Introduction. David R. Johanson Johanson Berenson LLP

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1 Introduction David R. Johanson Johanson Berenson LLP Perhaps the most powerful tax and business succession planning tool available to shareholders of a closely held company is the ability to sell stock to a trust created pursuant to an employee stock ownership plan (ESOP) and defer or permanently avoid taxation on any gain resulting from the sale. An ESOP also can produce greater commitment and productivity from employees and, in turn, greater share value, provided employees understand how their work affects share value. In order to generate these intangible benefits of broad-based employee ownership through an ESOP, employers must invest a substantial amount of time in developing an ownership culture (i.e., a general sense of responsibility for the success of the employer s business plan, including a focus on limiting expenses and maximizing revenues) or fostering a similar environment that already exists. An example of the tax advantages available for a sale to an ESOP is instructive. A shareholder who owns stock worth $3,000,000 in a closely held company (for which stock he or she originally paid $200,000) will pay $797,500 in federal and state income taxes on the sale (assuming a combined federal and state tax rate of approximately 27.5%), meaning that he or she will net $2,202,500, at best, from the sale. In contrast, by selling his or her stock to an ESOP, he or she will pay no federal income taxes, and possibly no state income taxes, on the sale. The selling shareholder will net $3,000,000 on the sale, a tax savings of $797,500! This tax deferral is available, however, only if the following requirements are satisfied: The selling shareholder must be either an individual, a trust, an estate, a partnership, or a subchapter S corporation (an S corporation ), and must have owned the stock sold to the ESOP for at least three years. The selling shareholder must not have received the stock from a qualified retirement plan (e.g., an ESOP or stock bonus plan), by exercising a stock option, or through an employee stock purchase program. The sale must otherwise qualify for capital gains treatment but for the sale to the ESOP. The stock sold to the ESOP must (in general) be voting common stock with the greatest voting and dividend rights of any class of common stock or preferred stock that is convertible into such voting common stock. For the 12 months preceding the sale to the ESOP, the company that establishes the ESOP must have had no class of stock that was readily tradable on an established securities market. After the sale, the ESOP must own at least 30% of the company that establishes the ESOP (on a fully diluted basis). Although not a requirement for the tax deferral, the company also must consent to the election of tax-deferred treatment, and a 10% excise tax is imposed on the company for certain dispositions of stock by the ESOP within three years after the sale (and while the ESOP loan is outstanding, in certain circumstances). Within a 15-month period beginning 3 months before the sale to the ESOP and ending 12 months after the sale, the selling shareholder must reinvest the sale proceeds in qualified

2 replacement securities (QRP) (common or preferred stock, bonds, and/or debt instruments) issued by publicly traded or closely held domestic corporations that use more than 50% of their assets in an active trade or business and whose passive investment income for the preceding year did not exceed 25% of their gross receipts. Municipal bonds are not eligible reinvestment vehicles, nor are certificates of deposit issued by banks or savings and loans, mutual funds, or securities issued by the U.S. Treasury. The ESOP must be established in a C corporation, not an S corporation. In addition to these requirements for the tax deferral, the company stock purchased by the ESOP may not be allocated to the seller, certain members of his or her family, or any shareholder in the company that establishes the ESOP who owns more than 25% of any class of company stock (at any time during the one-year period ending of the date of the sale to the ESOP or the date on which qualified securities are allocated to ESOP participants). A prohibited allocation causes a 50% excise tax to be imposed on the company, and adverse income tax consequences to the participant receiving the allocation, and may result in the disqualification of the plan with serious consequences (such as the disallowance of deductions for contributions to the plan and other penalties). The tax deferral has one downside that many selling shareholders focus on in that a subsequent sale of the QRP will trigger the tax that had been deferred by the sale to the ESOP. To address this problem, an investment alternative has been developed and carefully refined in recentover the years an innovative security known as an ESOP Note. ESOP Notes are publicly registered securities, issued by upper medium rated to highly rated companies such as Ford Motor CreditCaterpillar Financial Services Corporation, ITT Financial, Xerox Credit Corporation and General Electric Capital Corporation (the original issuers). Morgan Stanley Dean Witter, Paine Webber and Solomon Smith Barney LLC and other investment advisory firms have helped bring to market a number of similar securities in recent over the years. These ESOP Notes often have a maturity of 60 or more years and bear a floating rate coupon indexed to 30-day commercial paper, LIBOR or some other floating rate index. These securities also normally have call protection for 30 years. ESOP Notes can be margined up to 90% or more of their market value, if properly structured, allowing investors access to a substantial portion of their initial sale proceeds to create an actively-managed portfolio without triggering any tax liability on the part of the seller. The borrowing cost is usually the broker call loan rate (or, in recent years, a much better negotiated rate with Bankers Trust or other institutional lenders) plus a spread (in larger transactions, fifty basis points or lower), which is greatly offset by the income earned on the ESOP Notes. There are a number of traps for selling shareholders who do not properly structure their reinvestments in these securities. In recent years, a number of ESOP Notes sold and managed by the now-defunct Derivium Capital and its affiliate Optech have been the subject of Internal Revenue Service (IRS) audits, civil, and criminal cases. Accordingly, so caution and due diligence (both on the original issuers and the advisory firms) isare warranted. Careful planning of the reinvestment of the ESOP sale proceeds is extremely important. The business owner that sells his or her company to the employees can create liquidity today while deferring capital gains taxes indefinitely (as described above). In the event of the selling shareholder s death after the ESOP sale, his or her heirs will receive a stepped-up basis on the QRP, meaning the taxation on the sale of his or her business is avoided forever. With the help of a knowledgeable investment advisor, the selling shareholder also can design a well-diversified portfolio that can be rebalanced according to the changing fundamental and technical conditions of the capital markets. Gifting of QRP to a charitable remainder trust (CRT) is an alternative available to selling shareholders who want to establish an actively-

3 managed portfolio rather than buy and hold QRP in a well-diversified portfolio. If a selling shareholder has donative intent, this planning alternative has some merit. The primary drawback of this strategy is that, although the selling shareholder (and his or her family) may receive the income on the QRP transferred to the CRT during the selling shareholder s lifetime, the principal will be transferred to the designated charities upon the selling shareholder s death. Assuming this tax deferral/avoidance appeals to the owner of a closely held business, how does such an owner go about selling 30% or more of his or her company to an ESOP? The first step is a feasibility study, which tells the owner whether the characteristics of the company are such that he or she is a good candidate for a sale to an ESOP. This feasibility study may involve one or more conversations with a qualified employee ownership attorney or a full-blown written feasibility analysis prepared by an attorney or financial consultant. If the circumstances are such that the ESOP alternative is feasible, the next key step is to obtain a professional valuation of the entire company and of the portion of the company that is being sold to the ESOP. A valuation by an independent appraiser is one of the requirements for a transaction between an ESOP and an owner of the company that establishes the ESOP. Under the Employee Retirement Income Security Act of 1974, as amended, and the Internal Revenue Code of 1986, as amended, the ESOP cannot pay more than fair market value for the shares that it purchases from the selling shareholder. The independent appraisal is used by the ESOP fiduciary (a board of trustees, an administrative committee or an institutional trustee) to ensure that the ESOP does not pay more than fair market value for the shares, as determined as of the date of the sale. Based on existing case law, the ESOP fiduciary must conduct the proper due diligence to make this determination in good faith. The ESOP plan document and the ESOP trust agreement also must be designed and implemented as the valuation process progresses. If the company does not have adequate cash resources to finance the purchase of company stock by the ESOP, as is usually the case, the company must obtain a loan from a commercial lender, and loan terms (i.e., interest rate, prepayment penalties, commitment fees, costs, restrictive covenants and collateral, to list a few) must be negotiated. In addition, a stock purchase agreement between the owner of the company and the ESOP must be negotiated and prepared. The ESOP then typically borrows the money from the company, which, in turn, borrows from a commercial lender. Alternatively, the selling shareholder may agree to extend credit to the ESOP in exchange for a promissory note secured by the shares acquired with such extension of credit. The ESOP uses these loan proceeds to purchase company stock from the owner at no more than its fair market value, as determined by an independent appraiser and confirmed in good faith by the ESOP fiduciary as of the date of the purchase. The company s debt to the commercial lender and the ESOP s debt to the company is normally repaid over a five-, seven- or ten-year term (or more) with tax-deductible contributions by the company to the ESOP. The company, the ESOP, and the selling shareholders should work together to obtain the best terms possible for such financing. Collateral and personal guarantees (or the lack thereof) are often issues on which the parties may have differences that need to be resolved. In an ESOP created by a C corporation, contributions to the ESOP that are used to pay the interest on the ESOP s loan from the company are fully deductible. Contributions used to repay ESOP loan principal are deductible up to an amount equal to 25% of the total compensation paid or accrued to all participating employees, so long as not more than one-third of the contributions are allocated to highly compensated employees. Different (lower) limits apply for ESOPs established by S corporations.

4 Reasonable cash dividends paid on company stock acquired by an ESOP with an ESOP loan also are generally deductible by a C corporation plan sponsor to the extent they are used to repay that specific loan, provided that the company that establishes the ESOP and issues the dividends is not subject to the alternative minimum tax, in which event the dividends may not be fully deductible. Under current law, as enacted in 1997 for years beginning on or after January 1, 1998, S corporation ESOPs are exempt from the unrelated business income tax (UBIT); thus, if an ESOP owns all of an S corporation, no current tax is imposed on the company s income. (That income is eventually taxed because ESOP participants in S corporations are taxed on ESOP distributions, just as C corporation ESOP participants are.) The Clinton administration put forth a proposal in February 1999 that would have imposed UBIT on the ESOP s share of the S corporation s taxable income (at the regular corporate tax rate of 35%); however, neither the House of Representatives nor the Senate included this provision in the 1999 tax bill, and it was not enacted. The U.S. Treasury Department put forth a proposal in early 2000 that would limit the UBIT exemption to ESOP companies meeting certain rules; that provision was not enacted either. Also, in 2000, Congressman Ramstad (R-MN) and Senator Breaux (D-LA) proposed legislation allowing S corporation ESOP companies to continue to receive the tax advantages of existing laws so long as certain requirements designed to ensure the implementation of broad-based ESOPs were satisfied. The Breaux-Ramstad legislation was designed to avoid abuse of the UBIT exemption mentioned above (such as one-participant ESOPs set up solely to avoid taxes). The Breaux-Ramstad proposal also would have expanded the ESOP dividend deduction to include reinvested dividends. Like the other proposals, this did not become law. The Breaux-Ramstad proposal was attached to H.R (the Portman-Cardman bill ), which would have dramatically reformed ERISA and the qualified retirement plan provisions of the Code by, among other things, (1) expanding the aggregate dollar amount of contributions that may be allocated each limitation year on behalf of a participant from the lesser of 25% of compensation or $30,000 to the lesser of 25% of compensation or $40,000, (2) gradually increasing the dollar amount of salary reduction contributions that may be made each limitation year pursuant to a 401(k) plan from $10,500 to $15,000, and (3) eliminating the average deferral percentage and average contribution percentage testing that previously controlled the disparity of contributions pursuant to a 401(k) plan for highly compensated employees as compared to non-highly compensated employees. H.R died with the end of the 106 th Congress. It received bipartisan support in the U.S. House of Representatives when it was approved in July of 2000 by an overwhelming margin of over 400 votes. The U.S. Senate also passed a form of H.R with substantial bipartisan support in 1999 and the Senate Finance Committee approved the bill by a voice vote of all of its members in The U.S. Treasury Department opposed the Breaux-Ramstad proposal as included in the Portman-Cardin bill, but claimed to be willing to accept both with requested amendments. This opposition, plus the U.S. Treasury Department s opposition to other provisions of the Portman-Cardin bill related to various ERISA contribution and allocation limits, apparently played a role in stopping a last minute passage of the legislation in the mid-december 2000 timeframe. It also appears that the real reason that the Portman-Cardin bill did not pass at the end of the 106 th Congress, however, was that several Republican Senators opposed its passage in 2000 as they believe that in 2001 President Bush will develop a better tax cut bill. It is impossible to predict how the Bush Administration will respond to ESOPs and the bigger issues of ERISA and tax reform. Therefore, if the Breaux-Ramstad proposal is once again attached to another form of the Portman-Cardman bill in the 107 th Congress, it will likely come under scrutiny once again by the U.S. Treasury Department and the Bush Administration and may be amended in certain

5 respects. Nevertheless, it is likely that some kind of anti-abuse provision will eventually be enacted.although various members of Congress have proposed revising or eliminating the exemption, no such law has passed to date. As demonstrated by the above discussion, an ESOP is a versatile financial and motivational tool that can be used by a selling shareholder to obtain significant tax benefits in selling a portion or all of his or her company. An ESOP also can be used in connection with the spinoff of a division or corporate expansion or as an acquisition planning tool; it also can be given a special class of preferred stock to minimize equity dilution; and it can be combined with or offered in addition to a 401(k) plan to attract employee equity into a company. Selling stock to an ESOP should be irresistible to many closely held companies (for both financial and non-financial reasons) to the shareholders of such companies for the reasons discussed in this brief introduction to ESOPs.