Accounting & Tax Issues with an ESOP and Creating Tax Efficient Liquidity with ESOP 1042 Tax Deferral

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1 Accounting & Tax Issues with an ESOP and Creating Tax Efficient Liquidity with ESOP 1042 Tax Deferral September 21, 2017 Mark Flinchum, CPA, Partner, Katz, Sapper & Miller Brian Jenkins, Executive Director, J.P. Morgan Chase The information presented herein is general in nature and should not be acted upon without the advice of a professional KSM Business Services, Inc.

2 Employee Stock Ownership Plans - Different Viewpoints For the employees: It is an employee benefit plan that invests primarily in the stock of the employer company. For the business owner: It is a tax-advantaged way to sell part or all of a business. 2

3 ESOP Flexibility Ensures owner s legacy Retain operational control Significant tax benefits Creates gift and estate planning opportunities Ability to exit without selling to a competitor or outside party Ability to transition through a partial/full sale Employee incentives 3

4 Non-Leveraged vs. Leveraged Non-leveraged An ESOP with no debt related to share purchase. Cash contributions can be made by the Company to the ESOP which is then used to acquire shares for employees through distributions or be maintained in Other Investment Account. Leveraged Financing is using to purchase shares of the Company and those shares are then allocated to participants as the debt is paid down. 4

5 Leveraged ESOP Terms Direct loan - Third party lends directly to Trust Indirect/Inside/Employer loan - Company lends directly to Trust Outside loan - Third party lends directly to Company Unearned ESOP shares - Contra equity account 5

6 Stock Loan Reinvest Example of Leveraged ESOP Transaction In a leveraged ESOP transaction, the Company borrows from the Bank and lends proceeds to the ESOP, taking back a note from the ESOP. The ESOP then pays the Selling Shareholder cash in exchange for stock. If eligible for tax deferral treatment, Selling Shareholder will complete ESOP 1042 Rollover and invest in Qualified Replacement Property (QRP). Employees *For illustrative purposes only. J.P. Morgan Securities does not provide individual tax advice. Please consult your individual tax advisors prior to initiating any strategy. 6

7 Financial Statement Impact Balance Sheet Before ESOP Transaction Assets $10,000,000 Liabilities $ 5,000,000 Equity $ 5,000,000 Total $10,000,000 Total $10,000,000 7

8 Financial Statement Impact Balance Sheet After ESOP Transaction Assets $10,000,000 Liabilities $ 5,000,000 ESOP Debt $3,000,000 Equity $5,000,000 Unearned ESOP Shares ($3,000,000) Net Equity $2,000,000 Total $10,000,000 Total $10,000,000 8

9 Annual Contributions to the Trust Cash contribution Dividends/Distributions Combination of the above Stock contribution 9

10 Cash Contribution Accounting Company contributes cash to Trust bank account Recorded as an expense Contribution portion used to pay interest should not be recorded to contribution expense and should be recorded to interest expense (indirect or direct loan) 10

11 Accounting for Dividends Unallocated share dividends are always part of compensation cost These shares have not been allocated dividend payments are not part of equity Allocated share dividends reduce equity 11

12 Accounting for Unearned ESOP Share Reduction Indirect/Employer Loan Trust pays debt repayment to the Company Decrease to unearned ESOP shares for principal amount (original cost of shares) The portion the Trust recorded as interest expense is not coded to interest income it offsets interest expense Direct Loan Trust makes repayment to lender Company makes journal entry to reduce the liability and unearned ESOP shares for the principal amount paid 12

13 Contribution Accounting Total compensation cost will be average fair value of released shares Difference between original cost per share and average fair value per share is recorded through paid-in-capital or retained earning and is a non-cash adjustment ESOP compensation expense is part of operating income 13

14 Benefits with Corporate Structure S CORPORATION Company Contribution Deduction Contributions to the qualified plan are used to make principal and interest payments on the acquisition loan generally limited to 25% of payroll Pass-thru Entity + Tax Exempt Trust S Corporations pass earnings and tax liability to shareholders; ESOP Trust is exempt from income taxes If ESOP owns 100% of the common stock, there is no federal tax and, in most states, no state tax paid by the corporation One Class of Stock An S Corporation can only have one class of stock Distributions by the company are pro-rata Seller paper in any warrant design has to be structured as debt Substituted Benefit Cash benefit turned into non-cash benefit Aids in financing the transaction Owner No Capital Gains Tax Deferral No ESOP 1042 Rollover is available for sale of S Corporation stock to an ESOP. Installment Sale Treatment When seller financed, transaction may be eligible for installment sale treatment. Employees Receive stock allocations in ESOP (IRC 415) Financial (not operational) benefits of ownership Sellers and their family members can participate in ESOP 14

15 Benefits with Corporate Structure C CORPORATION Company Contribution Deduction Contributions to the qualified plan are used to make principal and interest payments on the acquisition loan generally limited to 25% of payroll Dividend Deduction C Corporation dividends paid to an ESOP on securities held by the ESOP are tax-deductible in some situations Convertible Preferred Stock A C Corporation provides flexibility to use convertible preferred stock Guaranteed dividend augments contributions Value of dividend reduces amount of common stock that is transferred to ESOP Substituted Benefit Cash benefit turned into a non-cash benefit Aids in financing the transaction Owner Capital Gains Tax Deferral Sellers can defer federal & state capital gains tax if proceeds are rolled over into QRP (IRC 1042). This is an ESOP 1042 Rollover. Step Up in Basis Seller s tax basis in the securities carries over. Current law provides for a step-up in cost basis at death of seller. Employees Receive stock allocations in ESOP (IRC 415) Financial (not operational) benefits of ownership Seller and their family members cannot participate in ESOP if 1042 elected 15

16 ESOP 1042 Rollover Tax Deferral What is it? An ESOP 1042 Rollover enables an individual or a trust to sell stock to a private company's ESOP and defer state and federal capital gains taxes indefinitely. The shareholder can sell their stock to the ESOP and elect to defer capital gains taxes by using proceeds of the sale to purchase securities of select domestic corporations. This is called an ESOP 1042 Rollover and the securities are often referred to as rollover securities. Personal Tax Benefit The Selling Shareholder is able to defer all state and federal capital gains taxes for as long as they hold the rollover securities. If the rollover securities are held through the shareholder s lifetime, the securities receive a step up in cost basis and capital gains taxes are eliminated before going into the estate. *J.P. Morgan Securities does not provide individual tax advice. Please consult your individual tax advisors prior to initiating any strategy. 16

17 ESOP 1042 Rollover Tax Deferral Completing an ESOP 1042 Rollover can defer, and eventually eliminate, all capital gains tax on the sale to an ESOP. The investor receives a stepped-up cost basis if QRP is held through the Selling Shareholder s lifetime. For seller-financed transactions, investments in QRP can be made for the total sale amount, even if the transaction did not generate full liquidity. Selling Shareholders may use leverage for personal use or to purchase QRP. The securities serve as collateral for the loan. External Financing Cash Cash Repay External Financing Contribution Seller Note Stock Margin Loan Cash Collateral *For illustrative purposes only. J.P. Morgan Securities does not provide individual tax advice. Please consult your individual tax advisors prior to initiating any strategy. 17

18 Requirements for ESOP 1042 Rollover An owner of a closely held C Corporation can defer state or federal capital gains taxation on stock sold to an ESOP if the seller reinvests ( ESOP 1042 Rollover") sale proceeds into QRP. QRP can include stocks, bonds, or other securities of select operating companies incorporated in the U.S. If the replacement property is held until death of the Selling Shareholder, the property transfers to their heirs with a steppedup cost basis. Eligibility requirements include: Must be C Corporation at time of sale to ESOP Minimum of 3 year holding period of stock sold to ESOP Must sell at least 30% of value of company s equity Must sell most senior stock Must reinvest proceeds in Qualified Replacement Property within 15 month period, commencing 3 months prior to closing or 12 months after closing 18

19 Qualified Replacement Property (QRP) Eligible As QRP Common Stock Preferred Stock Convertible Bonds Corporate Fixed Rate Bonds Corporate Floating Rate Notes (FRN) Not Eligible As QRP Municipal Bonds U.S. Government Bonds Bank CDs Mutual Funds Foreign Securities Real Estate Investment Trusts (REITs) Eligible Issuer Must Have More than 50% of its assets used in the active conduct of a trade or business No more than 25% of its gross income from passive sources *This is intended for informational purposes only and is not intended as an offer to sell or a solicitation of a product or service. 19

20 Sample Floating Rate Note Terms Term Issuer Rating Coupon Reset Maturity Call Option Detail Colgate-Palmolive Company Aa3 / AA- (Moody s / Standard & Poor s) 3 Month LIBOR minus 30bps Calculated quarterly and paid to investor quarterly 40 years when newly issued Non-callable for 30 years Put Option Years 1-5 at 98.00, Years 6-10 at 99.00, every third year thereafter at *This is intended for informational purposes only and is not intended as an offer to sell or a solicitation of a product or service. 20

21 Customized Analysis for Selling Shareholders ESOP 1042 Rollover Analysis Executive Summary Total Expected Tax Deferral $2,742,400 Total Expected Tax Deferral $2,742,400 Current LIBOR Rates If Interest Rates Rise by 2% 80% FRN / 10% Bonds 80% FRN / 10% Bonds Year Pay Tax 100% FRNs / 10% Equities Year Pay Tax 100% FRNs / 10% Equities 5 $8,538,479 $11,007,004 $11,297,644 5 $8,538,479 $11,132,414 $11,335, $10,225,847 $12,578,366 $13,257, $10,225,847 $12,863,594 $13,342, $12,290,056 $14,494,742 $15,689, $12,290,056 $14,983,634 $15,836, $14,823,180 $16,839,475 $18,719, $14,823,180 $17,587,908 $18,943, $17,941,069 $19,717,285 $22,502, $17,941,069 $20,796,468 $22,826, $21,789,674 $23,259,944 $27,240, $21,789,674 $24,760,620 $27,690,735 $30,000,000 $30,000,000 $25,000,000 Pay Tax $25,000,000 Pay Tax $20,000,000 $20,000,000 $15,000, % FRNs $15,000, % FRNs $10,000,000 $10,000,000 $5,000,000 $ $5,000,000 80% FRN / 10% Bonds / 10% Equities $ % FRN / 10% Bonds / 10% Equities *Hypothetical Analysis. This report is for illustrative purposes only. The asset allocation(s), investment strategies, and/or securities presented do not constitute any type of recommendation and is not intended to provide, and should not be relied on for accounting, legal, or tax advice. 21

22 Flexibility with Tax Deferral ESOP Sale Proceeds Account #1 Account #2 QRP Account Investment Account *This is intended for informational purposes only and is not intended as an offer to sell or a solicitation of a product or service. 22

23 Important Documents for Tax Deferral Statement of Consent Corporate document executed by officer of company Should be completed at closing Corporation files with its tax return Shareholder attaches to his or her ESOP 1042 election Statement of Election Shareholder executes with 1042 election Shareholder must execute and attach with tax return in tax year of ESOP sale Timing is very important Tax return must be filed timely, including all extensions, and the tax payer cannot amend his/her tax return to attain ESOP 1042 treatment Statement of Purchase Shareholder executes when 1042 complete Shareholder purchases QRP within 12 months of sale to ESOP Shareholder files notarized Statement of Purchase for QRP with their appropriate tax returns *J.P. Morgan Securities does not provide individual tax advice. Please consult your individual tax advisors prior to initiating any strategy. 23

24 PROFILE Mark Flinchum is a partner in Katz, Sapper & Miller s Business Advisory Group. He started with the firm in 1987 upon graduating from Indiana University. Mark is a trusted business and tax advisor to his clients. His expertise includes strategic tax planning, business analysis and structuring, advocacy in IRS tax matters, and consulting on financial statement issues. Mark has been involved in assisting clients with growth opportunities, financing structure, and succession planning issues. He has significant experience in planning, structuring, and negotiating M&A transactions. Mark represents several ESOPowned businesses and has structured a number of business sales to existing and newly formed ESOPs. Mark A. Flinchum, CPA Partner TEL FAX mflinchum@ksmcpa.com Mark s industry experience includes manufacturing and distribution, transportation, hospitality, and agriculture businesses. His attention to proactive, value-added business and tax advice to his clients has resulted in long-term trusted advisor relationships. Mark is a member of the firm s Transportation Services and Manufacturing and Distribution Services Groups, and is partner-in-charge of the ESOP Services Group. He is frequently a contributing author to firm publications, as well as transportation and ESOP industry trade publications. Mark is a regular presenter on ESOP issues and in the manufacturing, trucking, and hospitality industries. EDUCATION Mark received a Bachelor of Science degree in accounting from Indiana University. ASSOCIATIONS AND COMMUNITY INVOLVEMENT Mark is a member of the American Institute of Certified Public Accountants and the Indiana CPA Society. He is also a member of the American Trucking Associations and the Ohio Trucking Association. Mark serves as a vice president on the board of the Indiana chapter of the ESOP Association. He is currently on the board of Shepherd Center of Hamilton County and serves as a board member and treasurer for Miller Backers. Mark is a past chairman of the board of Noblesville Chamber of Commerce as well as a past board member of the Better Business Bureau of Central Indiana and Big Brothers Big Sisters of Central Indiana. He is also a past distinguished president of Kiwanis and has worked with Junior Achievement in an instructional capacity. 24

25 PROFILE Brian is a partner of the Alison Jenkins Podkulski Group and specializes in providing tax-efficient liquidity strategies for owners of closely held businesses. Brian brings years of experience and a team of professionals to each transaction, including business valuation consultants, attorneys, and lending specialists. He incorporates the vast banking and credit resources of J.P. Morgan to create strategies that fit his clients long-term financial objectives. Brian G. Jenkins Executive Director TEL FAX brian.jenkins@jpmorgan.com Brian has been involved in financial services for over 15 years, beginning with mergers and acquisitions with publicly traded companies. He developed a passion for understanding how entrepreneurs built their business and the unique challenges they face. That exposure formed the foundation for the services and expertise he now provides to his clients nationwide. Brian also has experience advising business owners on how to help create liquidity through the use of Employee Stock Ownership Plans (ESOPs). Prior to joining J.P. Morgan, Brian was a Vice President at Nortel Networks ( ). He and his team transitioned from UBS ( ) to their current role at J.P. Morgan Securities in early Brian received the Five Star Wealth Manager Award: Best in Client Satisfaction from Atlanta Magazine in 2008, 2009 and 2011.¹ Born in Pittsburgh, Brian spent several years in Europe where his father was responsible for corporate development for a major American corporation. Brian graduated from California Polytechnic State University with a B.S. degree in Economics, and completed an exchange program at the University of London. He then earned an M.B.A. in Marketing at St. Mary s College of California. Brian and his family live in Atlanta, where he enjoys traveling, playing tennis, running, and skiing. Brian is also active in several local charitable organizations. 25

26 Thank You Circular 230 Disclosure: IRS rules, which govern the way we conduct our tax practice, dictate that we give you the following notice: Any tax advice or opinion herein contained is not intended to be used, and cannot be used, by anyone to avoid the imposition of any federal tax penalties. 26

27 This presentation was prepared exclusively for the benefit and internal use of the J.P. Morgan client to whom it is directly addressed and delivered (including such client s subsidiaries, the Company ) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by J.P. Morgan. Neither this presentation nor any of its contents may be disclosed or used for any other purpose without the prior written consent of J.P. Morgan. The information in this presentation is based upon any management forecasts supplied to us and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. J.P. Morgan s opinions and estimates constitute J.P. Morgan s judgment and should be regarded as indicative, preliminary and for illustrative purposes only. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. J.P. Morgan makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction. Unless expressly contemplated hereby, the information in this presentation does not take into account the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuation and other effects. Notwithstanding anything herein to the contrary, the Company and each of its employees, representatives or other agents may disclose to any and all persons, without limitation of any kind, the U.S. federal and state income tax treatment and the U.S. federal and state income tax structure of the transactions contemplated hereby and all materials of any kind (including opinions or other tax analyses) that are provided to the Company relating to such tax treatment and tax structure insofar as such treatment and/or structure relates to a U.S. federal or state income tax strategy provided to the Company by J.P. Morgan. J.P. Morgan's policies on data privacy can be found at J.P. Morgan s policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. J.P. Morgan also prohibits its research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investors. JPMorgan Chase & Co. and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on, for tax, legal or accounting advice. You should consult your personal tax, legal and accounting advisors for advice before engaging in any transaction. J.P. Morgan is a marketing name for investment banking businesses of JPMorgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loan arranging, financial advisory and other investment banking activities are performed by a combination of J.P. Morgan Securities Inc., J.P. Morgan plc, J.P. Morgan Securities Ltd. and the appropriately licensed subsidiaries of JPMorgan Chase & Co. in EMEA and Asia-Pacific, and lending, derivatives and other commercial banking activities are performed by JPMorgan Chase Bank, N.A. J.P. Morgan deal team members may be employees of any of the foregoing entities. This presentation does not constitute a commitment by any J.P. Morgan entity to underwrite, subscribe for or place any securities or to extend or arrange credit or to provide any other services. 27