ESOP 101 Where Do We Begin?

Transcription

1 New England Chapter The ESOP Association 2015Annual Fall Conference October 1-2, 2015 ESOP 101 Where Do We Begin? Presented by Joe Marx VP- ESOP Consulting Principal Financial Group Richard Glassman Partner Schatz Brown Glassman, LLP ESOP Plus Mike Lucas Vice President Fred C. Church, Inc.

2 The problem with capitalism

3 is there are too few capitalists!

4 Employee ownership creates a broader distribution of wealth. It enables employees to share in the wealth they helped create.

5 U.S. ESOP s 18 Chapters 1,600+ ESOPs 50 States Pros The ESOP Association Est.1978 Employee Owned Company $20-50 Million Sales EO s 50% Mfg-Const-Eng 750,000 EO s $50 Billion+ Sales You Employee Owner

6 Life can only be understood backwards; but it must be lived forwards ~ Soren Kierkegaard

7 REVERSE LIFE CYCLE OF AN ESOP Retirement Benefit (Distributions) Eligibility Vested Account Balance (Shares and Cash) Contributions and Allocations Valuation

8 What is an ESOP? Before The Beginning Liquidity event for shareholders. Retirement Plan for employees Inserted into the Tax Code in 1974 (ERISA) to encourage the creation of ESOPs

9 The Beginning How does the ESOP get the stock? Purchase from existing shareholders (with or w/o loan) Purchase from the company (with or w/o loan) Contribution from the company Who is the shareholder when the ESOP owns stock? ESOP Trust is the shareholder, not the participants ESOP Trust owns the shares and participants have a beneficial interest in the shares When the ESOP is leveraged, ESOP owns shares, but shares are released to participants as the loan is repaid (suspense shares) Company has an obligation to buy back the shares of any participant who leaves

10 The Story Who Gets It and How? Eligible Participants Defined Categories (e.g., leased, unionized or other) Minimum Hours (for participation 1,000 or fewer) Minimum Age (no older than 21) Allocation Requirements Minimum Hours (for allocation 1,000 or fewer) Last Day Rule

11 The Story What Goes In and When? Contributions Defined Contribution Plan Contribution amounts are usually defined by the loan agreement (leveraged ESOP) or by company discretion (non-leveraged ESOP) Leveraged ESOP Shares may be held in suspense and released as the loan is paid (suspense shares) Allocations Any contribution or other addition to the plan has to be allocated to the participants by a defined formula (allocations) Any allocation formula is permissible so long as it is not discriminatory

12 The Story How Does it Add Up? Valuation In private companies, the stock in the ESOP account must be valued each year by an independent appraiser and the valuation must be reviewed by the trustee (valuation) A participant is entitled to the value of the account, but not to a set percentage of stock and cash (segregation or reshuffling)

13 The Story - How Much and When? Vested Value of Account How much is vested (vesting schedule) What is the value as of the payment date (valuation) Timing of Distributions What is the reason for employment termination (e.g., death, disability, retirement or something else) What is the method (lump sum or installment) What is the form (shares or cash put option) What is the latest allowed date (e.g., 1 year/5 years)

14 The Happy Ending - Distributions Distributions Paid to ESOP Participants Participants receive a taxable payment (in cash) equal to the vested value of their ESOP account on the date of payment (not the date of termination) (distribution) Checks are written by the company or by the ESOP, but the company always pays for the benefit (repurchase obligation) The shares in the account of an employee who leaves the company are taken out of circulation (redeemed) or reallocated to active participants (recycled)

15 Eligibility Rules Allocation Formula Distribution Rules Diversification Rules Pass-Through Voting Vesting Administration Allocation Formula Anti-Abuse Testing Contributions Prohibited Transactions Repurchase Obligation Suspense Shares Valuation Allocations (Complete) Repurchase Obligation Segregation Valuation Other: Have/Have Not Releveraging ESOP DESIGN ESOP GROWTH MATURE ESOP Board Management ESOP Committee Board Management ESOP Committee ESOP Trustee Board Management ESOP Committee ESOP Trustee

16 Term What is it? Who does it? When is it done? Why does it matter? Administration (not Plan Administrator) Following the end of each plan year and following receipt of each annual valuation report. Compliance testing and preparation of annual benefit statements for ESOP participants, showing number of shares, value and vested balance in each participant s account. Company engages third party administrator (TPA) to complete testing and to prepare statements based on company-provided census information, contributions and allocation formula. Company required to provide benefit statements Expertise of TPA firm helpful for overall plan compliance Testing includes compliance with Code Section 409(p) Allocation Formula and process for determining how much of a contribution goes to each participant (shares or cash). Allocation formula is determined by the company as part of the plan design. Any formula (e.g., allocations based on compensation, years of service, per capita) is permissible, so long as it is not discriminatory. Allocations based on compensation are the most common. Described in the plan and implemented and tested every year by the third party administrator as part of the plan administration process. Allocation formula lets the company decide how benefits will be provided under the plan Plan assets must be allocated to participants Full allocation of shares can result in have/have not status among employees Anti-Abuse Rules Rules described in Section 409(p) of the Internal Revenue Code for S corporation ESOPs. Company tests compliance with help of TPA. Compliance required every day of every year. Substantial excise taxes could apply for non-compliance Contribution Any assets contributed by the company to the ESOP (usually in cash or shares). Company makes the contribution to the plan and the ESOP Trustee accepts the contribution on behalf of the plan. Contribution is made on the date required by agreement, if any. If no agreement, contribution must be made no later than the filing date of the company s tax return for the year for which the company is seeking a deduction (e.g., September 15 for a December 31 company on extension). Contributions create benefits for participants and provide tax deductions to company Tax rules limit the deductibility of excessive contributions Cash contributions can be used to pre-fund repurchase obligation

17 Term What is it? Who does it? When is it done? Why does it matter? Distribution Amount paid out to an ESOP participant who has left the company for any reason (termination by company or employee or death, disability of retirement). The company may put cash into the plan for the plan to pay participants directly or the plan can distribute shares to the participant, and the company must repurchase the shares if the participant elects. The plan terms dictate when a participant is due to be paid a distribution based on the legal outer limits for payment. Tax rules dictate when and how benefits must be paid Value of benefits determined as of the distribution date based on the most recent valuation Diversification Describes the right of ESOP participants to diversify a portion of the company shares held in the participant s ESOP account. The company must offer participants with 10 years of service in the plan the opportunity to cash out a portion of their account balances in the ESOP. The plan terms will dictate whether the offer must be made only to active plan participants or also to former employees. Because diversification rights apply only to participants age 55 and over and with 10 years of service in the plan, diversification becomes an issue only when the plan is 10 years old. ESOP must be invested primarily in employer securities, so diversification permits participants to reduce their concentrated investment of employer stock as they near retirement Cash obligation of the company Eligibility Requirement defined in the plan for employees to be eligible to join the plan. Company may want ESOP eligibility to match the requirements of other company benefit plans. Eligibility requirements are part of the initial plan design. New employees are subject to the eligibility requirements. Cannot be more restrictive than the law permits Coordination with other plans may make administration easier Some classes of employees may be excluded from the ESOP Employer Securities To qualify as an ESOP, a plan must be designed to be invested primarily in employer securities (as defined in the Internal Revenue Code). The Internal Revenue Code defines what classes of securities constitute qualifying employer securities. The employer stock must always satisfy the qualification requirements. Both entity structure (e.g., corporation vs. LLC) and type of stock (e.g., common or preferred) must be reviewed for compliance with the rules

18 Term What is it? Who does it? When is it done? Why does it matter? Leveraged vs. Non-Leveraged A leveraged ESOP has an outstanding loan; a nonleveraged ESOP does not. An ESOP can borrow money. If it does, the lender is usually the company, but could be another third party. The loan is typically taken on when the ESOP purchases shares, and the terms of the loan are described in a loan agreement that satisfies the prohibited transaction rules. Loan payments are made as required by the loan agreement. ESOP is the only qualified benefit plan permitted to borrow money Loan regulates benefit stream (future employees can receive benefits) and has favorable tax benefits Distributions, dividends and contributions can be used for loan repayment Pass-Through Voting The right of participants to direct the trustee on certain matters put to a shareholder vote. The company gives notice to the participants that their input on a matter is sought, the participants direct the trustee as to their vote and the trustee evaluates the directions and votes the ESOP shares. Right applies when the company is undertaking a transaction that requires passthrough voting (defined in the Internal Revenue Code) or, if broader rights are granted in the plan, when these events take place. Participants do not vote shares directly, but direct the trustee Participant direction is subject to exercise of fiduciary duty by trustee Internal Revenue Code lists seven significant transactions that require participant input Prohibited Transaction Any non-exempt transaction between a benefit plan and a party in interest (generally, company or significant officer or shareholder). Every transaction between or among the ESOP, the company, a shareholder or an officer or director could be a prohibited transaction if it does not fit an available exemption. Never! Prohibited transaction exposes the plan, the company and the individuals to penalties, including excise taxes on the value of the transaction Every transaction in stock requires an opinion from an independent appraiser Put Option Right of participants to require the company to repurchase stock distributed from the ESOP The company must pay fair market value for participants who receive a stock distribution from the ESOP and would like the company to buy the stock back. Put option applies after stock is distributed from the plan S corporations cannot distribute stock Some C corporations may elect not to let participants keep stock after termination Different tax treatment

19 Term What is it? Who does it? When is it done? Why does it matter? Repurchase Obligation Obligation of the company to buy back the stock in participant accounts. All ESOP companies have this obligation. Company can calculate this number internally as part of its financial plan or can hire a consultant to help create a model to determine repurchase obligation. It is never too early to begin thinking about repurchase obligation. The obligation to repurchase stock can begin no later than five years after termination (but sometimes earlier) and distributions usually must be completed within five years after distributions begin. Retirement plan with benefits payable to participants who terminate employment for any reason (even termination for cause) Appraisers have different methodologies for addressing repurchase obligation Cash obligation of company Segregation (Reshuffling) Cashing out the shares of a participant who has left the company and is waiting to receive a payout. Company has discretion to replace shares in the account of a participant who is no longer employed with cash of equivalent value. Segregation can take place any time after the date a participant terminates employment through the date the distribution is due to be paid. It must be done in a nondiscriminatory way. May cap the value of the shares at the date of termination Helps to pre-fund the repurchase obligation Suspense Shares Shares not yet allocated to participants because they are collateral for a loan to the ESOP. As part of an exempt (i.e., not prohibited) loan transaction, the ESOP can pledge the shares it purchases with the loan proceeds. The shares are released into the accounts of ESOP participants as the loan is paid. The shares are released when the loan payment is made. The loan agreement and amortization schedule will provide for the contribution and payment schedule. Permits the company to manage the benefit stream to participants Provides for deductible contributions for the term of the loan Valuation Process for determining the value of the shares held by the ESOP. The company hires an independent (of the company) appraiser on behalf of the trustee to value the shares. The trustee reviews the appraisal to determine if it is acceptable. Usually once a year as of the last day of the plan year, but may be more often. In non-public companies, annual valuation sets value of the company s equity and the value of the participant accounts Determines value for distributions, diversification and any other transactions in the company s stock involving the ESOP (and possibly transactions that don t directly involve the ESOP).

20 Term What is it? Who does it? When is it done? Why does it matter? Vesting Schedule for ESOP benefit becoming non-forfeitable to the participant. Company determines the vesting schedule as part of the plan design. Can be no longer than 6-year scaled vesting or 3-year cliff vesting. Affects company s financial planning (by defining when participants have a nonforfeitable benefit) Affects cultural issues (e.g., employee awareness of the ESOP benefit and the value of their shares)

21 QUESTIONS?? JOSEPH E. MARX VP ESOP CONSULTING PRINCIPAL FINANCIAL GROUP 100 CORPORATE PKY, STE. 116 AMHERST, NY DIRECT RICHARD A. GLASSMAN PARTNER SCHATZ BROWN GLASSMAN LLP 1007 FARMINGTON AVE. SUITE 4 WEST HARTFORD, CT RGLASSMAN@ESOPPLUS.COM MICHAEL LUCAS VICE PRESIDENT FRED C. CHURCH, INC. MLUCAS@FREDCCHURCH.COM DIRECT: CELL: