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2 Employee Stock Ownership Plans: Is it the Right Fit for Our Company in the United States April 30, 2015 Presented By: Alexander L. Mounts Partner, Krieg DeVault LLP One Indiana Square, Suite 2800 Indianapolis, IN (317) Moderated By: Kristen Chittenden Associate General Counsel Hendry Marine Industries

3 Is your company publicly traded? Yes No

4 Do you have an ESOP or an ESOP component to your 401(k) plan? Yes, an ESOP Yes, an ESOP component to my 401(k) plan No, neither

5 What is an Employee Stock Ownership Plan? Tool of CORPORATE FINANCE/ SUCCESSION VEHICLE Tax-qualified RETIREMENT PLAN Invests primarily in EMPLOYER STOCK Numerous Federal tax incentives encourage implementation 5

6 6 Private Company ESOPs

7 Advantages of C and S Corporation ESOPs Flexibility Market for shareholders stock Unlike most buyers, serves as source of funds to purchase minority blocks Low marketability discount (typically 5%) on value of shares (private company) Succession planning vehicle for gradual transfer of ownership to next generation (often combined with transfers of ownership to management sweat equity ) Financial buyer with long term perspective Easily combined with 401(k) plan use of matching contributions to fund ESOP; some transactions allow employees to transfer 401(k) funds to ESOP Investment option for employees. Additional fiduciary protection since ESOP are designed to invest primarily in company stock. 7

8 Advantages of ESOPs Tax C Corporation If certain requirements in Code Section 1042 are met, selling shareholder(s) can defer (or even eliminate) taxable gain on sale All contributions to ESOP (including those used to repay loan) are tax deductible Cash dividends are deductible if used by ESOP to: repay loan, distributed to participants, or Used to buy more shares Allocations to participants accounts are tax deferred; distributions eligible for tax-free rollover Special tax treatment of net unrealized appreciation on distribution of stock 8

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

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

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

12 Fifth Third Bancorp v. Dudenhoeffer Case involving a public company ESOP. The Supreme Court ruled that there is no presumption of prudence to protect fiduciaries of plans designed to invest in company stock, and specifically ESOPs. While the decision eliminated the presumption of prudence rule, it replaces it with a pleading requirement that plaintiffs demonstrate the fiduciary acted imprudently.

13 ESOP Valuation Requirements Publicly traded companies use the current stock value. IRC Section 401(a)(28)(C)... All valuations of employer securities which are not readily tradeable on an established securities market... must be the subject of an independent appraisal ERISA Section 3(18) if there is no generally recognized market for the shares (i.e., they are not traded on a national securities exchange ), they must be the subject of a valuation which meets the requirements of the statute and regulations 13

14 ESOP Valuation Considerations (private company) ESOP Valuation vs. Multiple of Book How should ESOP shares be valued? Independent appraisal firm qualified and experienced with ESOP valuations Appropriate methods of valuing companies Weighting of methods Use of publicly available information regarding non-publicly traded companies Financial performance Merger and acquisition activity Effect of cash and stock dividends on value Effect of repurchase obligation on value 14

15 How does Company Stock get in an ESOP in a Public Company? Purchase in the market or from the company with employee deferrals, profit sharing contributions or matching contributions. Matching or profit sharing contributions made in the form of shares of stock.

16 Basic Structure of a Private Company ESOP Transaction (Bank Financing) Step 1 1. Bank Loan Employer 2. Pledge of Collateral Bank 16 Shareholders 4. Cash 5. Employer Stock ESOP

17 Basic Structure of a Private Company ESOP Transaction (Bank Financing) Step 2 Employer 3. Loan Payments Bank 1. Contributions Dividends Stock 17 ESOP

18 Basic Structure of a Private Company ESOP Transaction (Seller Only Financing) Step 1 Company Short Term Subordinated Note & Warrant 1 Redeem Shares Shareholder Subscribe for Newly Issued Shares 2 Long Term Note ESOP 18

19 Basic Structure of a Private Company ESOP Transaction (Seller Only Financing) Step 2 Company Note Payments Shareholder (Warrant) Note Payments Contributions (Including 401(k) Match ) Distributions Stock ESOP 19

20 Examples of Benefits of S Corporation ESOP Structure Net Income of $5,000,000 with No ESOP Corporate Tax -0- Net Income of $5,000,000 with 50% ESOP Corporate Tax -0- Net Income of $5,000,000 with 100% ESOP Corporate Tax -0- Individual Shareholder Tax: on 45% = $2,225,000 Total Tax Dividends = $2,225,000 Individual Shareholder Tax: on 45% = $1,125,000 ESOP Shareholder Tax on $2,500,000 = $0 Total Tax Dividends = $2,225,000 ESOP s Share = $1,125,000 ESOP Shareholder Tax on $5,000,000 = $0 Additional cash flow = $2,225,000 20

21 ESOP Myths Control will be lost/trustee will become involved in governance Employees or trustee must have seat on Board Management structure will change; the ESOP will become involved in management Stock valuation, compensation and/or corporation s financial statements must be disclosed (private company) Corporation will be less attractive to potential buyers Corporation cannot go public later An ESOP that buys less than 51% of stock cannot pay a control price 21

22 Characteristics of Well-Designed and Implemented ESOPs 22 Sanity check approach to implementation a. Stock valuation b. Feasibility c. Financing d. Commitment of key managers Independent, experienced advisors to ESOP a. Counsel b. Financial Advisor c. Trustee Well-educated ESOP Committee Well-prepared feasibility analysis a. Projections based on history b. Cushion for economic downturn Repurchase Liability Study (private company)

23 Characteristics of Well-Designed and Implemented ESOPs (Cont d) Carefully designed ESOP distribution provisions a. Forms (e.g. lump sums vs. installments) 23 b. Times (after loan paid vs. current) Non-dilutive sweat-equity plan for key management (or outright buy-in) Employment and non-compete agreements for key management Effective employee communications program ( Employee as Owner )

24 The 1042 ESOP Rollover The business owner can elect to defer the recognition of long-term capital gain on the sale of C corporation stock to an ESOP if certain requirements are satisfied: Owner must sell qualified securities - best common stock of a non-publicly traded C corporation Holding period must be at least three years at time of sale 24

25 The 1042 ESOP Rollover (cont d) Immediately after sale, ESOP must own at least: 30% of the total number of shares of each class of stock, or 30% of the value of all outstanding stock of the corporation Selling shareholder, members of family and 25 percent or greater shareholders cannot receive allocations of shares on which gain is deferred 25

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

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