THE ESOP ADVANTAGE. ESOP Midwest Conference September 11-12, 2014 Chicago Oak Brook Hills Resort Oak Brook, IL

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1 THE ESOP ADVANTAGE ESOP Midwest Conference September 11-12, 2014 Chicago Oak Brook Hills Resort Oak Brook, IL Brian Hector, Partner Morgan, Lewis & Bockius LLP 77 West Wacker Drive Chicago, IL Fred Jahns, MBA, CPA/ABV, ASA, President Brookwood Vance, LLC 360 W. Butterfield Rd., Suite 310 Elmhurst, Illinois

2 2013 Saw Higher Marginal Tax Rates Ordinary Income: 35% to 39.6% Medicare Surcharge on Passive Income: 3.8% Capital Gains: 15% to 20% Plus Medicare Surcharge: 23.8% Dividends: 15% to 20% Plus Medicare Surcharge: 23.8% Also, in addition to the above Federal increases, there have been increases in several of the individual state income taxes over the past few years 1

3 What is an ESOP? Employee benefit plan that must satisfy all the requirements of a qualified plan, as well as additional rules unique to an ESOP Designed to invest primarily in stock of the sponsoring employer 2

4 Purposes an ESOP can Serve 1. Employee benefit 2. Technique of corporate finance 3. Business perpetuation 4. Provide market for thinly-traded stock 5. Provide liquidity for estates of business owners 6. Business acquisition technique 3

5 General Benefits Founding Shareholder able to transition business to next generation in tax favored manner Founding shareholder can liquidate interest in company over time rather than all at once Founding shareholder can sell and still remain active in the business 4

6 Summary of Tax Incentives Benefits to Selling Shareholder If eligible, can defer (or altogether avoid) paying capital gains tax on the sale (more on that later) Benefits to Sponsoring Company Contributions are deductible Deductions for dividends paid to ESOP are deductible Benefits to Employee-Participants Earnings and contributions accumulate tax-free Employees not subject to tax on contributions or earnings allocated to their accounts until benefits distributed out to them upon termination of employment 5

7 Internal Sale: Sell Stock to an ESOP Leveraged ESOPs Company Borrows Funds Company makes internal loan to ESOP ESOP Purchases Stock Repayment/Contribution Deduct principal & interest Company contributes cash to ESOP ESOP repays internal loan Company repays external loan 6

8 Leveraged Transaction The fiduciary rules applicable to tax-qualified plans generally prohibit sponsoring employers from lending money to a qualified plan, guaranteeing a loan to a plan, or providing collateral for a loan However, a special exemption is provided for loans to ESOPs, where the loan proceeds are used to acquire common stock of the sponsoring employer or its controlled group member 7

9 Leveraged Transaction The ESOP uses the loan proceeds to purchase shares of the sponsoring corporation from stockholders The corporation makes annual cash contributions to the ESOP in an amount sufficient to pay the balance of the loan The corporation takes a deduction for the amounts so contributed Both the amounts used to pay principal as well as the amounts used to pay interest are deductible If C corporation, only amount used to pay principal counts against 25% deduction limit under code section 404, i.e., no deductible limit on the portion of the contribution used to pay the interest 8

10 Leveraged Transaction Example: Assume ABC company, a C corporation, implements an ESOP through an ESOP Loan transaction. The principal amount of the loan is $27,000,000. The interest rate is 8%. The term of the loan is 10 years. The yearly principal payment on the loan is $2,700,000. Company is able to take the full deduction of the payment and is in the 35% corporate tax bracket. 9

11 Leveraged Transaction Assume ABC company is a Minnesota corporation. The tax savings using an ESOP Loan transaction are as follows: Taxable Income State Corp. Tax Rate Federal Corp. Tax Rate Taxable Income Without ESOP Taxable Income With ESOP $10,000, % 35% $10,000,000 $7,300,000* Tax Savings Per Year $0 $1,116,990** Total Tax Savings Over 10 years (life of ESOP Loan) $0 $12,096,000*** *Calculated as $10,000,000, less the $2,700,000 ESOP Loan payment deduction **Calculated as $2,700,000 x 41.4% (35% federal corporate tax rate plus 9.8% state corporate tax rate less 3.4% federal deduction for state income tax expense) ***This does not include a total interest deduction of $4,914,756 over the life of the ESOP loan 10

12 Flow of Funds in a Leveraged Transaction Cash COMPANY 1 Bank Debt Seller(s) Cash Cash 3 Stock Sale 2 ESOP Trust (a)/ Employee Benefit Plan (a) The ESOP Trustee is represented by independent legal and financial advisors Promissory Note 1. Company borrows money from Bank 2. Company lends money to the newly formed ESOP and the ESOP executes a promissory note in favor of the company 3. ESOP purchases all or a portion of the selling shareholder(s) stock 11

13 IRC 1042 Election 1. Section 1042 of the Internal Revenue Code provides an opportunity for a taxpayer to defer the recognition of tax on the proceeds of a sale of stock of a C corporation to an ESOP if the proceeds are reinvested in securities of other corporations Available only with respect to sale of common stock of C corporations that are not publicly traded 2. Requirements: The stock must have been owned by the seller for at least three years Immediately after the sale, the ESOP owns at least 30 percent of the employer s stock Sale proceeds must be reinvested in Qualified Replacement Property ( QRP ) and reinvestment must occur within 12 months of date of sale to ESOP 12

14 IRC 1042 Election (cont d) The seller s shares must not be allocated back to the seller, to related parties of seller, or to 25-percent stockholders Because the 30% requirement is applied after the sale, an ESOP may be established for the purpose of enabling a large stockholder to sell all or a significant portion of his or her stock to the ESOP on a tax-deferred basis The gain deferred on the sale of the stock to the ESOP is taxed when the QRP is sold 13

15 IRC 1042 Election (cont d) However, if QRPs are held by taxpayer until death, taxpayer s estate gets step up in basis at death, resulting in permanent tax avoidance ESOP sponsoring company can elect S corporation status after the sale for greater tax advantage 14

16 Tax Deferral Savings in an ESOP vs. Regular Sale of Stock Regular Sale 1042 ESOP Sale Sale Price $10,000,000 $10,000,000 Basis 100, ,000 Taxable Gain 9,900,000 9,900,000 Federal LT Capital Gains Tax (23.8% with Medicare tax) 2,356,200 0 After-Tax Proceeds $7,643,800 $10,000,000 Tax Deferral Savings *$2,356,200 *This ESOP savings comparison only shows the Federal tax savings. There would also be a substantial savings at the state tax level as well. For example, Minnesota has a 7.9 percent long-term capital gains tax rate. Accordingly, if the owner in the above example is a Minnesota resident, that owner would save $3,138,300 if the owner sold to an ESOP. This savings reflects a combined tax rate of 31.7 percent on the sale (23.8 percent capital gains federal rate percent Minnesota rate). 15

17 Deferring Capital Gains IRC 1042 Definition A 1042 ESOP Exchange allows a shareholder to exchange his or her interest in a private company for a portfolio of qualified replacement property without paying any capital gains taxes on the transaction 16

18 IRC 1042 Transaction Qualified Replacement Property (QRP) Eligible Investments -Common Stock -Preferred Stock -Corporate Bonds or Notes -Convertible Bonds -Floating Rate Notes (FRNs) Investments that ARE NOT Considered QRP: -Mutual Funds -REITs (Real Estate Investment Trusts) -Municipal Bonds -Treasury Securities -Federal Agency Securities -International Domiciled Companies -Limited Partnerships You may not exchange one QRP for another! 17

19 Deferring Capital Gains Through Section 1042 Capital Gains from Business L O Investment Strategy Fixed Income QRP A N Alternative Investments US Equity Isolate QRP from Investment Strategy Emerging Markets Real Estate 18

20 Case Study: Madison Oven Mfg. Founded in 1972 by Jack Madison, age 68, who lives in Minnesota Jack is not looking to retire but would like to take out part of his equity, since his equity in the company makes up the vast majority of his net worth. Jack s desire is to stay in control of the company at least for now! Jack s cost basis in the stock is basically zero, as he began the company in his youth and built it from the ground up S Corp formed in Minnesota Jack turned down an unsolicited offer from a private equity firm 2 years ago for the whole company Jack believes the company is worth $38MM-$45MM 19

21 Madison Oven Mfg. Financials Revenues EBITDA 2009: $85,000, : $5,930, : $92,000, : $6,800, : $76,000, : $5,520, : $87,000, : $7,535,000 20

22 Madison Oven Mfg. ESOP Jack decides he wants to take advantage of I.R.C. Section 1042 to produce a Federal and state capital gains free sale Feasibility study produces an enterprise value of $33,333,333 which equals a 5 times multiple of the average EBITDA plus the company s net cash position Jack decides to sell 30% to the ESOP which equals $10,000,000 since it will be a capital gain free sale, leaves him in control of the company, and creates a market for the stock for a possible additional transaction later. Such a market for Madison Oven Mfg. stock presently does not exist 21

23 Conversion to a C Corp Since I.R.C. Section 1042 does not apply to S Corps, Jack will have to convert Madison Oven Mfg. to a C Corporation It will be 5 years before Madison Oven Mfg. could convert back to an S Corporation Expenses associated with the ESOP will mitigate most of the tax issues associated with C Corporation status In addition to expenses, remember that the loan repayment is also a big tax advantage 22

24 Tax Savings to Jack Madison Total Tax Breakdown Assuming Jack just pays taxes and moves on Federal Tax 20.0% $2,000,000 State Cap Gains 7.9% $790,000 Medicare Tax 3.8% $380,000 Total Taxes Paid 31.7% $3,170,000 Net Dollars 68.3% $6,830,000 By Utilizing Section 1042, JACK DEFERS $3,170,000 IN TAXES Upon Jack s death, the tax deferral becomes a permanent savings for Jack and his descendents 23

25 Mechanics of QRP Purchase Jack receives the sale proceeds of $10,000,000 at closing Jack establishes an account for the monetization loan and deposits $1,000,000 cash into the account Jack purchases $10,000,000 of Corporate Floating Rate Notes (FRNs) with the cash deposit plus a $9,000,000 loan Jack invests the remaining $9,000,000 he has from the closing in anything he wants 24

26 Deferring Capital Gains Through Section 1042 Capital Gains from Business L O Investment Strategy Fixed Income QRP A N Alternative Investments US Equity Isolate QRP from Investment Strategy Emerging Markets Real Estate 25

27 At Jack s Death At Jack s death, the Corporate Floating Rate Notes (FRNs) are putable back to the issuers for cash Heirs take that $10,000,000 cash and pay off the monetization loan of $9,000,000 netting $1,000,000 plus whatever Jack did with the $9,000,000 he netted from the closing Jack s tax basis in Madison Oven Mfg. (i.e., $0) is carried over into the QRPs so the stepped-up basis eliminates the capital gains tax recognition 26

28 S Corporation ESOP S corporations pay no tax at the corporate level S corporation earnings are taxed directly to the shareholders based on their relative shareholdings The ESOP is a tax exempt trust To the extent of the ESOP s ownership, the company s earnings are tax free Distributions of earnings are optional (usually determined by the tax requirements of non-esop shareholders) Significant increases in corporate cash flow 27

29 S Corporation ESOP 1. Like all other shareholders of an S corporation, an ESOP must include in its gross income its proportionate share of the S corporation's gross income 2. However, because an ESOP is exempt from federal taxation, all tax on the ESOP's proportionate share of the S corporation's income is exempt: under the general tax rules applicable to S corporations, the corporation itself is not subject to tax on its income although the ESOP must include its proportionate share of the S corporation's income in its gross income, it is not subject to tax on its own gross income therefore, if all of the stock of an S corporation is owned by an ESOP, there will be no tax on the corporation's current earnings! 28

30 S Corporation ESOP 1. Advantages of S election: avoidance of double tax on corporate earnings elimination of tax on ESOP s proportionate share of earnings avoidance of double tax on sale of assets 2. Disadvantages: if distributions are required in order to enable other shareholders to pay their taxes, required distributions to ESOP may result in adverse cash flow consequences tax-free rollover of gain on sale of stock to an ESOP does not apply if the plan sponsor is an S corporation limits on annual contributions to an ESOP are lower for an S corporation than for a C corporation Anti -Abuse rules may limit who can receive an allocation of employer stock (i.e., disqualified person rule) 29

31 Corporate Governance Corporate control Trustee votes for the board of directors Board of directors appoints the trustee Board of directors selects the officers Officers responsible for day-to-day operations Trustee is the owner of the stock, not the participants Trustee votes the stock Participants direct trustee on major corporate events Participants may be given additional voting rights Required for publicly traded companies 30

32 Corporate Governance ESOP Trustee Acts As ESOP Shareholder Shareholders Elect Board Of Directors Board of Directors ESOP TRUSTEE Appoints Officers & ESOP Trustee May Appoint ESOP Advisory Committee ESOP ADVISORY COMMITTEE OFFICERS 31

33 QUESTIONS? 32

34 SPEAKERS BIOGRAPHIES 33

35 Brian Hector, Partner, Morgan Lewis & Bockius, LLP Phone: Brian D. Hector is a partner in Morgan Lewis s Employee Benefits and Executive Compensation Practice and co-chair of the ESOP Task Force. Mr. Hector focuses his practice on ERISA and employee benefits law including the areas of ESOPs, qualified plans, all types of executive compensation, fiduciary liability, and related securities law issues. Mr. Hector is a nationally recognized ESOP attorney, who has advised several public and private ESOP companies with regard to corporate governance, succession planning strategies, ownership transition, and liquidity transactions. Mr. Hector has served as counsel to companies and shareholders regarding the use of ESOPs in numerous transactions, including equity repurchases, ownership succession transactions, leveraged buyouts, mergers, acquisitions, and corporate reorganizations. He has also represented lenders and trustees in ESOP transactions. Mr. Hector has an impressive history working with all types of benefit plans and executive compensation arrangements. He has also represented several clients before the IRS and the Department of Labor in connection with ESOP and employee benefits matters. 34

36 Fred Jahns, MBA, CPA/ABV, ASA President, Brookwood Vance, LLC Phone: Fred is founder and president of Brookwood Vance, LLC, a firm dedicated to valuing privately held equity interests and evaluating ownership succession alternatives for business owners. He is an Accredited Senior Appraiser (ASA) with the American Society of Appraisers and holds the Accredited in Business Valuation designation (ABV) awarded by the American Institute of Certified Public Accountants. Fred has more than 20 years of experience performing business valuations across a wide range of industries for clients engaged in ESOP transactions, trust and estate administration, litigated matters, and transactions involving the transfer of full or partial ownership interests in privately held companies. A frequent speaker, Fred has addressed such diverse organizations as the ESOP Association, Illinois CPA Society, DuPage Estate Planning Council, the National Gas Association of Houston, Canadian Energy Research Institute, Wisconsin Association of Manufacturers and Commerce, Texas Society of CPAs, Midwest Cogeneration Association, National Center for Employee Ownership, Institute for International Research, and the South Suburban Estate Planning Council. In addition, Fred has served as a guest lecturer at DePaul University and John Marshall Law School in Chicago and as an adjunct professor at Concordia University-Chicago. Fred began his career as a certified public accountant for Peat Marwick Mitchell & Co. and earned an MBA in Finance with distinction from DePaul University in Chicago. He has served in various capacities with numerous professional associations including three-term president of the Business Valuation Association of Chicago, six-term Vice President of the Illinois Chapter of the ESOP Association and chair of the Illinois CPA Society s Estate and Gift Tax Committee. Fred currently serves as a member of the Illinois CPA Society s Estate and Gift Tax Committee and as a member of the ESOP Association s Valuation Advisory Committee. 35

37 Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein