ESOP Workbook: The Ultimate Instru in Succession Planning

ESOP Workbook The Ultimate Instrument in Succession Planning Second Edition

Robert A. Frisch

John Wiley & Sons, Inc.

ESOP Workbook

ESOP Workbook The Ultimate Instrument in Succession Planning Second Edition

Robert A. Frisch

John Wiley & Sons, Inc.

Copyright © 2002 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate percopy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-22085-X. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www.Wiley.com

About the Author Robert A. Frisch is Chairman/CEO of The ESOT Group, Inc., headquartered nationally in Woodland Hills, California. The firm, incorporated in 1975, specializes in the implementation and continued management of Employee Stock Ownership Plans (ESOPs) and has implemented hundreds of ESOPs throughout the country. Frisch was a founder of a multistate financial corporation that was acquired by a conglomerate. He became vice president of a major Wall Street firm in charge of total financial planning for all their offices nationally. Frisch consults extensively with owners of closely held companies on perpetuating the family business and with public and private companies on management buyouts. The ESOT Group, Inc., known as the premier one-stop ESOP company, implements ESOPs and other equity-based compensation plans on a tailor-made “turnkey” basis. The company’s services include strategic planning, feasibility studies, ESOP plan design, obtaining IRS letters of determination, financing, repurchase liability studies, communicating the ownership culture to employees, and plan administration. The firm maintains a free 24-hour ESOP information hot line, (800) 422-ESOP (3767). Frisch is author of seven definitive books on ESOPs and is a frequent lecturer to trade groups of CEOs, CPAs, and financial planning groups on ESOPs. He is considered one of the major figures in the ESOP movement.

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Preface The author has written six earlier books plus his current one, ESOP: The Ultimate Instrument in Succession Planning, John Wiley & Sons, Inc., publisher (ISBN: 0-471-43444-2), but, although those books give a comprehensive treatment of the subject of Employee Stock Ownership Plans (ESOPs), none has ever provided a practical step-by-step guide that forces the reader through the paces of thought that must be considered in order to come to a proper conclusion in providing for the orderly transition of one’s business. This situation is rectified in this new publication, ESOP Workbook: The Ultimate Instrument in Succession Planning. The method of “forcing,” or putting one through the paces, comes into play because selections must be made and blanks must be completed. In this way, the reader will know that he or she has thought about virtually all of the alternatives surrounding selection of the many methods of succession planning. If the solution involves an ESOP, then the reader will be able to assist his or her advisor in the design process, thereby enabling the advisor to have a better understanding of the client’s wishes. The ESOP Workbook is designed to make the succession planning experience a pleasurable one, although it involves one of the most difficult of all business decisions. The good news is that The ESOP Workbook is likely to be used on only one occasion, and the decision that the book motivates will be the final one because the subject will be so thoroughly explored.

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Contents 1. How to Use this Workbook .................................................................1 2. What Is an ESOP?................................................................................2 3. What Are Your Objectives? ..................................................................5 4. Methods I Want to Use for Selling Stock..............................................7 5. Stockholder Sale of Stock Under IRC Section 1042 .............................8 6. Creating Capital ................................................................................10 7. Selecting the Implementer .................................................................12 8. ESOP Team........................................................................................13 9. Questions the Trustee Should Ask in Hiring an Appraiser...................14 10. Selecting a Trustee.............................................................................15 11. Naming the ESOP Committee ...........................................................17 12. Selecting the Administrator................................................................18 13. How to Communicate the ESOP to the Employees ............................19 14. Feasibility Study Questionnaire .........................................................20 15. Valuation of the Company for ESOP Purposes ...................................24 16. Financing ..........................................................................................26 17. Determining the Type of ESOP Transaction ........................................28 18. Estimating the Amount of Financing Needed .....................................29 19. Actions to Take Once You Have Decided to Install an ESOP ..............31 20. Allocation .........................................................................................32 21. Vesting ..............................................................................................33 22. Control..............................................................................................34 23. Designing the ESOP Plan Provisions with the Attorney ......................35 ix

x

Contents

24. How to Communicate the ESOP to the Employees ............................37 25. How to Coordinate the ESOP with Other Qualified Plans..................39 26. CHESOP ...........................................................................................41 27. Type of Qualified Replacement Property Selling Shareholder Might Contemplate ...........................................................................45 28. Repurchase Liability ..........................................................................47 29. Repurchase Liability Study Questionnaire .........................................49 30. Estate Planning ..................................................................................51 31. What Has the Major Stockholder Done in Connection with Estate Planning? ..........................................................................................52 32. Management Buyout .........................................................................53 33. Are You Selling Part or All of the Company to an Outsider at this Time? Why? .............................................................................54 34. Eligible Employees ............................................................................56 35. Contribution Limits ...........................................................................57 36. Census to Compute ...........................................................................58 37. Formula to Determine Contribution Limits ........................................60 38. Whether to Be a C- or an S-Corporation ESOP ..................................61 39. The Decision-Making Process ...........................................................63 40. Items You Should Consider in Converting from a C-Corporation to a Subchapter-S Corporation...........................................................64 41. Provisions That You Should Tell Your Advisor......................................65 42. Letting Your Employees in on Certain Aspects of Your Company ........71 43. Diversification...................................................................................73 44. How We Would Distribute ESOP Benefits .........................................74 45. Equity Benefit Other Than ESOPs.......................................................78 46. Accounting for the ESOP ...................................................................80 47. Anti-Abuse S-Corporation Rules ........................................................81 48. The Free ESOP Information Hotline ...................................................83

1 How to Use This Workbook This workbook can be used on a stand-alone basis in helping a CEO or the CEO’s advisor organize his or her thinking about whether an ESOP is right for achieving one’s objectives. It is designed to help one decide whether to become a Subchapter-S Corporation or a C-Corporation or, at some point, both. By organizing one’s thinking about the steps that must be considered, the workbook should be of great assistance to the CEO’s advisors in structuring an ESOP to the business owner’s greatest advantage in achieving what he or she would like to accomplish. The act of actually filling in blanks compels one to think out the various alternatives that must be considered in arriving at a fruitful decision. All of the blanks should be completed and the workbook given to the business owner’s advisors to help them prepare an ESOP document and transactions that will accomplish the owner’s goals. The author hopes that this workbook will be of great assistance in preparing one of the most meaningful documents of the business owner’s working career. A clear, though comprehensive, treatment of ESOPs is provided in this author’s book, ESOP: The Ultimate Instrument in Succession Planning, available at bookstores or from the author at (800) 422-ESOP (3767).

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2 What Is an ESOP? A dozen or so persons who might review an Employee Stock Ownership Plan (ESOP) would, in all likelihood, have a different view from each other about what it really is. To one, an ESOP might be perceived as a trust that provides equity to the employees of the sponsoring corporation with no contribution on their part. To another, it might be looked upon as a tax-favored financial vehicle to provide one with an exit from the company or as a means of marketing one’s stock. Still another individual might view the ESOP as a way to create capital for the company that sponsors such a plan. To someone else, the ESOP might be thought of as a way to cash out one’s co-stockholder, possibly with great tax enhancements to the selling shareholder and to the company. One might perceive the ESOP as a financial tool to facilitate a management buyout. All would recognize that an ESOP will endow both the company and the selling shareholders with tax benefits that no other qualified or nonqualified instrument will provide. These views are all correct if the ESOP plan and trust documents are well prepared and the transaction is well conceived and properly executed. The ESOP is a qualified employee benefit plan that is somewhat similar to other qualified plans such as a profit-sharing plan or a pension plan in that all of these plans fall under the Internal Revenue Code (IRC) Section 401. The word qualified means that the IRS will issue a Letter of Determination that signifies that the sponsoring corporation is entitled to a tax deduction of its yearly contributions to the employee trust. Other plans must generally invest cash contributions away from the sponsoring company, whereas an ESOP must invest its assets in qualified employer securities. All of these plans provide benefits to eligible employee participants, and those benefits can appreciate income tax free to enhance their retirement values. Numerous rules govern such plans, and the participants must be subjected to such things as a vesting schedule and certain distribution requirements. There is significant flexibility in the way an ESOP can be designed, and this Workbook will provide the reader with the knowledge to employ the variations that can be adopted.

ALLOCATING THE STOCK The amount of the corporate contributions are allocated to the accounts of the employee participants in accordance with their compensation—the higher the compensation, the larger the allocation. The amount of stock or cash that can be allocated to an employee’s ESOP account is limited, and these restrictions will be discussed in Chapter 20, “Allocation.”

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C Versus S-Company

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VESTING The participants are also subject to a vesting schedule, and any nonvested portions of their accounts that are forfeited when they terminate, retire, die, or become disabled are reallocated to the accounts of the remaining participants in the same way. The vesting schedule that is adopted must fall within the government’s safe harbor limitations, but it can generally be designed to conform with the sponsoring company’s objectives and employee makeup.

DIVERSIFICATION The ESOP is different from other qualified plans in several ways, such as the requirement that the assets of those other plans must be diversified while an ESOP can invest all of its assets in the sponsoring company’s stock. The ESOP is exempt from the diversification requirement for at least ten years after installation, at which time graduated diversification requirements may be imposed. (Please refer to Chapter 43.) The employees’ accounts must be diversified according to defined rules that must be applied.

PUT OPTIONS The participants of an ESOP are given a put option, or even two put options, against the corporation to be cashed out when the employees terminate, retire, die, or become disabled. The ESOP can assume the right to cash out the participant who leaves the company.

BORROWING ABILITY The ESOP is the only qualified plan that can be used to borrow money. It can do so to acquire qualified securities of the sponsor. In other words, it can become leveraged to buy stock. It can be used to purchase stock from stockholders who wish to sell or it can be used to buy authorized but unissued stock from the sponsoring company itself, thereby infusing capital into the company. Special strategies can be considered in leveraging the ESOP. These will be discussed in Chapter 16, “Financing.”

ACQUISITIONS A company can use the ESOP in order to acquire another company. It can do so with pretax dollars. The target company can even be merged into the sponsor or the acquiring company, and the owner of the target company can sell stock of the acquirer on a tax-deferred or even a tax-free basis. ESOPs can thereby help a corporation meet its expansion objectives.

C VERSUS S-COMPANY The C-Company has rules governing its ESOP that differ greatly from ESOPs of a Subchapter-S company. There are advantages of a C-Corporation ESOP that allow an owner to receive the tax benefits of IRC Section 1042, thereby allowing the seller to recognize no tax on the sale. It can also deduct dividends if used to be contributed to an ESOP to pay off a loan or if passed through the ESOP to the participants within 90 days. The advantages afforded to the Subchapter-S Corporation that sponsors an ESOP include the fact that if it owns all of the company stock, it can operate in a completely tax-free environment.

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What Is an ESOP?

There are other advantages as well as some disadvantages, such as the fact that such a company is not permitted to pay a dividend. It can, however, make distributions that can be used to repay ESOP loans. That can be considered to be somewhat of an offset. This topic will be further considered in Chapter 38, “Whether to be a C- or an S-Corporation ESOP.”

BEST OF BOTH WORLDS The sponsoring corporation may be a C-Company, thereby enabling the shareholder to sell stock in accordance with IRC Section 1042 and elect to be taxed as a Subchapter-S corporation in a subsequent tax year. In this way, the best of both worlds can be achieved. This workbook will assist a CEO or the company’s advisor to sort out what he or she would like to accomplish. It is meant to keep the process simple, although well organized, because that is the way all good succession plans are meant to be.

3 What Are Your Objectives? The first step in the process is to determine what you wish to accomplish and put your objectives in writing so you and your advisors will always remember what you would like to accomplish. Unless one goes through the physical act of actually itemizing what one wishes to be done, a less than desirable result may occur. Our objectives are to: Check applicable one(s): 1. 2. 3. 4. 5. 6. 7.

____ ____ ____ ____ ____ ____ ____

8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19.

____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

20. 21. 22. 23. 24.

____ ____ ____ ____ ____

Get retirement income from selling company. Retire immediately. Retire gradually. Number of years? _____. Repay debt. Transfer equity to employees. Transfer the company to employees at large. Sell to managers. a. ____ Give them control. b. ____ Give them less than control. Raise capital for company growth. Increase employee productivity by providing equity to them. Save personal taxes upon selling company stock. Get corporate tax deduction upon selling our stock. Sell company to another company for its management skills. Cultivate new manager in preparing for sale of the company. Sell the company stock in stages. Cash out another stockholder totally. Cash out another stockholder partially. Cash out all other stockholders partially. Cash out all other stockholders totally. Increase working capital. a. ____ For capital equipment and improvements. b. ____ For an acquisition. c. ____ To be stronger and attract a merger candidate. Diversify assets. Divest a division or a subsidiary. Acquire another company. Create an employee benefit. Sell to the public. 5

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What Are Your Objectives? 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36.

____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

Sell to other owners of this company. Sell in a rollup. Sell part of my stock to an outside individual who is not a competitor. Sell all of my stock to an outside individual who is not a competitor. Sell all of my stock to a competitor. Sell part of my stock to an ESOP. Sell all of my stock to an ESOP. Attract an outside executive(s). Raise capital for equipment. Raise capital to be stronger to attract a merger candidate. Pay less taxes. Other. Explain.

4 Methods I Want to Use for Selling Stock It is important to consider the alternatives that are available to you in connection with the disposition of your stock. Here are some of the possible choices that should be put forth to your advisor: Check applicable one(s): 1. 2. 3. 4. 5. 6. 7.

____ ____ ____ ____ ____ ____ ____

8. ____ 9. ____

10. 11. 12. 13. 14. 15. 16. 17. 18.

____ ____ ____ ____ ____ ____ ____ ____ ____

I want to sell to a venture capitalist. I want to sell some of my stock to another company. I want to sell all of my stock to another company. I want to sell some of my stock to some of my employees. I want to sell all of my stock to some of my employees. I want to sell some of my stock to all of my employees. I want to sell all of my stock to all of my employees. ____ a. They have the money to buy it. ____ b. They do not have the money to buy it. I want to sell newly issued company stock to get a tax deduction. I want to sell newly issued company stock to give equity to employees. ____ a. To repay loyalty. ____ b. As an incentive to them. ____ c. To attract new employees. I want to sell my own stock. I want to trade my company stock for stock of another company. I want to sell some of my stock to an ESOP. I want to sell all of my stock to an ESOP. I want to sell in stages to an ESOP over the next _____ years. I want to sell to an individual who will possibly become my successor. I want to sell part of my stock to an individual and part to an ESOP. I want to recapitalize my company. Other. Please explain.

NOTE: Some of these options are duplicates of the previous chapter in order to help clarify your wishes.

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5 Stockholder Sale of Stock Under IRC Section 1042 Most ESOPs are structured with the prime objective of providing for succession planning, the first step of which is creating a market for the owner’s stock. This strategy is often used to diversify one’s assets, which usually consist of paper that is otherwise nonliquidable.

PURPOSE OF THE SALE Perhaps an owner of a private corporation has one child who has been groomed to take over and operate the business someday, but the owner may have other children to whom he or she would like to give an equivalent amount other than company stock. By selling some of the stock to an ESOP, the selling shareholder would realize cash, which might be given to the children who are not involved in the business. By giving the children stock after having just sold a majority to the ESOP, the stock that the parent gives would be entitled to a minority discount, making it easier to make gifts within the $11,000 annual gift exclusion or $22,000 to each recipient with the consent of the spouse subject to periodic adjustments. The stock would be further reduced in value for purposes of the gifts if the company were leveraged for the purchase of the parents’ stock. A management buyout is yet another reason to sell most of the stock to an ESOP, letting the managers buy the remaining shares and having effective control of all of the stock that is held by the ESOP as well. The beauty of this approach is that the sponsoring corporation is able to deduct the cost of the transition by deducting both principal and interest repayments. Another benefit goes to the covered employees who get equity added to their ESOP accounts, income tax free, and without paying a dime for it.

SELLING STOCK WITHOUT PAYING TAX The selling shareholder selling stock under IRC Section 1042 is able to defer capital gains tax on the stock’s appreciation if the shareholder has qualified in the following manner: 1. The stock is that of a C-Corporation. 2. The shareholder has owned the stock for three or more years. 3. The sale results in the ESOP owning 30 percent or more of the outstanding stock of all classes of stock.

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Steps that Must be Taken for the Section 1042 Election

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4. The selling shareholder reinvests the proceeds of the sale in qualified replacement property (QRP) within 12 months after the sale or 3 months before the sale. (QRP is securities of domestic operating companies where not more than 25 percent of the income is from passive income. A more thorough discussion of QRP is contained in Chapter 27, “Type of Qualified Replacement Property Selling Shareholder Might Contemplate.”)

TAX CONSEQUENCES Although the tax is only deferred, as noted previously, it is not exempt. But it can be exempt if the shareholder retains the QRP until death, in which case the basis in the security is stepped up to the market value of the QRP, and there will be no capital gains tax to pay. If the step-up in basis is not available, or if the QRP is disposed of during the selling stockholder’s lifetime, the appreciation is taxed down to the original basis of the corporation’s stock. Sometimes, charitable techniques are employed that have the effect of eliminating capital gains tax. This is discussed in Chapter 26, “CHESOP.” It should be referenced here that the IRC Section 1042 election is available only for stock of C-Corporations. Stock of Subchapter-S corporations is not eligible for this election.

STEPS THAT MUST BE TAKEN FOR THE SECTION 1042 ELECTION 1. The corporation must agree to allow the IRC Section 1042 election by signing a consent form. ____ The corporation’s consent form will be signed and ___________________ will be responsible to see to it that this occurs. 2. The selling shareholder must have each purchase of QRP securities notarized. ____ The selling shareholder knows that this must be done.

6 Creating Capital The ESOP can be used to create capital by borrowing money and deducting the repayments. Principal payments, normally not deductible, would become deductible if used to repay debt by the ESOP to acquire stock. The taxes saved would also be contributions and can be considered to be infusions of capital. A C-Corporation or a Subchapter-S Corporation can make a deductible contribution of cash or stock to an ESOP and get a tax deduction for the amount contributed. Chapter 35, “How to Compute Eligible Deductible Contribution,” discusses the limits of the amount that can be contributed. The amount that can be paid into the ESOP of a C-Corporation will differ from what can be contributed to that of a Subchapter-S ESOP. No contributions by the employees are to be permitted. Only the sponsoring corporation can contribute to the ESOP. The stock of the corporation must be valued by an independent valuation company. Principal payments of corporate existing debt or payments to new borrowings can also be made to seem to be deductible, even though they are not, by having the corporation contribute stock to an ESOP in an amount equal to each principal payment on the obligation.

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Exhibit 6-1 How to Infuse Capital Into the Company Through a Leveraged ESOP Transaction

2. $1 Million Loan 3. $1 Million Cash 4. Sells $1 Million Stock Corporation

5. Annual Deductible Contributions Equal to Principal and Interest

ESOP

6. Annual Payment of Principal and Interest

7. Annual Repayment of Principal and Interest (Deductible) 1. $1 Million Loan

Bank

1. 2. 3. 4. 5.

Bank lends the corporation $1 million. Corporation lends $1 million to ESOP. ESOP pays $1 million to corporation for newly issued stock. Corporation sells $1 million of stock to ESOP. Corporation makes annual tax-deductible contributions to ESOP equal to principal and interest. 6. ESOP repays principal and interest to the corporation. 7. Corporation repays principal and interest to the bank. NOTE: Stock is allocated to the employee participants' accounts as principal or principal and interest is repaid.

Exhibit 6-2 How to Increase Capital Through a Nonleveraged Cashless ESOP Transaction

Corporation

ESOP Stock (Deductible)

1. Corporation makes tax-deductible contribution of stock to ESOP. 2. The working capital is increased by the tax savings as deductible contributions of stock are made. 3. Contributions can be made to equal the amount of principal payments on a corporate loan. Principal payments are not tax-deductible, but contributions of company stock can create a deduction without using cash. 4. This is less dilutionary in a growing company than the example in Exhibit 6-1.

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7 Selecting the Implementer Selection of the implementer is critical to the success of the ESOP. The firm that is engaged by the company to implement the plan must be experienced in installing ESOPs and ensuring that the transactions will be completed by competent team members. The implementer will possibly be able to install the ESOP within his or her own firm or may have an experienced attorney with whom he or she has worked, or if the transaction is to be complex, he or she may bring in other specialists. In any event, the person doing the valuation must be independent and should not also be the implementer unless the firm is of such a size as to have a “Chinese Wall” departmentally. The implementer should assist in the implementation process of a complex ESOP by introducing experienced team members such as the attorneys, financial advisors, valuation firms if not the same as the financial advisor, and potential trustee. The implementer should also procure fee commitments from the various team members. The coordinator will customarily introduce valuation firms, but the trustee is the one who will actually hire the valuation firm, and the sponsoring corporation can write the check for the fee. The implementer the company has selected is .

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8 ESOP Team In order for the transaction to occur seamlessly, the implementation team should be put in position at the outset. The coordinator is the logical person to assist in the selection process because he or she will have the experience to know who can fill which shoes. The ESOP team should be engaged as soon as it is determined that an ESOP is to be created.

LARGE TRANSACTION Coordinator* (e.g., The ESOT Group, Inc.) ________________________________________ Financial Procurer (investment banker, financial advisor) ____________________________ Valuation Firm (must be an independent firm) _____________________________________ ESOP Counsel ______________________________________________________________ Trustee ____________________________________________________________________ The trustee will engage its own counsel. ESOP Administrator (e.g., The ESOT Group, Inc.)__________________________________ Investment Advisor __________________________________________________________ The trustee will engage its own financial advisor. Employee Communications Specialist ___________________________________________ *The coordinator can assist in the team selection.

SMALLER TRANSACTION Coordinator* _______________________________________________________________ Valuation Firm ______________________________________________________________ ESOP Administrator _________________________________________________________ *It is possible for the coordinator to handle the complete transaction with the exception of the valuation by an independent appraiser.

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9 Questions the Trustee Should Ask in Hiring an Appraiser An independent appraisal of the stock as a going concern must be done effective as of the date stock is sold or contributed to an ESOP. It is important that the valuation firm be experienced in valuating corporations that anticipate implementing an ESOP. Name of valuation firm being interviewed _____________________________________________ Check as you ask these questions: ______

______ ______

______

______

______

______ ______

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Satisfactory?

Are you in the business of performing valuations on a part-time or on a fulltime basis? (In other words, are you moonlighting or are you in the appraisal business for real?) What designations do your senior members hold? To what professional associations or societies do you belong? Some of the associations or societies that can be pertinent are The American Society of Appraisers, The American Society of CPAs (the valuation section), NAIFTA, or others. ___________________? What do your senior members do to keep up with your continuing education as it applies to ESOPs? For example, are you aware of the major court cases that may affect what you do? Does your firm subscribe to any of the major services that provide research information that pertains to ESOP? Such sources might be Commerce Clearing House (CCH), Ibbotson, Standard and Poors, or others. Have you been an expert witness in court or defended your valuations successfully in court or against the Internal Revenue Service of the Department of Labor? Do you have any references? Do you teach or speak at meetings of your peers or have you had articles published on the subject of business valuations?

______ ______

______

______

______

______ ______ ______

10 Selecting a Trustee In selecting a trustee, it is important to remember that the Economic Retirement Income Security Act of 1974 (ERISA) as amended sets forth the following parameters of a trustee’s duty: • • •

•

The Trustee must act solely in the interests of the plan participants and beneficiaries. The Trustee must act for the exclusive purpose of providing benefits to plan participants and their beneficiaries and defraying reasonable expenses of administering the trust. The Trustee must act with care, skill, and prudence and diligence, which, under the circumstances then prevailing, a prudent man acting in like capacity and familiar with such matters would use in the conduct of an enterprise of alike character and with like aims. The Trustee must act in accordance with the plan and trust agreement insofar as the plan and trust agreement are consistent with ERISA; in the event of a conflict, ERISA would require the ESOP Trustee to act in a manner that is consistent with the ERISA standards listed below (the Overriding ERISA Fiduciary Standards), and the ESOP Trustee would not be required to follow the plan or trust agreement, but must act in accordance with the Overriding ERISA Fiduciary Standards and in accordance with the applicable requirements of law.

The trustee must be aware of numerous practical supervisory duties. An ignorance of what is required knowledge is not an acceptable excuse for violating any of the trustee’s duties. Keeping these basic thoughts in mind, one may conclude that serving as the ESOP Trustee is still within the CEO’s comfort zone and being able to sleep nights; however, the decision might be that a commercial Trustee is needed. These individuals make it their business to do things properly and to accept the fiduciary responsibility of serving as Trustee.

DIRECTED OR SELF-DIRECTED TRUSTEE The trustee can be either directed or self-directed. The latter will add more responsibility to the shoulders of the trustee. If the trustee is to be directed, the direction would come from the ESOP committee. In other words, the trustee in this case is precluded from taking action except at the direction of the ESOP committee, which is selected by the corporation’s Board of Directors.

INDEPENDENT TRUSTEE The trustee must act independently. In a legal transaction, particularly one that involves other stockholders, the trustee is an institutional one, such as from a bank or a trust company.

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16

Selecting a Trustee

An ESOP that involves only a sale or contribution of newly issued stock or a small transaction often is done with the company owner or CEO as the trustee. In any event, the trustee must function independently and essentially wear a different hat for the occasion. The penalties for violating one’s fiduciary duty can be significant. For example, if it is determined that the trustee did not opine properly regarding the value of the stock, although a valuation firm performed the valuation, the trustee can be obliged to make up any shortage. It is possible to reduce one’s degree of risk by purchasing a fiduciary’s policy of insurance.

11 Naming the ESOP Committee The ESOP committee is all-important. Typically, it directs the trustee on how to vote the ESOP stock, except for those relatively rare instances in which the trustee is self-directed. In small transactions, the company owner is usually the committee. In large transactions, the company owner, in addition to a few others, usually constitute the committee. In a directed trustee situation, it is important that the major stockholder maintain control of the ESOP committee if he or she is concerned about corporate control if the ESOP will hold a majority of the stock. Only one person needs to constitute the committee. The committee member(s) is (are) selected by the board. In larger transactions, the ESOP committee is also selected by the Board of Directors. It may contain employee representation but is usually controlled by top management. Members the board has chosen for membership in the ESOP committee are: 1.

_____________________________

Title ___________________

2.

_____________________________

Title ___________________

3.

_____________________________

Title ___________________

4.

_____________________________

Title ___________________

5.

_____________________________

Title ___________________

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12 Selecting the Administrator The ESOP administrator or record keeper has the daunting task of maintaining records of the number of shares that should be allocated to the employee’s account, the amount that is vested, the family members who are not permitted to participate, the nonfamily stockholders who are precluded from participation, the stock basis, the various classes of stock, whether Section 1042 rules apply, whether interest or dividends are to be included as part of IRC Sections 404 and 413, all about dividends, the differences in handling a C-Corporation and a Subchapter-S Corporation ESOP, and other matters. It is essential that the ESOP administrator not merely dabble in ESOPs, but have many plans on the books and be committed to keeping up with the ESOP world and the changes that occur. ______ ______

We will administer the plan inhouse. ___________________ will be in charge of the administration. We will use an outside administrator. I have selected ___________________________ as the plan administrator.

NOTE: The ESOP administrator is not a fiduciary.

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13 Feasibility Study In order to determine if an ESOP is an appropriate financial vehicle for a company to implement, it is wise to have a feasibility study performed by an ESOP specialist. Such a study should be designed to enable the board of directors of the corporation to make an informed decision about whether the company can afford to buy some of the stock from shareholders who would like to sell. The primary questions that should be considered are those itemized in the questionnaire in the following chapter. By completing the answers to this form, the owners of the company should get a clearer picture of what their objectives are and how realistic their plans to achieve them are. By studying the answers to these questions, an informed ESOP practitioner should be able to determine the feasibility of implementing an ESOP or be able to advise how best to structure the transaction the corporation is contemplating and to determine what might be done with other employee benefit plans to which the company has been contributing. The study should also help determine whether the company should consider changing its format from Subchapter-S to a C-Corporation or vice versa. It should also address the question of which family members of stockholders selling their shares under the IRC Section 1042 election should be deleted as plan participants and what nonqualified plan might be designed to offset their deprivation of having stock allocated to them in the ESOP. It may be feasible and desirable to give certain executives incentive benefits. This can also be determined by a feasibility study.

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14 Feasibility Study Questionnaire It is wise to prepare a data sheet concerning some of the pertinent facts about your company so that these facts will not be overlooked when discussing the idea of implementing an ESOP with your advisors. Name of Corporation Address: Street City ___________________ State ________________ ZIP Phone (_____) ____________________________ FAX (_____) CEO ____________________________________ CFO Name of Contact ___________________________ E-Mail Stockholders

No. of Shares or %

Date of Birth

Annual Payroll $ _________________ Selling Owner’s Salary & Bonus $ Total number of full-time employees __________ How many of these are non-union? Defined Benefit Pension Plan? __________ $ ___________________ Money Purchase Pension Plan? __________ $ ___________________ Profit-Sharing Plan? __________ $ ___________________ 401(k)? __________ $ ___________________

Plan Assets $ __________ Annual Contribution Plan Assets $ __________ Annual Contribution Plan Assets $ __________ Annual Contribution Plan Assets $ __________ Corporate Match

Subchapter-S Corporation? (Y/N) _________. Regular Corporate Fiscal Year:________/________. C-Corporation? (Y/N) _________. Fiscal Year: _________/_________. LLC? (Y/N) _________. Fiscal Year: _________/_________

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Feasibility Study Questionnaire

21

Annual revenue for three prior years, the current year and projection for three future years: DATE 1. Revenue for FYE _____/_____/_____ 2. Revenue for FYE _____/_____/_____ 3. Revenue for FYE _____/_____/_____ 4. Revenue for FYE _____/_____/_____ 5. Revenue for FYE _____/_____/_____ 6. Revenue for FYE _____/_____/_____ 7. Revenue for FYE _____/_____/_____

(3 years ago) (2 years ago) (last year) (current year) (next year) (2 years future) (3 years future)

$___________________________ $___________________________ $___________________________ $___________________________ $___________________________ $___________________________ $___________________________

EBITDA (Earnings before interest, taxes, depreciation and amortization) for: 1. This year 2. Last year

$ ___________ $ ___________

Estimated Fair Market Value of Corporation Book Value of the Corporation Long-term Debt of the Corporation (amount) When is it scheduled to be paid off?

$ ___________________ $ ___________________ $ ___________________ _____/_____/_____.

Estimated growth in the value of the company for the next five years: 1. _____/_____/_____ 2. _____/_____/_____ 3. _____/_____/_____ 4. _____/_____/_____ 5. _____/_____/_____

___________________ % ___________________ % ___________________ % ___________________ % ___________________ %

Is there a Buy/Sell Agreement? Yes _____ No _____ Amount Funded? At death $ ___________________ At disability $ ___________________ Does the company have good second-line management who could run the company? Yes ________ No ________ If Yes, who? Are the owner’s children likely successors? Yes ________ No ________ If Yes, which ones? Are there other children not involved in the running or ownership of the company? Yes ________ No ________ If Yes, who?

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Feasibility Study Questionnaire

CORPORATE & PERSONAL OBJECTIVES: (Check those items in order of importance.) ______ ______

Cash out one or more shareholders and avoid capital gains tax. Which ones?

______

How much? $ ___________________ Sell or merge the company

______

______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ ______

Get some capital out of the company while retaining control, salary, and perks. How much? $ ___________________ Perpetuate the company through a son/daughter who works for the company. Retire Immediately _____ Next five years _____ Ten years or more _____ Infuse working capital into the company. How much? $ __________________ Acquire another company with pretax dollars. Sell company to a management group with tax advantages to both buyer and seller. Get equity into the hands of employees with shareholder and company tax benefits. Go public. Go private. Create a private marketplace for company stock. Recover taxes paid in prior years. Induce employees to remain with the company. Entice executives to join the firm. Refinance existing debt, making both principal and interest tax-deductible. Increase employee productivity and thereby increase company profitability. Reduce the cost of employee benefits and stop the cash drain of pension and profit-sharing plans.

Details:

If ESOP will not be used for a Section 1042 sale, will it be used to create capital? Yes ________ No ________ If so, how much will your company borrow? $ ______________ Do you have a qualified plan? Yes ________ No ________ If so, profit-sharing plan, 401(k), defined contribution plan, defined benefit plan, SIMPLE plan, other? Please circle.

Feasibility Study Questionnaire

23

If 401(k), how much did the company match for the past three years? Year ________ $ ______________ Year ________ $ ______________ Year ________ $ ______________ Family members of selling stockholders working for the company: (In-laws do not count as family for a C-Corporation IRC Section 1042 transaction.) ___________________ Salary $ ______________ ___________________ Salary $ ______________ ___________________ Salary $ ______________ ___________________ Salary $ ______________ ___________________ Salary $ ______________ Owners of 25 percent or more of the stock: Note: Owners of 25 percent or more of the stock in and outside of the ESOP will be excluded if anyone elects under Section 1042. Their family members will also be excluded. Owners of 25 percent or more of the stock after the transaction:

Family members of 25 percent stocklholders:

ESOP loan to be serviced by the corporation: Amount $___________ Term ___________ Will more than one lender be involved?________ Will owner take back a note?_________ Will a dividend be used to service the note?________ What class(es) of stock does the company have?__________________________________ What type will be created e.g. convertible preferred________? Super Common?_________ Details of the loan if available______________________________________________________ (attach loan documents)

15 Valuation of the Company for ESOP Purposes Definition of fair market value is stated under IRC Sections 20.2031-1(b) and 25.2512-1 of the Department of the Treasury regulations: “Fair market value is a value at which a willing buyer and a willing seller, both informed of the relevant facts about the business, could reasonably conduct a transaction, neither person acting under compulsion to do so.” The ESOP requires that the stock of a privately held corporation be valued each year that there is stock in the ESOP. The ESOP is permitted to pay no more than fair market value but can pay less.

MINORITY DISCOUNT If a minority amount of stock is to be acquired by an ESOP, the valuation firm will most likely assign a minority discount to the value of the stock. The discount will usually range from 10 to 35 percent of the nondiscounted value of the stock. The degree of the discount usually depends on the valuation firm that is employed. The discount can sometimes be avoided even though only a minority is being sold. If the ESOP is given an option under an independent trustee to acquire 50 percent plus one share within several years, the trustee will usually opine that a minority discount will not be applied, notwithstanding the fact that only a minority amount of the stock is being sold currently.

MARKETABILITY DISCOUNT In addition to the minority discount, a discount for lack of marketability may also be applied, although because the ESOP gives its participants a put option to sell their stock to the ESOP, such a discount is seldom applied. Here is a simple calculation to develop a possible sense of what the value may approximate; however, this activity is no substitute for an independent valuation by a competent business valuation firm.

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Marketability Discount NET ASSETS Company Assets Less Long Term Liabilities Less Short Term Liabilities Total Liabilities NET ASSETS NET EARNINGS Gross Revenue Less Expenses PRETAX EARNINGS

25

$_________________ $_________________ $_________________ <$_________________> $

$_________________ <$_________________> $

Public Comparable Industry Comparisons are traded at___________⫻ pretax earnings. Using an earnings approach, my company has an approximate valuation range of $_____________ to $______________. If net assets are greater than the value determined by the earnings approach, then the net asset value may be used instead of the earnings approach. Sometimes the multiple of earnings methodologies is enhanced by some of the value of assets where the latter are a national factor in achieving the net earnings. This simplistic exercise may help give the owner(s) an idea of the range of value of many private companies using an income approach, although an accurate fair valuation for an ESOP can only be established by an independent appraisal firm. The valuation firm will use as its basis for the valuation the eight methodologies itemized under Revenue Ruling 59-60, which are: 1. The nature of the business and the history of the enterprise from its inception 2. The economic outlook in general and the condition and outlook of the specific industry in particular 3. The book value of the stock and the financial condition of the business 4. The earnings capacity of the company 5. The dividend-paying capacity of the company 6. Whether the enterprise has goodwill or other intangible value 7. Sale of the stock and the size of the block to be valued 8. The market price of stocks of corporations engaged in the same or similar lines of business having their stocks actively traded in a free and open market, either on an exchange or in the over-the-counter market The valuation firm will add several factors that pertain specifically to the specific company being evaluated.

16 Financing In a leveraged ESOP, the loan is generally arranged so that the bank lends to the corporation, the outside loan, and the corporation lends to the ESOP, the inside loan. The inside loan is usually a mirror loan (i.e., on the same terms as the outside loan) but it can be on substantially different terms. The latter instance is often the result of an insufficient covered payroll, the IRS Section 415 limits being too low to allow the company to service principal on a short-term loan.

USE OF FINANCING The ESOP can use financing for the following purposes. For what would you have the ESOP use financing? Check applicable one(s): 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

Cash out stockholders using IRC Section 1042. Cash out stockholders not using IRC Section 1042. Make divestitures. Increase working capital by buying newly issued stock. Acquire other companies. Transfer equity to employees. Increase cashflow. Refinance existing debt. Make capital improvements. Establish cushion for contingencies. Other

COLLATERAL REQUIREMENTS Companies often borrow money in order to acquire assets that would be anticipated to help them compete more advantageously and become more profitable as a result. Bank loans are more easily obtainable for such a purpose. Moreover, the asset being acquired can become a part of the collateral needed by the bank if such collateral is required. In the case of an ESOP loan made to acquire stock from the owner, no such tangible asset is being acquired. Stock only has a limited value to a bank, which prefers hard assets as its collateral. In the situation whereby the owner is selling stock to the ESOP, the proceeds are leaving the company.

26

Term

27

Granted, the qualified replacement property can be used as collateral if required and if the selling shareholder is willing to help collateralize the loan. If such is the case, the lender will probably release the personal collateral from pledge on a priority basis as the principal is amortized. This may result in the complete release from the guarantee in a shorter time than the company’s collateral will be. In any event, the seller will be able to receive the dividend and interest earnings on the QRP during the collateralization period. We can often find ways for a company to obtain financing where no personal collateral is required.

VALUATION It is wise in an ESOP loan to obtain an independent valuation that is realistic from the bank’s standpoint. If the valuation is not deemed to be excessive from the lender’s perspective, then it is more likely that a loan would be in the offing. The coordinator should be able to provide the company with the names of experienced valuation firms.

TERM The term of the ESOP loan can vary from about one month or so to 20 or more years, depending primarily on the lender’s appetite for the economy, the industry, the company, and the purpose of the loan.

17 Determining the Type of ESOP Transaction Check applicable one(s): 1. ____ Would you sell to your ESOP as a C-Company under IRC Section 1042? 2. ____ Would you sell to your ESOP as a C-Company not under IRC Section 1042 and remain a participant of the ESOP? 3. ____ Would you sell all of your stock? 4. ____ Would you sell only a portion of your stock? 5. ____ Will the transaction involve the ESOP buying out another stockholder’s stock? 6. ____ If so, is that stockholder a majority or a minority stockholder? 7. ____ Will the ESOP be used to buy only newly issued stock? 8. ____ Will the ESOP be used only to have newly issued stock contributed to it for a tax deduction and an employee benefit? (Note: This can accrue toward the 30 percent threshold except for the allocation to the owner.) 9. ____ Will you sell stock to the ESOP not under IRC Section 1042 as a Subchapter-S Corporation? 10. ____ Will the company procure outside financing? 11. ____ Will you take back a note from the ESOP? 12. ____ Will another stockholder take back a note from the ESOP? 13. ____ Will a separate class of stock be sold to the ESOP? 14. ____ If so, will it be super common? 15. ____ Or, will it be convertible preferred? 16. ____ Will the ESOP stock pay dividends? 17. ____ Will the company contribute only cash to the ESOP annually for a few years to accrue toward the 30 percent threshold? 18. ____ Will multiple traunches of stock be sold over time (i.e., 30 percent this year and more later)? SUMMARY OF WHAT I WOULD LIKE TO DO

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18 Estimating the Amount of Financing Needed The amount of financing needed (i.e., how much stock of owners or newly issued stock would we like to have be sold to the ESOP?) must be estimated. Can we sell the total amount of stock that we wish to sell now or must the stock be sold in sequential blocks? The amount of stock we would like to sell now: $ ______________ Amount of equity we believe we can obtain Amount of senior debt we believe we can obtain Amount of equity or mezzanine financing we must obtain TOTAL

$ ______________ $ ______________ $ ______________ $ ______________

NOTES: An equity investor generally requires a return of about 35 to 40 percent. Mezzanine investors generally currently require a return of 15 to 25 percent. Senior debt providers generally currently charge 8 to 12 percent. Equity and/or mezzanine financing is required where there is a shortfall on the senior debt.

SOURCES OF FINANCING The amount of financing that will be required for the transaction being contemplated may determine the need for various levels of financing such as the following: Check applicable one(s): Equity ______ ______ ______

Outside investor Management group Assets of your company’s qualified plan Mezzanine Debt

______ ______

Subordinated to the senior lender Obtainable from a bank, outside investor, selling shareholder, insurance company, pension fund, your profit-sharing plan

29

30

Estimating the Amount of Financing Needed Senior Debt

______ ______

Your own bank or another Selling shareholder

HOW MUCH SENIOR FINANCING MY COMPANY CAN EXPECT TO OBTAIN Fixed Assets (net of loans): Accounts Receivable: Inventory: Real Estate:

$ ______________ $ ______________ $ ______________ $ ______________ TOTAL AVAILABLE

Banks generally lend: 50% or $ ______________ 85% or $ ______________ 50% or $ ______________ 70% or $ ______________ $ ______________

NOTE: Some banks are cashflow based. Most lenders will agree to use part or all of the seller’s qualified replacement property (QRP), stocks, or bonds of domestic corporations as collateral. This would most likely be released dollar for dollar as principal is paid down. Certain lenders may require no personal guarantee.

19 Actions to Take Once You Have Decided to Install an ESOP Check if you have done these: 1.

2. 3. 4.

5.

6.

____ Take the idea to the board of directors. If you are the board in reality, have the minutes of the board meeting resolve that the corporation will have an ESOP implemented as of a date that you or the board will decide upon. ____ The board of directors should engage a coordinator of the ESOP project to help select the players who will be engaged to implement the ESOP. ____ The board of directors should appoint the ESOP trustee. A committee is often designated to preselect a trustee and take its selection to the board for its approval. ____ It is important that the company stock be appraised by an independent appraiser. The fee of the appraiser can be paid by the corporation, but the appraiser must legally be hired by the ESOP trustee, not the corporation. ____ In order to assess the feasibility of installing an ESOP, it is a good idea to determine the amount of financing the corporation can procure. If a fairness opinion is required, will the valuation firm be qualified to perform one or will another firm have to be engaged? ____ The CFO is usually designated to obtain the financing.

NOTE: If your company adopts a plan before its fiscal year-end, the company can obtain a tax deduction in this current year but contribute cash to the ESOP in the following year before the end of its accrual period and its six-month extension. Only when the ESOP is used to acquire stock must the stock be valued.

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20 Allocation The way that the allocation formula works is to allocate the assets of the ESOP according to compensation. The includable compensation is determined by the ESOP plan document, and it may be based on salary or on salary and bonus. Only a certain amount of a participant’s compensation can be considered. Currently in year 2002, it is $200,000, but this will increase for inflation. A cap on the amount that can be allocated to a participant’s ESOP account is $40,000 currently in 2002, but this, too, will be increased annually. The amounts deferred under 401(k) plans had to be counted toward these limits of contribution in the past, but they are no longer considered to be additions under current law. The amount of compensation that is put into a cafeteria plan (an IRS Section 125 plan) similarly does not count as an addition. The amount of the corporation’s annual contribution cannot exceed the amount that can be allocated to the ESOP. Interest or dividends of C-Corporations or distributions of Subchapter-S Corporations that are paid into ESOPs do not constitute additions to a participant’s ESOP account. The maximum amount of corporate contribution that can be contributed to a participant’s ESOP account in a C-Corporation is 25 percent of compensation, whether or not the ESOP is leveraged. As previously noted, both interest and reasonable dividends may be allocated to a participant’s account in a C-Corporation’s ESOP. In the ESOP of a Subchapter-S Corporation, interest is considered an addition and accrues toward the 25 percent limitation. Distributions made to a SubchapterS ESOP are not treated as additions and can be allocated beyond the 25 percent limitation on allocations. If the plan is top heavy (i.e., 60 percent of the stock being allocated is allocated to highly compensated employees) then the interest and dividends of a C-Corporation are considered to be additions to the plan and are not allocated in addition to the 25 percent of compensation. It is also possible to allocate additional stock based on granting points for each year of past service.

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21 Vesting The ESOP will have a vesting schedule that will affect the amount of stock that the ESOP participants will be eligible to receive. If a company has a high degree of turnover, the forfeitures should be substantial, and they will be reallocated to the accounts of those who remain participants of the ESOP. The stock that is forfeited will be reallocated in accordance with the remaining participants’compensation as was the original allocation. If the ESOP is considered top heavy, (i.e., where 60 percent or more of the ESOP’s assets will be allocated to the more highly compensated participants), then an accelerated vesting schedule must be used. Two safe harbor governmental mandated vesting schedules are available to be used in an ESOP. They are the following: ______

______

______ ______

Seven-year vesting: End of year one—zero vesting End of year two—zero vesting End of year three—20 percent of the account balance End of year four—40 percent of the account balance End of year five—60 percent of the account balance End of year six—80 percent of the account balance End of year seven—100 percent of the account balance Cliff Vesting: End of year one through year four—zero vesting End of year five—100 percent of the account balance Immediate 100 percent vesting Top Heavy Vesting: End of year one—zero vesting End of year two—20 percent of the account balance End of year three—40 percent of the account balance End of year four—60 percent of the account balance End of year five—80 percent of the account balance End of year six—100 percent of the account balance

If a profit-sharing plan is to be converted to an ESOP, the vesting account of the profit-sharing account must be used. The amount of the converted profit-sharing account that is vested will remain vested in the ESOP. It is possible to give credit for past service, thereby rewarding the long-time personnel who have remained loyal to the company dating back to an earlier date. The sponsoring corporation can design the vesting schedule as sort of a “golden handcuff.” 33

22 Control The effective control of an ESOP does not necessarily mandate that one side has more shares than the other because the vote need not be passed through to the employee participants of the plan except for six grave issues, namely: • • • • • •

Merger Consolidation Sale of substantially all of the company assets Liquidation Reorganization Recapitalization

It may be of interest to note that in the case of a sale of stock, the vote need not be passed through to the employees. Therefore, if one has even one share of stock outside of the ESOP trust, that individual can realize effective control of the vote. ______

It is the intention of the Company’s Board of Directors that ______ % of the stock be held by

______

It is the intention of the Company’s Board of Directors that the ESOP own 100% of the stock.

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23 Designing the ESOP Plan Provisions with the Attorney The experienced ESOP implementer will be able to complete this section for the attorney, but the experienced ESOP attorney will need to attest to the accuracy of the responses. Certain provisions are subjective, and a great deal of flexibility may be incorporated into the plan. Other provisions in the plan are required by statute and are somewhat inflexible. The following will be of great assistance to the drafter of the documents, even though some of these provisions may have to be modified in the final design: ESOP DOCUMENT DESIGN CHECKLIST 1. 2.

3. 4. 5. 6. 7.

ESOP Plan effective date: ____________ Type of Plan ________ Stock Bonus ________ Stock Bonus/Money Purchase If this type, what percent is contributed to Money Purchase? ____% For how many years? ____ Provision for leveraging? ____ Yes ____ No Will seller be utilizing IRC § 1042 provision (deferral of capital gains through purchase of a qualifying security?) ____ Yes ____ No Is Company a ________ Sub “S” Corporation? ________ “C” Corporation? Company’s Fiscal Year End ________ ESOP Plan Year End ________ Participation rules: a. Minimum age to be a Participant in the ESOP ________ b. Minimum Years of Service to be a Participant ________ c. Past service credit? ________ d. Minimum hours required? ____ Yes (1,000 hours) ____ No e. Employee Classes Excluded:

f. Plan Entry Date(s)

________ Annually ________ Quarterly

________ Semi-annually ________ Other: 35

36 8.

9. 10.

11. 12. 13. 14.

15. 16.

17. 18.

Designing the ESOP Plan Provisions with the Attorney Vesting schedule: ____ 0 vesting for 3 years, then 20%/year, full vesting in 7 years ____ 5-year cliff vesting ____ other Minimum hours ( ____ ) Allocation rules: a. Minimum hours for contribution ( ____ ) b. Definition of Compensation for Allocation: ________ Total Compensation ________ c. Employment on last day required ____ Yes ____ No d. Interest and Principal ________ Principal Only ________ Reallocation of Forfeitures ________ Five-year Break in Service ________ Five-year Break in Service/Following Distribution Break in Service ⫽ ________ hours 1042 Employees to share in allocation of non-1042 stock? ____ Yes ____ No Distribution Rules: a. Defer all until ESOP debt is retired? ____ Yes ____ No b. Retirees ________ Year Following ________ Other: _____________________________ c. Death ________ Year Following ________ Other: _____________________________ ________ Do not defer until debt is repaid d. Disability ________ Year Following ________ Other: _____________________________ ________ Do not defer until debt is repaid e. Quit or Fired ________ Six Years ____ Other: __________________________ _________ Minimum Distribution Amount f. Distribute Stock ____ Yes ____ No g. Distribute Cash Only ____ Yes ____ No h. Decision maker re: how to distribute (lump sum, etc.) ____ Trustees ____ Participant Self-trusteed? ____ Yes ____ No Definition of Disability: An illness or injury of a potentially permanent nature, expected to last for a continuous period of not less than 12 months, certified by a physician selected by or satisfactory to the Employer, which prevents the Employee from engaging in any occupation for wage or profit for which the Employee is reasonably fitted by training, education, or experience. Or other

Definition of Retirement: Union Employees included automatically?* ____ Yes

____ No

*Only if you have had good-faith bargaining regarding retirement benefits may members of collective bargaining units be excluded. To include them, it is necessary to obtain approval from the union.

24 How to Communicate the ESOP to the Employees Communicating the ESOP benefits to the employees is all-important. The more extensive the communications, the greater mileage the company will receive from the employees. The only legal requirement is that the employees receive a copy of the summary plan description (SPD). Anything beyond this is pure icing on the cake. Communications can take the form of a meeting with the rank-and-file employees on site or off site. This can be done by the company staff, or a professional ESOP communicator can be engaged. A popular method of communicating the ESOP is to hire a professional communicator to train the managers, who will then take the message to the troops under the manager’s command. In this way, new employees can be included in the communication process. In all cases, the program should include a question-and-answer period. The owners of the company should be forthright about the reasons they have sold their stock and they should convey the tax benefits that will accrue to them as well as to the company. The corporation should explain the hazards to the company in undertaking the debt load to fund the ESOP for the acquisition of stock. It should also explain how the repurchase liability to cash out the ESOP participants will be handled. The ESOP should not simply be presented as a one-way street, whereby the employees would recognize no challenging problems. Studies show that the more participative management the company practices, the better the understanding and appreciation of equity ownership the ESOP participants will have, and productivity improvement is a byproduct of this greater understanding. It has been determined that ESOP companies outperform their peers that do not have ESOPs—the better the communications, the better the productivity. In many cases, a basic understanding of the financial statements can have a major effect on employees because this would impart to them an appreciation of how profitability affects the value of their stock accounts. The employees should be helped to understand the basic way in which the ESOP works. They do not have to be burdened with the intricate details of the plan, however. The overall tone of the meeting should be on a positive note because, after all, the company did come to the conclusion to implement an ESOP. It must have seemed to be a good idea to the decision makers. Internal managers should be trained to answer the many questions they will continue to receive after the introductory meeting is held. There is no end to the depth of communications that can occur and the level of expense that can be expected. The corporation should limit the expenses of the communications to a finite amount. It is important that the history as well as the projected future of the company be emphasized at the communications meeting so that employees are given some insight into where they are heading and what they should strive for. 37

38

How to Communicate the ESOP to the Employees

Some of the communication aids might be a video made for the occasion, or the company might adopt a general video that has been made for ESOP companies, use booklets, payroll handouts, posters, or simply chalkboards or flipcharts. The company intends to communicate the ESOP by: Check applicable one(s): ______ ______

Having an on-site meeting. Having ______ on-site meetings. (a) Denote location(s):

______ ______

Having an off-site meeting. Having ______ off-site meetings. (a) Denote location(s):

______ ______ ______ ______

Time of the meeting(s) ______ Breakfast, lunch, predinner snack, dinner, nothing will be served. Circle one(s). Overheads, slides, powerpoint, flipchart, chalkboard, other will be needed. Circle one(s). Summary Plan Description (SPD) will be handed out at the meeting(s). SPD will be distributed ______ days before the meeting(s). It will be translated into _______________________ and _______________________. Translation is required if 10 percent or more of the employees are of a foreign nationality. Sound system is required.

The following other material will be distributed: ________________________________________ ________________________________ will be the meeting leader. Personnel that will speak are

Orchestrated by

25 How to Coordinate the ESOP with Other Qualified Plans PARTIAL CONVERSION OF PROFIT-SHARING PLAN A corporation can perform a full conversion or a partial conversion of a qualified profit-sharing plan. Partial conversion refers to the act of converting the plan and its assets to an ESOP. The assets are not used to purchase the sponsor’s stock but will be administered in the ESOP as the “Other Cash Account.” All new cash is used to purchase employer stock from the company or from a stockholder.

FULL CONVERSION OF A PROFIT-SHARING PLAN A full conversion of a profit-sharing plan results in using all or part of the profit-sharing plan assets to purchase the sponsoring corporation’s stock. This should not be done lightly because of the potential fiduciary liability that may arise as a result of using funds of the employees. Although it is legally permitted, some of the employees may raise an objection. If the conversion is done improperly, it may be considered to be a sale of stock by the Securities and Exchange Commission (SEC), causing the stock to be registered with the SEC. Informed counsel should be consulted on this matter.

TRUSTEE ACTION The trustee is sometimes willing to use about 10 percent or more of the profit-sharing plan assets in this manner without the consent of the employees. An offering of employer stock to the employers may be treated by the SEC as a sale of securities that must conform with certain SEC requirements. The employees are usually polled informally about the amount of assets in their plan that they would be willing to use to purchase employer stock. An offering memorandum would be prepared for this occasion. This is almost akin to a prospectus in that it shares financial history concerning the company as well as a list of the stockholders, the amount of stock they hold, and their compensation.

401(K) The amount of assets that have accumulated as a result of the sponsoring employer’s matching contributions to a 401(k) plan are treated in a similar fashion because this is really a profit-sharing plan. The employees may continue to make voluntary deferrals into their 401(k) accounts. They have no effect on the amounts that can be contributed to the ESOP by the sponsor and allocated to the employees’ accounts under IRC Sections 404 and 415, respectively. 39

40

How to Coordinate the ESOP with Other Qualified Plans

PENSION PLAN Conversion of a pension plan is considered to be tantamount to terminating the plan, in which case the account balances become immediately vested. Pension plans can exist along with an ESOP but are often terminated because of the contribution and allocation limitations imposed by IRC Sections 404 and 415, respectively, and because the corporation’s cashflow might be perceived to be better used for servicing ESOP debt to acquire stock from a shareholder.

CONCLUSION We will:

26 CHESOP The CHESOP (Charitable ESOP) can be several things to different people. The concept is designed to use the ESOP tax advantages and the tax and other benefits that a charity qualified under IRC Section 501(c) (3) offers. One need not be charitably inclined to desire the tax benefits of a CHESOP, but it helps. The basic idea is that one can give appreciated stock to a public charity and can deduct up to 30 percent of the donor’s adjusted gross income (AGI). The tax deduction can be carried forward for five years plus the current year. The stock must be valued by an independent valuation firm. The charity, under no preconceived arrangement, will undoubtedly want to find a buyer for these shares, particularly if they are shares of a private company. If the charity sells the shares to the company’s ESOP, the corporation will get a tax deduction for making a cash contribution to the ESOP. The donor gets a deduction and so does the corporation—two deductions for one gift. The gift also escapes capital gains tax on the donation. If the donor gives stock to a charitable remainder trust (CRT), he or she and the spouse can avoid capital gains tax and get an income tax deduction based on the charity’s remainder interest. This varies with the age of the donor(s) and the percentage of the corpus the donor(s) seek(s) as an income stream because this will affect the residual amount that the charity will receive. The CRT is designed to provide the donor(s) with a lifetime income stream, and the investment’s appreciation will not be subject to tax. It will also escape estate taxes. The ESOP can provide the funding through deductible corporate contributions. The ESOP can be leveraged or nonleveraged, depending on the cash requirements. 1.

2.

____ Do you plan on using any of the various charitable techniques such as involve donating stock to the following? ____ Outright gift to a 501(c) (3) public charity ____ Private foundation ____ Charitable remainder trust (CRT) ____ Charitable annuity ____ Family limited partnership (FLP), transferring limited partnership (LP) units to a charity. Note: The FLP should be established and stock transferred to it in order that the FLP be the entity making the gifts of stock to a charity or to your foundation if it is the entity that sells the stock under IRC Section 1042. NOTE: These strategies can involve both a personal tax deduction, a corporate tax deduction, and possibly an income stream. The owner deducts part or all of the gifts, and the corporation deducts the contribution to the ESOP, which may buy the stock from the charity in non-prearranged transactions.

41

42

CHESOP 3.

____ Have you established your charitable foundation if this is the route you plan to take? How much is the basis of the selling stockholders? $ _________________.

If you intend to use a CRT in connection with an ESOP, please complete the following: Check applicable one: 1. 2. 3. 4. 5.

____ ____ ____ ____

My stock has been valued by an independent appraisal company. I have established a CRT. I have given stock to my (our) CRT. I have received a calculation of my (our) tax deduction and income stream in connection with a CRT. ____ I want to give stock to the following charity or charities: a. ____________________ b. ____________________ c. ____________________

Results of CHESOP using a CRT: 1. 2. 3. 4. 5.

Donor bypasses capital gains tax. Donor gets a tax deduction for CRT’s remainder interest. This is determinable by IRS table. The assets of a CRT can be actively managed income tax free. Donor receives a monthly income stream. Corporation receives a tax deduction for principal and interest payments for an ESOP loan to acquire the donated stock from the CRT. 6. Children’s wealth replacement trust (WRT) insurance replaces their lost inheritance. 7. Charity benefits by the legacy.

Exhibit 26-1 CHESOP

Donor

1. Donates Stock (Deduction)

Charity

4. Pays Cash

2. Sells Stock

3. Contributes Cash (Deduction) Corporation

ESOP

1. Donor makes tax-deductible donation of stock. 2. Charity sells the stock to ESOP (not prearranged). 3. Corporation makes tax-deductible contribution of cash to ESOP. 4. ESOP pays cash to charity.

NOTE: Donor might establish an irrevocable trust funded by life insurance (Wealth Replacement Trust) benefiting the children because they would otherwise be disinherited. Result: • • • •

Donor gets a tax deduction. Corporation does too. Stock is allocated to the employees' accounts. No capital gains tax. Tax-free accumulation. No estate tax.

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Exhibit 26-2 CHESOP Using a Charitable Remainder Trust (CRT)

Donor

8.

1. Donates Stock (Partial Deduction)

CRT

6. Pays Income

9. Remainder Interest to Charity 2. Sells Stock

5. Pays Cash

WRT with Life Insurance 10. Stock is allocated to employees' accounts

4. Annual Contributions (Deduction) Corporation

ESOP

7. Repays Bank 3.* Lends Cash

Bank 1. Donor donates employer stock to CRT. 2. CRT sells stock (not prearranged) to ESOP. 3. Bank lends money to ESOP.* 4. Corporation makes annual deductible contribution to ESOP equal to principal and interest. 5. ESOP pays CRT for the stock. 6. CRT pays monthly income to donor. 7. ESOP repays bank. 8. Insurance paid for by tax deduction and income stream pays children's trust at death into Wealth Replacement Trust (WRT), an irrevocable trust. 9. CRT retains remainder at death. 10. Employer stock is allocated to the employees' accounts. * Bank generally prefers to lend to the corporation, which then lends to the ESOP. The corporation makes annual deductible contributions to the ESOP. The ESOP then repays the corporation, which repays the bank.

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27 Type of Qualified Replacement Property Selling Shareholder Might Contemplate Only stock of a private C-Corporation that has been owned by the seller for three years or more may be sold by the owner under IRC Section 1042. The shareholder selling under IRC Section 1042 must invest in qualified replacement property (QRP) within 3 months before or 12 months after the sale of the owner’s stock. As previously noted, in order to realize the tax benefits under Code Section 1042, the transaction must result in the ESOP owning 30 percent or more of the outstanding stock of the company. QRP must be securities (stock or bonds of domestic corporations); not more than 25 percent of their income can be passive. Neither CDs, municipal bonds, nor any other government security is eligible. If you sell your QRP during your lifetime, you will be taxed down to your original basis on what you sell but not on what you do not sell. If you wish not to be taxed on the capital gains, you would invest in a static portfolio. This will receive a step-up in basis at death under current law; however, if you prefer, there is a strategy that will allow you to have an actively traded portfolio without incurring tax. This can be accomplished by investing in a floating-rate note (FRN). A floating-rate note qualifies as QRP and is a long-term bond (30 years or more or perhaps as long as 80 years) that is issued by certain A- or AA- rated companies that can be borrowed against up to 90 percent or more. The FRN pays a rate of interest and the borrower pays the bank a rate of interest. The result is a net out-of-pocket expense of about 1 percent or, if the amount is large, the result can be about a wash or a zero cost. The amount borrowed can be invested in an actively traded portfolio without triggering the capital gains tax down to the selling stockholder’s basis. This is possible because the FRN qualifies as the QRP, and because one borrows against the FRN, it serves as a means whereby one’s assets can become monetized.

STRATEGY If the company is unwilling to take on a large debt load to a bank, the seller can take back a note from the ESOP and only 10 percent need be put up to purchase the FRN. In a simultaneous transaction, the 90 percent loan is made. The company would make deductible contributions to the ESOP that are equal to principal and interest payments. Because the ESOP pays this to the selling shareholder, he or she will be taxed only on the interest, not on the principal. This strategy can be used by itself or in conjunction with a bank loan. In the latter case, the seller’s note would undoubtedly be subordinated to the bank loan. 45

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Type of Qualified Replacement Property Selling Shareholder Might Contemplate

CHECKLIST FOR COMPLYING WITH IRC SECTION 1042 Check applicable one(s): 1. ____ We have considered the QRP strategy that involves an FRN. 2. ____ We intend that the QRP be in the form of individual stocks and/or bonds. ____ a. 100 percent ____ b. Part 1 and part 2 3. ____ I want my shares to be sold under Section 1042. 4. ____ Another stockholder or stockholders intends to sell under Section 1042 along with me or without me. 5. ____ My company is a C-Corporation. 6. ____ I have held the stock for three or more years. 7. ____ Other stockholders who are electing under Section 1042 have held the stock for three or more years. 8. ____ The corporation has signed a consent form to permit each electing shareholder to sell under Section 1042. 9. ____ The electing shareholder has until ___/___/___ to purchase QRP or has done so on ___/___/___ . 10. ____ The electing shareholder has the securities as indication that they comprise the QRP.

28 Repurchase Liability The participants of an ESOP of a private company have the right to receive cash when they terminate, retire, die, or become disabled according to the distribution rules that have been adapted. They are given two put options against the company, on which they have 60 days to exercise the option. The second option must occur in the year following the year of termination and after the following valuation. It is wise to quantify the amount of cash that the company will require in order to perform its obligation. This can be done by having a repurchase liability study performed. It is essential to know that the put options can be exercised by the ESOP. This is called recycling the stock because the same amount remains in the ESOP after the stock is repurchased by the trustee. If the company purchases the stock, it is called a redemption. In this case, the transaction will decrease the number of shares owned by the ESOP, and the company increases its ownership percentage of the corporation. The questionnaire in Chapter 29 can be used to perform a repurchase liability study or to have one performed by a specialist in this field. It is important to consider whether a fund should be started for this purpose or whether the stock’s repurchase should be accomplished from the company’s cashflow. This may have an ultimate effect on the value of the company. The ultimate reward to an ESOP participant lies in the fact that someday the stock in his or her account will be reduced to cash. This will be triggered when the employee terminates, dies, becomes disabled, or retires. The distribution of the employee’s account balance must be in the form of stock unless the sponsor is a bank or unless the articles of incorporation are amended to require that substantially all of the stock must be owned by employees or by the ESOP. The ESOP documents give the employee two put options, one to be exercised by the employee against the sponsoring company within 60 days of distribution and the other within 60 days following the valuation in the following year. In practice and in any event, the employees expect that their accounts will be cashed out. The big question the company should have is where the cash will come from. This cash requirement is referred to as the ESOP Repurchase Liability. The amount of the cash that will be needed can be predicted by a repurchase liability study. The timing of the need can also be predicted within reason. As company conditions change, thereby tarnishing the assumptions on which the study is based, a new study should be performed. The repurchase obligation is insidious, but it can be easily reckoned with if adequate planning is performed. The repurchase liability will tend to reduce the corporation’s fair market value because cash goes off the balance sheet to cash out the terminated participant. There are various ways to cope with this, namely: 1. Funding out of current cash flow. This method is suitable for years wherein the payout obligations are low and relatively level from year to year. If large amounts of stock must be cashed out, this method may drain too much working capital. It may also exceed the contribution limits. 47

48

Repurchase Liability 2. Sinking fund in the ESOP. Corporate contributions to create the fund are tax deductible and grow in a tax-free environment, but those contributions to the ESOP must be allocated to the accounts of the ESOP participants, thereby exacerbating the repurchase liability. 3. Sinking fund in the corporation. This is better, but the contributions to the fund in the corporation must be made with after-tax dollars. The earnings on the investment are subject to taxation. This method is useful where there are large payout obligations. The asset remains on the balance sheet. 4. Corporate-owned life insurance. Corporate-owned life insurance (COLI), although created with after-tax dollars, accumulates cash values tax free and is not allocated to the accounts of the ESOP participants. The cash values may be withdrawn tax free down to the basis or borrowed thereafter. It can be used to redeem the stock back to the corporation or to recycle the stock in the ESOP. 5. Borrow the cash from a bank. The payback of principal must be paid back with after-tax dollars. Interest, an added obligation, is deductible, however. This approach should be considered only for large distributions and where there is inadequate time to create a sinking fund or COLI build-up. A company cannot be certain that a bank will lend it the funds at the time of need. 6. Going public. This is not a practical option for most companies, and it is costly in any event, but it will eliminate the repurchase liability. 7. Stock can be sold to other employees. Again, creating a market for the stock may be impractical and it is dilutionary, but it will help solve the repurchase obligation.

The method the company wishes to adopt for solving the repurchase liability is dependent upon the owner’s goals and can be a combination of the various methodologies.

29 Repurchase Liability Study Questionnaire Potential lenders often require that an ESOP repurchase liability study be performed in order to arrive at a decision as to whether or not to make a loan to the company who is considering the installation of an ESOP. The study would be designed to quantify the amount of stock that is to be purchased from the accounts of the participants who terminate by reason of death, retirement, disability, or simply leaving the firm permanently. The study should also be valuable to the sponsor in order to determine the company’s future requirements, and the information in this questionnaire will be useful in performing a repurchase liability study. Legal name of corporation: Address: Phone: ___________________ FAX: ___________________ E-mail: ___________________ Date ESOP was or is to be adopted: _____/_____/_____ Data accurate as of _____/_____/_____ What is the corporate fiscal year? _____/_____/_____ Number of shares outstanding: _____ Value of the company: _____ Is company taxed as a C-Corporation? (Y or N) _____ Is company taxed as a Subchapter S-Corporation? (Y or N) _____ Date of the last company valuation: _____/_____/_____ How many shares of stock were sold or will be sold to the ESOP? _____ Eligibility age? _____ Class of shares: (Common, Preferred, Class A or Class B) _____ Normal retirement age? _____ Is ESOP leveraged? (Y or N) _____ If so, please attach loan details. Is there full vesting at death? (Y or N) _____ Will shares repurchased from terminated employees be reallocated to the remaining participants? (Y or N) _____ 49

50

Repurchase Liability Study Questionnaire

How many years of service are required for eligibility? _____ Vesting schedule for participants: ___________________ ___________________ Credit for past service? (Y or N) _____ If so, how many years? _____ Is there full vesting upon permanent disability? (Y or N) _____ Is there full vesting upon death? (Y or N) _____ Number of years for delaying reallocation of forfeited, nonvested stock: _____ Account balances less than $___________ will be distributed immediately. Disability –– for balances exceeding minimum will they be paid in installments or lump sum? (Y or N) _____ Death –– for balances exceeding minimum will they be paid in installments or lump sum? (Y or N) _____ Will those participants who leave the company be replaced? (Y or N) _____ What is the assumed annual growth rate of new hires? _____% Retirement –– for balances exceeding minimum will they be paid in installments or lump sum? (Y or N) _____ Turnover –– for balances exceeding minimum will they be paid in installments or lump sum? (Y or N) _____ Is any ESOP stock pre-1987 stock? (Y or N) _____ If so, how many shares? _____ If any, which class? _____ Which stockholders, if any, have elected to sell shares in any amount under IRC Section 1042?

List any brother, sister, spouses, children, or grandchildren of those who elected under IRC Section 1042 employed by the firm: Are terminated participants to be replaced? (Y or N) _____ Turnover Assumptions: High, medium, or low rates? ___________________ Disability Assumptions: High, medium, or low rates? ___________________ Mortality Assumptions: High, medium, or low rates? ___________________ Assumed compensation increase rate: _____% Will ESOP subsequently own a great percentage of the company? (Y or N) _____ If so, approximately when and what percentage? _____ If the corporation is now a C-Corporation, will it subsequently become a Subchapter S-Corporation? (Y or N) _____ If so, when? ___________________ NOTE: Please attach the most current annual census and the most recent appraisal and a projection, if any along with any loan data.

30 Estate Planning The ESOP transaction can provide liquidity in one’s estate in order to provide for estate taxes or perhaps provide for the children who are not to be involved in the business. Various legal strategies can be adopted as a means of minimizing estate taxes or directing the assets to where they can be most effective. Life insurance may play a part in the planning effort, and it is important to determine what entity is to be the owner and which is to be the beneficiary. This may determine whether the proceeds will be included or excluded in the estate for purposes of being taxed in the estate. The estate planning team generally involves an estate planning attorney, a financial planner, a life insurance professional, and a certified public accountant. A strategy for giving stock to one’s heirs can follow a Section 1042 sale of stock to the ESOP. The amount borrowed will reduce the value of the company stock, a good time for making gifts to the children. If the parent sells 51 percent of the company stock to the ESOP, the seller’s remaining shares will constitute a minority, which will subject those shares to a minority discount. This will permit the parent to give a much larger amount of stock without hitting the gift tax limitations. The questionnaire in the following chapter is a checklist of some of the more commonly used planning elements of an effective estate plan that should be considered.

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31 What Has the Major Stockholder Done in Connection with Estate Planning? Check what you have done 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

52

____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

Check what needs to be done ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

INSTRUMENTS I HAVE INSTALLED: Will Living (Revocable) Trust Irrevocable Trust Grantor Retained Annuity Trust (GRAT) Charitable Remainder Trust Generation Skipping Trust Charitable Lead Trust Family Limited Partnership Life insurance has been purchased. Dynasty Trust Gifts Other: (Please describe)

32 Management Buyout The ESOP is a useful financial instrument when it comes to management buyouts for three primary reasons, namely: •

•

•

Managers seldom have the money that is required to purchase the stock or the assets of the company; therefore, if the owner of the company sells most of the stock to an ESOP, the managers would have to come up with substantially less cash to buy the remaining amount of stock from the owner. They would still be able to effectively control the stock in the ESOP because the vote need not be passed through to the ESOP participants except for grave issues such as merger or liquidation. Both the owner and the corporation get a tax break. The selling shareholder recognizes no capital gains taxation on the sale of his or her stock, and the corporation is able to deduct the principal payments as well as loan interest. Because the selling shareholder nets a greater after-tax return on the sale of the stock to an ESOP, the owner is frequently motivated to give a better break to the managers, which will often reflect a portion of the tax savings he or she realizes. This may make the deal more attractive.

The managers might be awarded some restricted stock after the ESOP becomes leveraged, thereby reducing the stock’s fair market value and making it much easier for the managers to buy the stock.

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33 Are You Selling Part or All of the Company to an Outsider at This Time? Why? Sale of all of the company to an outside party has its consequences and should not be done lightly. Perhaps it may be advantageous to sell part to an ESOP and part to an outside investor. Consider the following questions: •

• • •

What are your motives? What are the investor’s motives? Is the outside investor merely looking to invest in your company as a good investment or is the intention greater involvement in the company’s operations and perhaps control? Is a management buyout feasible or preferable to a purchase by an outside investor? If the purchase of your company by an outside investor is a good investment for that entity, might it not be a better investment for you and/or your family? Do you have good activities planned for your retirement or will you be bored or perhaps be a bore to your family?

These are some of the considerations that require concentrated thought when the opportunity to sell the company to an outsider presents itself. Check applicable one(s): 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

Selling ____ percent to an ESOP and ____ percent to an outsider. Capital needs for growth. Company is in financial disarray. A strategic buyer has made an offer. I am engaged in estate planning and need liquidity. I have no one who can manage my company. The timing is good for putting the company on the block. I will disregard the tax impact. I want to remain involved with the company. I am not concerned about confidentiality. I am concerned about confidentiality with my employees. I am concerned about confidentiality with my competitors. I am concerned about confidentiality with my suppliers. I have ample and rewarding activities if I ease off from all or a portion of the daily routines of my company. 15. ____ I do not feel guilty about the possibility that the sale may disrupt the lives of some of my employees. 54

____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

Are You Selling Part or All of the Company to an Outsider at This Time? Why?

55

16. ____ I feel guilty about the possibility that the sale may disrupt the lives of some of my employees. 17. ____ I do not mind if my company is not to be perpetuated. 18. ____ Other

34 Eligible Employees Contributions to the ESOP are governed by IRC Section 404. The allocations to the participants’ accounts are governed by IRC Section 415. Those employees who have one year of service are eligible to become participants; however, this service requirement may be eliminated if the sponsoring corporation so desires and if the ESOP plan documents are worded to provide this allowance. One who is age 21 or older is required to participate. Notwithstanding this, those younger than age 21 may be included if the sponsor wishes and if the ESOP is designed to provide for this allowance.

UNION MEMBERS Members of collective bargaining companies may be excluded if the company had previously engaged in good-faith bargaining for retirement benefits. The ESOP documents can be made to include union members, but this must be cleared with the union hierarchy. I wish to exclude union members (Y or N): _____.

COMPENSATION The plan can provide that eligible compensation can include commissions, or it can be worded to exclude commission.

COMPENSATION THAT CAN COUNT The amount of an individual’s compensation that is eligible to be included for ESOP allocation is $200,000 in 2002, but will be increased with inflation. The maximum dollar amount that can be allocated is $40,000 in 2002. This, too, is destined to be increased. The ESOP may be designed to cap the includable amount of a participant’s compensation at a stated lower amount. I wish to cap includable compensation for participants at $______________.

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35 Contribution Limits C-CORPORATION LEVERAGED ESOP A C-Corporation is eligible to make an annual tax-deductible contribution of up to 25 percent of covered compensation to cover principal payments in a nonleveraged or leveraged ESOP. It can deduct contributions of interest payments as well. Dividends, if reasonable, can also be deducted if used to repay ESOP debt or paid to an ESOP and passed through to the participants on the shares that are allocated to them in the ESOP. Alternatively, the dividends can be deducted if paid to the ESOP directly and based on the shares allocated to them in the ESOP. Other rules noted earlier prevail for top-heavy plans.

S-CORPORATION ESOP After 2001, an S-Corporation can make a deductible contribution of up to 25 percent of covered compensation to an ESOP, but unlike C-Corporations, contribution of interest payments to the ESOP would be included as part of the 25 percent. For contributions to a nonleveraged ESOP of a C-Corporation before 2002, the company was limited to 15 percent of eligible compensation. A C-Corporation could contribute up to 25 percent in a leveraged ESOP for servicing debt principal to acquire stock. In addition to interest repayment, it could also deduct dividends if used to repay debt and passed through to the participants. Prior to 2002, an S-Corporation was still limited to a deductible contribution of 15 percent of covered payroll even if the plan were leveraged. This could be increased in a leveraged or unleveraged ESOP, through the addition of a money purchase ESOP. Known as a combination ESOP, the company could contribute up to 25 percent of covered payroll. In a C-Corporation, interest could be deducted in addition to this 25 percent. For contributions to S-Corporations that were made after 2001, the eligible contribution limit has been 25 percent of covered compensation whether or not the plan is leveraged. A Subchapter-S Corporation may also use its K-I distribution to repay debt. Compensation of the selling shareholder and lineal descendents, as well as owners of 25 percent of the stock and family members, are ineligible for contributions or allocations and should be eliminated from the chart in Chapter 36.

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36 Census to Compute Covered Compensation Name

Date of Birth

Date of Hire

Eligible Compensation

1.

$

2.

$

3.

$

4.

$

5.

$

6.

$

7.

$

8.

$

9.

$

10.

$

11.

$

12.

$

13.

$

14.

$

15.

$

58

Computing the ESOP Participants’ Covered Compensation Name

Date of Birth

Date of Hire

59 Eligible Compensation

16.

$

17.

$

18.

$

19.

$

20.

$

21.

$

22.

$

23.

$

24.

$

25.

$

26.

$

27.

$

28.

$

29.

$

30.

$

31.

$

32.

$

33.

$

34.

$

35.

$

36.

$

37 Formula to Determine Contribution Limits The amounts that can be contributed to an ESOP depend on whether the plan is leveraged and on whether the company is a C-Corporation or a Subchapter-S Corporation post 2001.

NONLEVERAGED C- OR S-CORPORATION ESOP Post 2001: .25 ⫻ covered payroll $ ______________ ⫽ $ ______________.

LEVERAGED C-CORPORATION .25 ⫻ covered payroll $ ______________ ⫹ $ ______________ interest ⫹ $ ______________ dividends ⫽ $ ______________ . NOTE: Interest in an S-Corporation is included as part of the contribution limit. The amount of deduction for pricipal reduction will vary after the initial year as interest varies. An S-Corporation cannot pay dividends; however, distributions can be used for servicing debt. Amount of the debt $ ______________ . Term of the loan: ____ years. Amount of deductible contribution that can be made: $ ______________ /year one.

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38 Whether to Be a C- or an S-Corporation ESOP It is critical to determine whether a company should function as a C-Corporation or a Subchapter-S Corporation. This chapter reviews the properties of each and enables one to make a decision about which is more appropriate.

PROPERTIES OF A C-CORPORATION • • • • • •

The C-Corporation is subject to double taxation—to the corporation and then to the company’s stockholder. There can be more than one class of stock. Dividends can be paid to the stockholders. A C-Corporation is not limited to the number of shareholders it may have. Profits may be retained in the corporation if they are reasonable or paid to the stockholders as nondeductible, taxable dividends. The C-Corporation is subject to the Alternative Minimum Tax (AMT). Congress is considering eliminating the AMT as of 2002.

PROPERTIES OF A SUBCHAPTER-S CORPORATION •

• • •

• • •

A Subchapter-S Corporation subjects the stockholders to a single tax. There is no tax at the Subchapter-S Corporation’s corporate level, but taxes, if any, are passed through to the owner(s) and are pro-rated to the ownership. The income is passed through to the shareholders. The owners, under current law, are typically in a higher federal tax bracket than the corporation would be in a corporation were it taxed. The S-Corporation is not subject to the AMT. There can only be one class of stock, common voting stock. Dividends are not permitted in a Subchapter-S Corporation, but since distributions of profits may be made to the stockholders, there is a tradeoff. Alternatively, the S-Corporation may retain profits, although they will still be taxed to the stockholders on a pro-rata basis. Several states also follow this method of Sub-S taxation. Certain types of trusts cannot own Subchapter-S stock. A Subchapter-S Corporation will generally pay a salary to its owner(s) and distribute a sufficient amount to the stockholder(s) to enable the shareholder(s) to pay income taxes.

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62

Whether to Be a C-or an S-Corporation ESOP •

A Subchapter-S Corporation is permitted to have no more than 75 stockholders. The trustee of an ESOP counts as the only stockholder for an ESOP irrespective of the number of participants in the plan.

AN ESOP IN A C-CORPORATION As was noted in Chapter 35, a C-Corporation can deduct up to 25 percent of covered (includable) payroll in a nonleveraged or leveraged ESOP, but in the latter, it can also deduct reasonable dividends, plus unlimited interest. An S-Corporation can do the same; however, it is not permitted to pay dividends nor can it pay interest as part of the 25 percent limitation. Distributions may be used to repay ESOP debt, however. This can be considered somewhat of a tradeoff for its inability to pay dividends.

IRC SECTION 1042 The owner of a C-Corporation can use IRC Section 1042 and defer taxes on the sale of stock to an ESOP if he or she meets the requirements as noted earlier.

AN ESOP IN A SUBCHAPTER-S CORPORATION • •

•

No nonresident aliens can own Sub-S stock. There are ____ nonresident aliens who own stock in this company. For 2 percent owners or more of C-Corp stock, fringe benefits are not recognized on Form W-2, whereas 2 percent or higher owners of S-Corp stock are not recognized on Form W2 on stock that is in the ESOP. Sale of C-Corporation assets results in double taxation. This is not the case were the company a Subchapter-S corporation.

This corporation [ ] does or [ ] does not contemplate a sale of assets. Corporate cashflow of a profitable Subchapter-S company is generally increased because it pays no taxes; however, if the company cannot use this increased cashflow effectively, it would add little to its growth. Distributions to an ESOP as a shareholder are permitted to be used to repay ESOP loans. Some practitioners have opined that they may also be used for ESOP repurchase liability. The owner(s) of a Subchapter-S Corporation is (are) not permitted to defer capital gains taxes on the sale of his or her stock because IRC Section 1042 is unavailable to the stockholder(s).

CONVERSION OF A C-CORPORATION TO A SUBCHAPTER-S CORPORATION A C-Corporation can elect to be taxed as a Subchapter-S Corporation unless it has elected under Subchapter-S within the past five years; however, it can apply to the Internal Revenue Service to waive some or all of the five-year waiting requirement. The election may or may not be granted. A conversion of a C-Corporation to a Subchapter-S Corporation would generally subject the company to tax on the “built-in gains” if the underlying gains are sold within 10 years of the conversion. Recapture of any existing LIFO is taxed at the corporation level if the C-Corporation is converted to the Subchapter-S election. Although the consensus of well-known valuation firms is that the form of taxation of C-Corporation versus Subchapter-S Corporation taxation does not affect the value of the stock of the company, the retention or use of the tax savings to create value can cause the stock value to increase. If the stock of a Subchapter-S Corporation is 100 percent ESOP-owned, neither the corporation nor its owner will pay taxes.

39 The Decision-Making Process This chapter will help the owner of a corporation decide succinctly whether the company should be taxed as a C-Company, a Subchapter-S Corporation, or another form of company. 1. This firm is a: C-Corporation Subchapter-S Corporation Limited Liability Corporation (LLC) taxed as a partnership Limited Liability Corporation (LLC) taxed as a corporation Partnership Sole Proprietorship 2. The firm has ____ owners. 3. The owner stockholder in a C-Corporation who is contemplating a sale of stock under IRC Section 1042 has owned the stock since _____/_____/_____ . (Needs three or more years.) 4. The firm has a total annual payroll of $ ____________ . a. Annual payroll of those employees over age 21 with more than one year of service not counting in excess of $200,000 for any one employee $ _____________ . Note: Section 4(a) can be used to determine the amount of covered payroll that can be used in connection with a sale by the owner. b. The firm has a total annual payroll of 4(a) less the compensation of the selling shareholder and that of the selling shareholder’s family and of any 25 percent or more shareholder and his or her relatives of $_____________ . Note: 4(b) is used to determine the amount of covered payroll that can be used in connection with a sale by the owner under IRC Section 1042. The amount that can be deducted by a C- or a Subchapter-S Corporation for a nonleveraged ESOP is $ _____________ ⫻ .25 ⫽ $ _____________ . 4(a) In a Section 1042 transaction, the amount that can be deducted by a C-Corporation in a leveraged ESOP is: $ _____________ ⫻ .25 ⫽ $ _____________ ⫹ reasonable dividends used to repay 4(b) ESOP debt $ _____________ ⫹ interest $ _____________ .

SUBCHAPTER-S CORPORATION Section 1042 is not available to be used in a Subchapter-S Corporation. The deductible limits for a leveraged or a nonleveraged ESOP after 2000 are $ _____________ ⫻ .15 ⫽ $ _____________ . This includes interest payments, if any. K-I distributions to the ESOP for a leveraged ESOP can also be used to repay ESOP debt. Distributions to the ESOP are expected to average $ _____________ . 63

40 Items You Should Consider in Converting from a C-Corporation to a Subchapter-S Corporation My C-Corporation is subject to $ _____________ of AMT. (As of 2002, Congress is considering eliminating the AMT.) It will involve $ _____________ of LIFO that must be recaptured if we elect to be taxed as a Subchapter-S Corporation. The corporation is in the ____ percent federal income tax bracket and the ____ percent net income tax bracket. The stockholders as a group draw $ _____________ and are subject to federal and state income taxes in the ____ percent combined federal and state income tax bracket. The company pays dividends to its stockholders. The dividend for the year being considered would be ____ percent of profits or $ _____________ . ____ percent of the stock is owned by a trust. A Subchapter-S Corporation’s stock cannot be owned by a trust. As a Subchapter-S Corporation, the profits of $ ____ would be retained in the company, distributing only that amount to the stockholders needed to pay their taxes, viz, $ ____ . NOTE: The stockholders would be subject to taxes on the amount of profits that would be retained in the company or distributed to them pro-rata to their ownership. If stock is distributed or sold to the ESOP of a Subchapter-S corporation, the portion of the profits that would be taxable to the ESOP as an owner pro-rata would not be taxed because the ESOP is a tax-qualified plan and is a non-taxpayer. The amount of stock that would be acquired by the ESOP would be ____ percent. That is the percentage of profits that would not be taxed. The rest, ____ percent, would be taxed. The major stockholder(s) would take back a note amount to $ ____ for ____ percent of the stock that would be sold to the ESOP of a Subchapter-S corporation. An outside lender would lend the funds to buy that amount of the stock. If a C-Corporation, the selling stockholder(s) would invest in qualified replacement property (QRP) to help satisfy the requirement of IRC Section 1042. The shareholder would invest in a floating-rate note (FRN) and borrow up to 90 percent against the note so as to have an actively traded portfolio. Therefore, one would have to have or borrow only 10 percent of the value of the stock being sold, or ____ percent.

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41 Provisions That You Should Tell Your Advisor ASSUMPTION: This Plan is to be qualified as an ESOP under IRC Section 401(a). PLANS ALREADY IN FORCE: ____ ESOP ____ Money Purchase Plan ____ 401(k) Plan ____ Stock Bonus Plan ____ Defined Benefit Pension Plan ____ Profit-Sharing Plan DATE ESOP IS TO BE EFFECTIVE:

_____/_____/_____

TYPE OF CORPORATION SPONSORING ESOP: ____C-Corporation ____S-Corporation ____LLC Taxed as Corporation LEGAL NAME OF SPONSOR: DATE OF INCORPORATION:

_____/_____/_____

STATE OF INCORPORATION: NAMES OF ANY SUBSIDIARIES:

ADDRESS OF SUBSIDIARIES:

NUMBER OF EMPLOYEES OF EACH SUBSIDIARY:

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66

Provisions That You Should Tell Your Advisor

SUBSIDIARIES YOU WANT TO INCLUDE GIVEN THAT CHOICE:

DATES OF INCORPORATION OF INCLUDABLE SUBSIDIARIES:

_____/_____/_____ _____/_____/_____

ADMINISTRATIVE COMMITTEE NAMES:

TRUSTEE(S):

ELIGIBILITY:

____ Minimum Age ____ Number of months of service ____ YES ____ NO All present employees 1,000 Service hours in Plan Year ____ Other

BEGINNING OF PLAN YEAR:

_____/_____/_____

ALLOCATION DATE(S):

_____/_____/_____

ENTRY DATE(S):

____ First day of plan year after employee fulfills eligibility requirements. ____ First day of the first month and after the sixth month of the plan year. ____ First day of each quarter. ____ Retroactive to the first day of the plan year. ____ Other dates.

DEFINE HOURS OF SERVICE: ________ General Method. This is based on the actual counting of hours of service during the applicable 12-consecutive-month computation period. An hour of service is any hour for which an employee is paid or is entitled to payment to the employer. An hour of service includes any hour for which payments are made due to an employee’s vacation, sickness, holiday, disability, layoff, jury duty, military duty, or leave of absence, even if the employee no longer works for the company. It also includes any hour for which back pay is awarded. ________ Elapsed Time Method. The plan is generally required to take into account the period of time that elapses while the employee is employed with the employer regardless of the actual number of hours the employee completes during such period. ________ Count 190 hours of service for each month for which the employee is paid or entitled to payment for at least one hour of service.

Provisions That You Should Tell Your Advisor

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________ Count 95 hours of service for each semi-monthly period for which the employee is paid or entitled to payment for at least one hour of service. ________ Count 45 hours of service for each week for which the employee is paid or entitled to payment for at least one hour of service. ________ Count 10 hours of service for each day for which the employee is paid or entitled to payment for at least one hour of service. DEFINITION OF BREAK IN SERVICE:

____ Not employed as of the plan year. ____ Fewer than 501 service hours in a plan year. ____ Other definition(s)

REHIRING REQUIREMENTS:

____ Eligible to rejoin ESOP as of reemployment date ____ Other requirement(s)

COMPENSATION DEFINED:

____ Base salary only ____ Bonus ____ Commission ____ Overtime ____ For the period _____/_____/_____ to _____/_____/_____ ____ From the first day of the plan year ____ As of the date of becoming a participant ____ Other

NORMAL RETIREMENT:

____ As of age 65 ____ Add ____ years of plan participation ____ Add ____ years of service to the sponsor ____ Other

EARLY RETIREMENT:

____ As of attaining age ____ or thereafter _____ Other

DEFINITION OF DISABILITY ESOP TO BE LEVERAGED:

____ Yes

____ No

ALLOCATIONS:

____ Employees employed on the last day of the plan year ____ Employees who have 1,000 hours of service in the plan year pro-rated to plan year’s compensation

SPONSOR CONTRIBUTION:

____ At sponsor’s discretion within IRC Section 404 and 415 limits ____ Amount required to pay principal and interest on an ESOP loan

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Provisions That You Should Tell Your Advisor

PARTICIPANT’S CONTRIBUTIONS: ____ Allowed up to $____ or ____% of compensation ____ Not allowed FORFEITURES OF NONVESTED ACCOUNTS: ____ Upon separation of service ____ Upon distribution ____ Upon break in service for one year ____ Upon break in service for five years ____Other REALLOCATION OF FORFEITURES: ____ Pro-rata of compensation ____ Other DATE OF SPONSOR’S CONTRIBUTION: ____ Date necessary to repay loan ____ Date necessary for the current year’s income tax deduction SPONSOR TO PAY DIVIDENDS TO THE PLAN: ____ Yes ____ To be distributed to the participants ____ To be used by the plan for debt reduction ____ No ANNUAL ADDITIONS:

Include loan interest ____ Yes ____ No Dividends ____ Yes ____ No

VESTING:

Credited for past service with the sponsor ____ For all past years ____ For ____ past years

THE PLAN IS TOP HEAVY:

____ Yes ____ No

Provisions That You Should Tell Your Advisor SCHEDULE OF VESTING:

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Years of Service 1 2 3 4 5 6 7 Disability Death Retirement

% Vested ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

SPONSORING CORPORATION BYLAW PROVISION: Substantially all of the stock must be owned by employees or an employee trust. ____ Yes ____ No DISTRIBUTION POLICY:

Disability

Death

Termination

Retirement

____ Stock will be distributed ____ Cash will be distributed ____ Stock and cash will be distributed ____ Lump Sum ____ Installments ____ Within 1 year after the end of the retirement occurs ____ Other ____ Lump Sum ____ Installments ____ Within 1 year after the end of the retirement occurs ____ Other ____ Lump Sum ____ Installments ____ Within 1 year after the end of the retirement occurs ____ Other ____ Lump Sum ____ Installments ____ Within 1 year after the end of the retirement occurs ____ Other

QDRO IS ALLOWED TO RECEIVE PAYMENT(S) BEFORE PARTICIPANT:

LOANS TO PARTICIPANTS PERMITTED:

____ Yes ____ No ____ Yes ____ No

plan year in which

plan year in which

plan year in which

plan year in which

70 ANY EXCEPTIONS FOR LEVERAGED SHARES:

AGE 701⁄2 MANDATORY DISTRIBUTION FOR ACTIVE EMPLOYEES LIMITED TO 5% OWNERS OR HIGHER:

Provisions That You Should Tell Your Advisor

____ Yes ____ No Explain:

____ Yes ____ No

42 Letting Your Employees in on Certain Aspects of Your Company

INFORMATION THAT EMPLOYEES MUST HAVE It is perfectly proper to keep the employees out of the corporate information loop, although they may be participants of an ESOP. The only thing about the business that they are legally entitled to see is the value of the stock that is allocated to their ESOP accounts. They will see this information at least annually in the form of an allocation statement.

OPEN BOOK MANAGEMENT It is important to note, however, that study after study shows that the more participative management there is in conjunction with ESOP stock ownership, the greater the productivity. Employees want to know what is happening in the environment to which they devote the greatest part of their waking hours. 1. Are you willing to share more information than you are now doing? ____ Yes ____ No ____ Maybe If the answer is “no,” then perhaps you may not find it fruitful to read this chapter further. If it is either of the other two answers, perhaps this chapter will help you focus on which segments of information you are willing to share and which make you a bit squeamish about imparting to your troops. 2. What company information are you now sharing with all of your employees? a. ____ All financial information b. ____ Limited financial information c. ____ Marketing information d. ____ Contemplated location moves e. ____ Succession planning f. ____ The value of your company’s stock 3. What information are you most concerned that your competitors would learn about? a. ____ All financial information b. ____ Limited financial information c. ____ Marketing information d. ____ Contemplated location moves

71

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Letting Your Employees in on Certain Aspects of Your Company e. ____ Succession planning f. ____ The value of your company’s stock 4. Name some things that are unique about your company. a. b. c. d. e. 5. Which of the above are you or would you be willing to share with all of your employees? ____ a. ____ b. ____ c. ____ d. ____ e. 6. Are all of your employees familiar with the major terms used by your company? ____ Yes ____ No Would you be willing to educate all of your employees so as to make them familiar with the major terms used by your company? ____Yes ____ No 7. Examples of financial information that might be given to all of your employees on a monthly basis: _____/_____/_____ Prior Period Sales, fees, or commissions

$ ____________

$ ____________

Salaries or labor costs

$ ____________

$ ____________

Materials

$ ____________

$ ____________

Advertising & sales

$ ____________

$ ____________

Less other manufacturing costs

$ ____________

$ ____________

Less Total Expenses

$ ____________

$ ____________

Gross Profits

$ ____________

$ ____________

Less Contribution to ESOP

$ ____________

$ ____________

Net Profit

$ ____________

$ ____________

43 Diversification The assets for the participants’ accounts in an ESOP are required to be diversified. This will apply to those who are participants in the plan for 10 years or more. The purpose of this provision is to avoid the last-minute requirement that the sponsoring corporation would have to have enough cash on hand to cash out the employee participant at retirement. By making it a gradual process, this is helpful to the corporation, while giving a greater feeling of security to the ESOP participant. For those employees who have been participants of the ESOP for 10 years and who reach age 55, 25 percent of the assets of their account balances must be diversified, which means that the participant must be given three investment selections other than employer stock. When the participant attains the age of 60, 50 percent of his or her account balance must be diversified. Upon reaching age 65, 100 percent of the participant’s account balance is subject to diversification. In order to be certain the cash is on hand in the corporation, it is prudent that the company establish a corporate-owned sinking fund for this purpose. The fund will remain an asset of the corporation until the time arrives to use it to make tax-deductible contributions to purchase company stock from the ESOP participant’s account. The alternative use of such a fund would be for the company to redeem stock from the participant’s account on an after-tax basis. ____ The corporation will establish a sinking fund to meet the diversification requirements. ____ The corporation plans on meeting the diversification requirement when needed out of the current cashflow.

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44 How We Would Distribute ESOP Benefits The distribution rules for the ESOP should be applied uniformly for all of the participants. The rules will be set forth according to the provisions of the ESOP plan as well as the policy. They must be adhered to by the ESOP trustee, the ESOP Committee, the ESOP Administrator, and the company’s Board of Directors. The ESOP Committee generally designs the ESOP policy. This is usually done with the sponsoring company’s assistance.

THE ESOP POLICY The ESOP plan and the ESOP policy will have an impact on the financial aspects of the company that sponsors the ESOP. Some of the distribution provisions are required to be in the plan document because they comprise the minimal requirements of the IRS Code, such as the requirement of a CCorporation ESOP that the terminating ESOP participant must be given the right to demand stock. It is appropriate to note that this requirement can be overridden by a company bylaw change that requires company stock to be owned substantially by employees or by an employee trust. An ESOP policy will be of great assistance to the plan Trustee, the ESOP Committee, the ESOP Administrator, and the Company Board of Directors by providing them with guidelines they can use to communicate the ESOP better to the participants and to apply the distribution rules uniformly across the board. Proper wording of the ESOP documents is important to the continuing well-being of the sponsoring corporation because this affects the repurchase liability of the company. The requirement, for example, that employees be paid out in the form of a lump sum as opposed to installments upon leaving the company can create problems for the sponsoring company if it has several back-to-back participants leaving due to disability, death, retirement, or for other reasons. The distribution policy can impact not only the way the company may set aside funds for the repurchase liability but also the way the employees perceive the ESOP. For example, the employees may prefer a policy whereby their account balances would be paid out as soon as is practical rather than their being delayed or disbursed in installments.

THE ESOP COMMITTEE The ESOP Committee is usually given the responsibility to direct the trustee to make distributions to ESOP participants. ______________________________________ will direct the trustee, ______________________________________ , as to what distributions are to be made. 74

Adequate Security

75

In order to decide on the terms of a distribution policy, it is crucial that there is no conflict with the terms of other corporate documents, such as the corporate bylaws or Articles of Incorporation, loan covenants, or precedence of any earlier distributions.

SUBCHAPTER-S CORPORATION DISTRIBUTION POLICY Subchapter-S Corporation ESOPs should not necessarily require that distributions be made in the form of stock because S-Corporations cannot have more than 75 shareholders. This provision must be made with a great deal of forethought or advice. Some corporations distribute stock but redeem it immediately. C-Corporations are required to make distributions in the form of stock unless overridden by the bylaws, as noted earlier.

PUT OPTIONS The corporation has an obligation pursuant to a put option to redeem the stock in the terminating participants’ ESOP accounts. The ESOP can relieve the corporation of this repurchase liability if it repurchases the stock. The ESOP document must give the participant two put options to have the corporation redeem their shares following the date of distribution. Each is for a 60-day period. If the participant does not exercise his or her put option during the first option period, he or she is given a second put option during the following plan year and after the stock is again valued. The terminated participant must be informed of the stock’s resulting value in this put period. After this, the stock is no longer required to be redeemed by the corporation. The participant must be paid within 30 days after he or she exercises the put option, whether in a lump sum or beginning with the initial installment, and the payment must be in accordance with the stock’s valuation in the year when each installment is paid.

ADEQUATE SECURITY The corporation must provide the participant with adequate security on any remaining installments that are still to be paid to the ex-participant, such as a letter of credit, an ESOP bond, or a perfected security interest in the sponsoring corporation’s assets. Aside from the collateral, the corporation must pay the ex-participant a reasonable rate of interest on the outstanding balance of the Participant Note. The Distribution Policy should help assure the sponsoring corporation, the ESOP Committee, and the trustee that there is consistency in the handling of distributions. The distributions can be deferred until the end of the ESOP’s note term of the note payment, but not to exceed 10 years. Alternately, the company and the ESOP committee may choose not to delay them. If the ESOP is not leveraged, the distributions must begin in the sixth year following a normal separation. The corporation and the ESOP Committee could set a policy whereby the distribution is made more promptly. As a general principle, the corporation feels that it would prefer to: ____ a. Delay distribution ____ b. Distribute in a lump sum The document should state that if the terminating participant’s balance is a certain amount, such as $5,000 or less, the corporation would make a payment of the full amount as soon as is practical. The level of prompt minimum distributable amount that we would prefer is $ ____________.

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How We Would Distribute ESOP Benefits

In the event of separation because of death, disability, or normal retirement, distribution must occur no later than one year following that plan year.

TO REDEEM OR TO RECYCLE? The corporation can state in its distribution policy whether it intends to recycle the stock being distributed, whereby the ESOP would purchase the stock from the terminated participants’ accounts, thereby keeping a constant amount of stock in the ESOP or to redeem the stock back into the company, thus changing the ownership in favor of the corporation. The first method would result in a corporate tax deduction, whereas the redemption method would be done with after-tax dollars. The decision could be made to redeem the shares and to contribute them to the ESOP in the following year at the prevailing price. If the corporation is in a growth mode, this would result in less corporate dilution because fewer shares would be contributed for a given amount of tax deduction. The distribution policy would also state whether the corporation or the ESOP would make distributions in a lump sum or in an installment mode. If the participant’s account balance exceeds $145,000, the distribution on an installment basis can be stretched out an additional year up to an additional five years. This is adjusted for inflation. After age 70-1/2, minimum distributions must be made according to a government table. By establishing a distribution policy, the sponsoring corporation will enhance its ability to forecast its budgets better. The trustee can be better assured that its distributions will be carried out more uniformly among the employees. ____ a. ____ b. ____ c. ____ d.

We prefer to recycle the stock. We prefer to redeem the stock. We prefer to redeem the stock, then contribute it to the ESOP in the following year. We prefer to redeem the stock, then contribute cash to the ESOP.

Here are some of the choices that should be considered when formulating a distribution policy for your ESOP: The trustee will make distributions to the participants, which are triggered by disability, retirement, or death: 1. 2. 3. 4.

[ ] Immediately after severance in the form of a lump sum. [ ] As soon as is practical, but after the plan administration has been made for the plan year of the occurrence. [ ] In substantially equal installments over a period of ____ years beginning on _____/_____/_____ . [ ] Other, as follows: .

If termination occurs for reasons other than those noted previously, participants shall be paid in the following form: [ ] Installments that will begin after termination: 1. [ ] Starting in year six and payable in five substantially equal payments. 2. [ ] As soon as is practical after the ESOP’s administration has been done for the plan year in which the severance occurred. 3. [ ] As soon as is practical after a break-in-service, but after the ESOP’s administration has been completed for the plan year in which the severance occurred. 4. [ ] As soon as is practical after the ESOP’s administration has been completed for the plan year in which the severance occurred. 5. [ ] Other, as follows: .

To Redeem or to Recycle?

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[ ] Distributions in the form of stock will be repurchased by: 1. [ ] Having the ESOP recycle (purchase) the stock, thereby keeping the percentage owned by the ESOP constant. 2. [ ] Having the corporation redeem (purchase) the stock, thereby reducing the percentage owned by the ESOP. 3. [ ] Having the corporation redeem the stock and recontribute it in the following year. In a growing company, this results in fewer shares being contributed for a given tax deduction. 4. Distributions will be in the form of: a. [ ] Cash b. [ ] Stock c. [ ] Both. What percent? ____% cash and ____% stock.

45 Equity Benefit Other Than ESOPs A private corporation might consider adopting programs that involve using some of the various types of stock or stock-related plans for their employees because of the limitations of qualified plans under IRC Sections 415 or 404. Another reason for considering other stock plans might be that some are nonqualified, thereby allowing them to be discriminatory. Such plans need not be used in lieu of ESOPs, but can supplement them. Some of the more popular plans to be considered are listed as follows.

PHANTOM STOCK OPTION This is essentially a glorified bonus plan. An employee of the Board’s choice may be selected for this program. The measure of the benefit is the company’s stock, to which a value may be attributed according to a formula, or perhaps an independent valuation may be used. The reward to the selected employee will be in the form of a cash payment to him or her. The employee must remain employed with the company for a stated period in order to be allowed to exercise the option, at which time he or she is given the cash. The employee is not taxed at the time the phantom stock is granted, but is taxed at ordinary rates at the time of distribution. The company deducts the amount of the distribution as a compensation expense. The amount being distributed must be considered to be reasonable compensation in order to receive this tax treatment. Income or a loss may be recognized when the shares are sold to the corporation. The phantom stock plan’s restricted period may mature at the end of a stated period of years or even delayed until retirement. It behooves an employee who is granted the phantom stock to help make the phantom stock appreciate. The advantage to the company’s owner is that no new shares are given to the employee; therefore, no dilution to the owner’s ownership ever occurs. Furthermore, the owner can grant this incentive plan to certain key employees only. The advantage to the employee is that there is no cash outlay on his or her part.

STOCK APPRECIATION RIGHTS (SARS) This approach is similar to a phantom stock plan in that it, too, amounts to a bonus to the employee who performs well. The employee typically will choose the time that the SAR is distributed to him or her. The employee receives ordinary income tax treatment, and the company gets a tax deduction upon exercise.

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Restricted Stock

79

NONQUALIFIED STOCK OPTION PLAN (NSO) The nonqualified stock option plan (NSO) offers the employee an opportunity to participate in the growth of the company. The employee is given the right to purchase stock at a price that the company sets at the time of the option’s grant. The employee may exercise the option at a time of his or her choice. The optionee is not taxed at the time of grant but is taxed as ordinary income upon exercise on the spread between the fair market value at exercise and the exercise price. If, for example, the price at the time the option is granted amounts to, say, $35 per share, and the price at the time the option is exercised is $65, the optionee receives ordinary tax treatment on the difference, namely, $30 per share. The company gets a tax deduction when the employees recognize taxable income. The optionee is taxed on the difference between the sales price and the fair market value of the stock upon exercise. This can be granted on a discretionary basis.

RESTRICTED STOCK The corporation is able to give restricted stock to selected employees at a bargain price by granting it shortly after the ESOP becomes leveraged, thereby reducing the value of the corporation’s stock. A further discount may apply because restrictions are placed on the stock. If the employee leaves the company while the restrictions apply, the employee will lose a portion of the value. ____ The company intends to offer a ____________________________________ plan to the following employees:

Other plan: ____ This is in addition to an ESOP. ____ This is in lieu of an ESOP.

46 Accounting for the ESOP

NONLEVERAGED ESOP If cash is contributed to the ESOP to purchase stock, the amount of the contribution is treated as a charge to compensation expense. When stock is contributed to an ESOP, it is recorded on the financials as being charged to compensation expense. The difference between the par value and fair market value of the stock is credited to pay capital. If a cash contribution is used to purchase stock from a stockholder, it would not be shown as an asset of the corporation. If the cash were used to purchase authorized but unissued stock from the corporation, cash would be transferred into the corporation. This amount should be recorded on the balance sheet as an increase in cash on the asset side of the ledger. Whether a loan is made to the company and the company makes a loan of those proceeds to its ESOP or the loan is made directly to the ESOP, the result is identical. The loan is includable on the liability side as debt. There is a reduction in the contra-equity account as the debt is paid off.

LEVERAGED ESOP In the case of a leveraged ESOP, a contra-equity account is shown as an equal debt on the balance sheet in the equity section, and it is reduced approximately as the current year’s fair market value of the principal of the loan is retired. Contributions made toward the principal payment element of the ESOP loan are recorded as a compensation expense, while interest is treated as interest on any corporate loan is handled. If the stock is allocated to participants, the dividends are charged to retained earnings. Dividend repayments of ESOP debt is considered compensation if the stock is unallocated to the participants. In the instance where the corporation lends the ESOP money by taking back a note, this is not to be treated as a note receivable from the ESOP. The ESOP’s obligation should not be recorded as a note payable on the corporate balance sheet.

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47 Anti-Abuse S-Corporation Rules As of January 1, 1998, Congress made it possible and practical for a Subchapter-S Corporation to have an ESOP. The ESOP could own stock of a Subchapter-S Company without the unrelated business income tax (UBIT) being imposed on it, as had been the case. A one-or two-person corporation could benefit from the fact that the corporation could be wholly owned by an ESOP and thereby operate in a totally tax-free environment. This type of abusive tactic was eliminated by the anti-abuse portion of The Economic Growth and Tax Reconciliation Act of 2001 (EGTRRA), which was legislated into law as of June 7, 2001. The law affects ESOPs of Subchapter-S Corporations that were created after March 14, 2001, or for C-Corporations that sponsor ESOPs and became Subchapter-S Corporations after March 14, 2001. S-Corporation sponsors of ESOPs that were in existence before that date are protected by a grandfathering provision until the plan year that starts after December 31, 2004. The anti-abuse section of the law introduces several new rules, including, in no special order, the following: • • • • • • •

Disqualified Persons Rule Synthetic Equity Special Deemed Abuse Rule Deemed-Owned Shares Shares of S-Corporation Stock Disqualified Persons Nonallocation Year

An individual owns 10 percent or more of the shares or 20 percent under the family attribution rules if they are considered to be “deemed owned.” A year in which a participant of an ESOP in a Subchapter-S Corporation established after March 14, 2001, holds 50 percent of company stock is a “nonallocation year.” Synthetic Equity is considered to be the equivalent of Subchapter-S capital stock if it results in the individual becoming a “disqualified person” or in the ESOP’s plan year as being a “nonallocation year.” The corporation would be subject to an excise tax of 50 percent of the fair market value of the “deemed-owned” shares by disqualified persons, and the disqualified persons would be required to pay income tax as though the shares were distributed to them. “Synthetic Equity” includes restricted stock, stock options, stock appreciation rights, phantom stock, or similar plans that are related to share performance of the company’s stock. To compute the amount of the “deemed-owned” shares, one must include the amount of stock held by a broad range of family members that include the individual’s spouse, lineal descendant, ancestor, or spouse of the latter two categories. Also included in this attribution rule are the individual’s siblings and their spouses or lineal descendants. 81

82

Anti-Abuse S-Corporation Rules

To comply with the various rules that govern ESOPs for Subchapter-S Corporations, one should check with a knowledgeable practitioner. This chart may be useful in determining if any relatives are employed by the Subchapter-S Company that is considering installing an ESOP. Spouse(s) of the stockholder(s):

Sibling(s) of the stockholder(s):

Spouse(s) of the sibling(s):

Lineal descendants of the stockholder(s):

Ancestors of the stockholder(s) or of any sibling(s):

At the present time, one appears to be able to set up a Sub-S Management Corporation having a nominal value and selling it to an ESOP of the management company. The owner and selected key persons, along with their salaries, are transferred to the management company as employees. The original company pays a tax-deductible fee, roughly equivalent to its profits, to the management company for proper enumerated services. After paying salaries which were transferred and modest expenses, the management fee is used to informally fund a non-qualified deferred compensation plan for the owner and/or selected key employees. The other employees of both companies are covered by their 401(k), which is combined with the ESOP to become a KSOP. This becomes a discriminatory plan, which is unaffected by the antiabuse provisions if established properly.

48 The Free ESOP Information Hotline (800) 422-ESOP (3767) There is a tremendous information gap pertaining to ESOPs. If this were not so, the vast majority of profitable and growing corporations with an annual payroll of approximately $500,000 or more would have such a plan. Consider the following questions: • • • • • • • • • •

Why wouldn’t a private company owner want to diversify his or her assets by establishing a private trading center for the stock of his or her corporation? Why wouldn’t the owner want to be able to sell some or essentially all of his or her stock, tax-deferred or possibly tax free, and still vote and control the stock he or she sold? Why wouldn’t a company want to finance growth with pretax dollars? Why wouldn’t the CEO want to accelerate the repayment of existing loans by deducting principal as well as interest? Why wouldn’t the major or minor stockholder want to buy out a co-stockholder’s interest with pretax rather than after-tax dollars? Why wouldn’t a company want to gain market share by using tax savings to reduce prices or acquire competitors? Why wouldn’t a corporation want to recover taxes in three prior years? Why wouldn’t the corporate decision maker want to replace costly pension and profit sharing plans with the most cost-effective employee benefit plan? Why wouldn’t the corporation want to match its employees’ 401(k) plan contributions with employer stock rather than cash? Why wouldn’t the company want to reward loyalty while increasing productivity?

Why? I’ll tell you why. It is generally because of an information gap. This often manifests itself in the form of erroneous perceptions (e.g., “I don’t want the employees to tell me how to run my company” or “I don’t want to dilute my stock” or “I don’t want to lose control”). Perhaps a trusted advisor responds to the CEO’s query by offering the well-meaning, nonscientific, discussion-ending comment: “ESOPs? They’ve got problems.” The author’s response to this often-heard observation is: “Everything that is worthwhile has problems. Being married has problems, having kids has problems, and running a corporation has problems. You still do these things nonetheless.” We have observed over the years that it is common for owners of private corporations to want information concerning ESOPs, but they do not know where to obtain it. Moreover, they often do not even know what questions to ask.

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The Free ESOP Information Hotline

In order to help ESOPs proliferate by providing a resource for those who are interested in receiving specific information, The ESOT Group has established a free ESOP Information Hotline. From past experience, we know that CEOs, CFPs, CPAs, attorneys, financial planners, and life insurance advisors will find this service to be of particular value. THE FREE ESOP INFORMATION HOTLINE IS: (800) 422-ESOP (3767)