ESOP 101. What Would You Like to Know About ESOPs? New England Chapter ESOP Association Fall Conference 2018

Transcription

1 ESOP 101 What Would You Like to Know About ESOPs? New England Chapter ESOP Association Fall Conference 2018

2 Presenters Nick J. Francia, The Capital ESOP Group, First Vice President Wealth Management (moderator) Susan Halevi, SES ESOP Strategies, Of Counsel Joe Marx, Principal Financial Group, Vice President - Consulting 2

3 Agenda Introductions ESOP Basics o Getting in o What do I get? o When do I get it? ESOP Company Governance Questions/Discussion Note - Capitalized terms in this presentation are generally defined in the ESOP plan document. 3

4 What is an ESOP? Employee Stock Ownership Plan Qualified defined contribution retirement plan, under the Internal Revenue Code and ERISA Plan assets (primarily Company stock) held in ESOP Trust for benefit of employees Value of the employees ESOP benefit is tied to the success of the company they work for National Center for Employee Ownership (NCEO) estimates 6,669 ESOPs covering > 14 million employees 1 1 March 2018, 4

5 How is an ESOP different from a 401(k)? ESOP invests primarily in the Company s stock Company funds the ESOP with contributions, dividends (C-corp) and S-distributions (S-corp) ESOP is usually created to purchase all or part of the Company from owners Owners can sell to ESOP instead of an outside buyer May provide tax advantages for the sellers and the Company 5

6 When can I get into the ESOP? Eligible Employees get in automatically once they meet the plan s eligibility requirements Eligibility depends on your ESOP s requirements o Possible age requirement (e.g., must be at least age 21) o Service requirement (e.g., 1 year of service as defined in the Plan) What are your ESOP s eligibility requirements? Participant = Employee who has an ESOP Account 6

7 When is my actual Entry Date? Eligible Employees join the ESOP on the Entry Date (as defined in the Plan) Typically next Entry Date after eligible but could be retroactive o First day of the 1st and 7th month of the Plan Year after eligibility o First day of the Plan Year in which you meet eligibility o Date of hire o One year from date of hire o First day of the next quarter o First day of the next month 7

8 When do I get a contribution to my Account? For example: o 1,000 Hours of Service during the Plan Year o Employed by Company on last day of Plan Year Hours and last-day requirements often waived if participant dies, is disabled or retires What are your ESOP s contribution eligibility requirements? 8

9 Do I get to keep my Account Balance? Your Account is subject to vesting; i.e., How long an employee must work at the Company to have a nonforfeitable right to their ESOP Account Vesting schedule depends on the ESOP Plan For example: o 1,000 Hours of Service per Plan Year o For the required number of Plan Years By law, the longest allowed vesting schedule is 6 years graded (incremental) or 3 years cliff (all at once) Usually 100% vesting upon death, disability or retirement What s your ESOP s vesting schedule? 9

10 What s in my ESOP Account? (And how did it get there?) How Company stock gets into the ESOP (example) ESOP Trust purchases shares of Company stock, from the Company or from a selling shareholder Stock purchase may be financed by a loan to the Company (which then lends money to the ESOP Trust) As the loan is repaid Company stock is allocated o Other allocations of cash and stock by the Company Contributions Dividends (C-corp) and S-distributions (S-corp) Repurchases of shares from other Participants Forfeiture of non-vested shares if Participant leaves o Gain/Loss on investments (Company stock and other) 10

11 Annual share release from repayment of ESOP loan ESOP Trust Loan Repayment Contribution Company ESOP Loan Share Allocation 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 11 For illustrative purpose only.

12 Can I contribute to the ESOP? Most ESOPs allow only employer contributions Board of directors determines contribution amount each year Discretionary, often determined by the amounts needed for: o ESOP loan payments o Distributions to terminated Participants o 401(k) plan matching contributions made to the ESOP 12

13 How are Contributions Allocated to my Account? Contribution allocation formula depends on the Plan Pro-rata based on Eligible Compensation Point system based on Compensation and Years of Service What is your ESOP s Contribution allocation formula? 13

14 How is the value of stock in my ESOP Account determined? ESOP Trustee must obtain a valuation of the Company stock at least once a year ESOP Trustee hires an independent, qualified appraiser to help determine the fair market value of the Company Valuation firm works for the ESOP Trustee Employees do not receive copies of the ESOP valuation, however each Participant receives an annual statement with the value of their Account, in cash and stock 14

15 What is fair market value? Appraising a company is complex, including analysis of historical financial statements and projections Let s keep it simple: Consider a house. The appraiser looks at the condition of the house and the price of comparable houses A house valued at $250,000 with a mortgage of $100,000 has an equity value of $150,000 A company valued at $10,000,000 with a bank loan of $2,000,000 has an equity value of $8,000,000 When a company borrows money to finance the ESOP s purchase of stock, the equity value of the company goes down until the debt is repaid 15

16 When do I get to take a distribution from my ESOP Account? Death, disability, retirement Distribution usually begins in the year following the event Other termination No later than 6 years following year of termination Exception: The beginning of a distribution may be delayed if the ESOP still owes money on the shares Cash or stock Lump sum or annual installments (not more than 5 years, unless the distribution is very large) What are your ESOP s distribution provisions? 16

17 What is Repurchase Obligation/Liability Companies that sponsor ESOPs must provide eligible Participants with a put option on shares held by the ESOP and distributed to Participants When a Participant receives a distribution of Company stock from the ESOP, the put option gives the Participant the right to have the Company buy back their shares at fair market value (FMV) (unless the stock is publicly traded) 17

18 May I invest in something other than Company stock? Diversification Qualified Participant requirements o Age 55 or older AND o 10 years participation in the ESOP o Six-year diversification period o 25% diversification (cumulative) in the first 5 years o 50% diversification in year 6 o Some ESOPs permit earlier and longer periods How the ESOP may respond to diversification elections o Distribution of cash or stock o Offer at least three investment options o Transfer to another qualified defined contribution plan of the Company with at least 3 investment options 18

19 Corporate Governance

20 Non-ESOP Company Ownership and Management Stockholders Board of Directors COMPANY Officers Managers Employees 20 For illustrative purpose only.

21 100% ESOP Company Ownership and Management Stockholder [ESOP Trustee] Board of Directors COMPANY Officers Managers Employees 21 For illustrative purpose only.

22 Company/ESOP Trustee/Employees Company - ESOP Sponsor. Administers the Plan, including allocations, participant statements, filing requirements ESOP Trustee - ESOP fiduciary. Safeguards plan assets, acts in the best interest of the ESOP and Participants in the ESOP Employees Beneficial owners of the ESOP Trust 22

23 If the ESOP owns the company, who runs it? Do I have a vote? ESOP Trustee represents the ESOP s interest and votes on behalf of the ESOP and Participants In special circumstances, ESOP Plan Participants can vote their shares (pass-through voting) o Merger or consolidation of the Company o Sale of substantially all assets o Liquidation o Dissolution o Recapitalization 23

24 Corporate Governance The Board o Funding/Contributions/Benefit Level o Benefits/Distributions/Repurchase Obligation o ESOP Strategy/Sustainability o ESOP Culture and Communications ESOP Trustee o Voting for the Board o Determination of Value o Oversight 24

25 Trustee Interaction with Board Trustee elects Board members Board of Directors appoints the Trustee. Huh? Board answers to the shareholders. Trustee answers to the Plan and Participants. Board executes resolutions to perform its role. Board resolutions requiring shareholder approval are also executed by Trustee. 25

26 Trustee Interaction with Board (Cont d) Board approves year-end financial statements and financial projections. Trustee reviews year-end financial statements and financial projections. Trustee establishes value with assistance from valuation firm (the valuation report). Dialogue between Board and Trustee. Valuation firm is engaged by Trustee. 26

27 The Capital ESOP Group Nick joined UBS in Prior to his tenure at UBS, he worked with high net worth individuals at a hedge fund in Greenwich, CT. As a member of the Capital ESOP Group, Nick focuses on educating business owners on different tax-efficient monetization strategies, empowering them to make informed decisions. He is committed to helping clients recognize their options, understand the pros and cons of each strategy and choose which succession plan is best for themselves and their families. Nick also creates tailored cash flow models comparing the taxable sale of privately held businesses and a Section 1042 tax-deferred sale to an ESOP. Nick J. Francia, CEPA First Vice President Wealth Management Certified Exit Planning Advisor 1501 K St. NW, Suite 1100 Washington, DC (202) nick.francia@ubs.com 27 With a consultative approach, Nick earns his clients trust through open and transparent communication and working with clients tax and legal advisors to construct an overarching strategy. In 2016 and 2017, Nick was named to UBS s Director s Council. In 2017, he earned the title of First Vice President Wealth Management. He is frequently asked to speak on a national level regarding Employee Stock Ownership Plans and IRC Section He is an Associate Member of the Finance Committee for the ESOP Association and a member of the National Center for Employee Ownership. Recognized for his leadership skills, Nick was appointed Vice President of Business Networking International in DC. Nick graduated from the University of Mary Washington in Fredericksburg, Virginia, where he earned a bachelor s degree in economics. He was a dedicated member of the university s baseball team and continues to be an active member of his alma mater s Alumni Association. In his leisure time, Nick enjoys spending time with family, reading, fly-fishing and traveling with his wife, Mary Elizabeth.

28 SES ESOP Strategies Susan represents companies and trustees in ESOP acquisitions, transactions and administration, and provides advice to cooperative businesses. Susan also has previous experience in both commercial law (including middle market lending) and real estate law. Susan Halevi Of Counsel P.O. Box 25 Southampton, MA (direct) (cell) 28 In addition to her work with ESOP and co-ops, Susan has represented nonprofit organizations including a community media center and a grassroots veterans organization, and litigated First Amendment claims in federal court. Susan is an alumna of the Albuquerque FBI Citizens Academy and received a certificate from the Leadership for Diversity Institute offered by NCBI (National Coalition Building Institute International). Susan graduated from Duke Law School (J.D., honors), where she was an articles editor of the Duke Law Journal and a member of the Moot Court Board. Following law school, Susan clerked for the Honorable Collins J. Seitz, Chief Judge of the U.S. Court of Appeals for the Third Circuit. Susan is a member of the bar of The Commonwealth of Massachusetts (active) and the State of Hawaii (currently inactive status). Susan brings a broad range of experience, technical skill and a problemsolving approach to her work with middle-market companies, owners in transition and ESOP trustees. She especially enjoys working with people and organizations as they address challenging issues together.

29 Principal Financial Group Joe is a Vice President of Consulting in Retirement and Income Solutions 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. Joseph E. Marx, CPA 100 Corporate Parkway Suite 116 Amherst, NY (716) 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 the New Jersey/New York Chapter Executive Committee. 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. marx.joseph@principal.com 29 CPA does not provide tax or accounting services on behalf of the companies of the Principal Financial Group.

30 The Presenters gather their data from sources they consider reliable; however, they do not guarantee the accuracy or completeness of the information provided within this presentation. The material presented reflects information known to the Presenters at the time this presentation was written, and this information is subject to change. The Presenters make no representations or warranties, expressed or implied, regarding the accuracy of this material. The views expressed in this material accurately reflect the personal views of the authors and do not necessarily coincide with those of their employers. The Presenters do not provide accounting, tax or legal advice. The information and material presented herein is provided for educational and informational purposes only and is not intended to constitute accounting, tax or legal advice or to substitute for obtaining accounting, tax or legal advice from an attorney or licensed CPA. Nick J. Francia and the Capital ESOP Group are not affiliated with any company of the Principal Financial Group. SG&F Steiker, Greenapple and Fusco P.C., and Susan Halevi are not affiliated with any company of the Principal Financial Group. 30

31 More questions?

32 Glossary of ESOP Terms

33 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 33

34 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 34

35 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 35

36 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). 36

37 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) 37