An Introduction to Employee Stock Ownership Plans (ESOPs) Alexander L. Mounts, Partner Krieg DeVault LLP

Transcription

1 An Introduction to Employee Stock Ownership Plans (ESOPs) Alexander L. Mounts, Partner Krieg DeVault LLP August 29, 2018

2 What is an Employee Stock Ownership Plan? Tool of CORPORATE FINANCE/SUCCESSION VEHICLE Tax-qualified RETIREMENT PLAN Invests primarily in EMPLOYER STOCK Numerous Federal tax incentives encourage implementation 2

3 ESOPs in the U.S. Common transition strategy: Alternative to selling to an outsider Gradual Tax *6,669 benefits ESOPs 14 million employees $1.3 trillion in plan assets Common transition strategy: Alternative to selling to an outsider Gradual Tax benefits *March 2018 National Center for Employee Ownership ( 3

4 National ESOPs 4

5 Indiana ESOPs 5

6 Good ESOP Candidates Closely held U.S. based company Company can be a C-corp or an S-corp At least 20 employees (companies with small payroll bases may encounter problems under Code Sections 415 and 409(p)) Profitable Debt capacity Stable earnings Supportive management 6

7 Good ESOP Candidates Identified ESOP objectives Create and realize employee retirement benefits, cultural improvements, and operational efficiencies Protect the shareholders legacy and Company heritage while realizing liquidity Company desiring to utilize corporate tax savings to increase growth and accelerate debt repayment Reward employees and management who helped build the Company 7

8 Flexibility Advantages ESOPs Market for shareholders stock Unlike most buyers, serves as source of funds to purchase minority blocks Low marketability discount (typically 5%) on value of shares Succession planning vehicle for gradual transfer of ownership to next generation (often combined with transfers of ownership to management sweat equity ) Financial buyer with long term perspective Easily combined with 401(k) plan use of matching contributions to fund ESOP; some transactions allow employees to transfer 401(k) funds to ESOP 8

9 Advantages of ESOPs Tax ESOP s share of company s income is not subject to tax Contributions to ESOP are tax deductible (important if ESOP owns less than 100%) ESOP s share of tax dividends can be used to repay loan, satisfy repurchase liability or pay expenses Allocations to participants accounts are tax deferred; distributions are eligible for tax-free rollover Special tax treatment of net unrealized appreciation on distribution of stock 9

10 Effect on Employees (Well Communicated ESOPs) Pride of ownership culture Recruiting/retention tool Increased commitment and enthusiasm Material increase in value of corporation* *See Key Studies on Employee Ownership and Corporate Performance at 10

11 Disadvantages of an ESOP Cost and number of service providers Complexity Communication Repurchase liability Less diversification of retirement assets Fiduciary responsibility/liability 11

12 ESOP Valuation Considerations ESOP Valuation vs. Multiple of Book How should ESOP shares be valued? Independent appraisal firm qualified and experienced with ESOP valuations Appropriate methods of valuing companies Weighting of methods Use of publicly available information regarding non-publicly traded companies Financial performance Merger and acquisition activity Effect of cash and stock dividends on value Effect of repurchase obligation on value 12

13 Basic Structure of an ESOP Transaction (Bank Financing) 1. Bank Loan Step 1 Employer 2. Pledge of Collateral Bank Shareholders 4. Cash/Note 5. Employer Stock ESOP 13

14 Basic Structure of an ESOP Transaction Step 2 Employer 3. Loan Payments Bank 1. Contributions Dividends Stock Seller ESOP 14

15 Examples of Benefits of S Corporation ESOP Structure Net Income of $5,000,000 with No ESOP Corporate Tax -0- Net Income of $5,000,000 with 50% ESOP Corporate Tax -0- Net Income of $5,000,000 with 100% ESOP Corporate Tax -0- Individual Shareholder Tax: on 45% = $2,225,000 Total Tax Dividends = $2,225,000 Individual Shareholder Tax: on 45% = $1,125,000 ESOP Shareholder Tax on $2,500,000 = $0 Total Tax Dividends = $2,225,000 ESOP s Share = $1,125,000 ESOP Shareholder Tax on $5,000,000 = $0 Additional cash flow = $2,225,000 15

16 ESOP Myths ESOP Trustee will become involved in running the company Employees or trustee must have seat on Board Management structure will change; the ESOP will become involved in management Stock valuation, compensation and/or corporation s financial statements must be disclosed Corporation will be less attractive to potential buyers Corporation cannot go public later 16

17 Characteristics of Well-Designed and Implemented ESOPs Sanity check approach to implementation a. Stock valuation b. Feasibility c. Financing d. Commitment of key managers Independent, experienced advisors to ESOP a. Counsel b. Financial Advisor c. Trustee Well-educated ESOP Committee Well-prepared feasibility analysis a. Projections based on history b. Cushion for economic downturn Repurchase Liability Study 17

18 Disclaimers These slides are for educational purposes only and are not intended, and should not be relied upon, as legal or accounting advice. Pursuant to Circular 230 promulgated by the Internal Revenue Service, please be advised that these slides were not intended or written to be used, and that they cannot be used, for the purposes of avoiding federal tax penalties unless otherwise expressly indicated

19 Speaker Contact Information Alexander L. Mounts, Partner Krieg DeVault LLP One Indiana Square, Ste Indianapolis, IN E: P:

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