scenario 2 Scenario 3 47

48 Results: Number of Shares Repurchased (20-Year Period) 48

49 Results: Cost of Repurchase Obligations (20-Year Period) $7,000,000 $6,000,000 $5,000,000 $4,000,000 $3,000,000 $2,000,000 $1,000,000 $0 Scenario 1 Scenario 2 Scenario 3 49

50 Results: Cost of Repurchase Obligations (20-Year Period) 50

51 Concluding Thoughts Completing a repurchase study early on in the life of the ESOP will allow you to develop a long-term repurchase obligation strategy You will be able to understand the challenges you are facing and the potential solutions, and Make decisions that are consistent with your goals and constraints If you haven t done so yet, it s not too late to plan Have a repurchase obligation study performed; identify the issues and challenges you are facing Work with a team of competent ESOP professionals who can help you take corrective action

52 Questions? Tina DiCroce, ESOP Economics, Inc Tina Fisher, SES Advisers, Inc Ann Caresani, Porter Wright Morris & Arthur LLP