Employee Stock Ownership Plans

ESOP Services, Inc.

Copyright 2008

ESOP Services, Inc.

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OverviewESOP Uses for Your ClientsThe MechanicsThe AdvantagesCreating an ESOPCandidate Checklist

ESOPs

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Overview

11,000 ESOPs in U.S. (10% of private sector)

3,500 majority owned by the ESOP

2,000 are 100% owned by the ESOP

Found in all industries with more than 25% in manufacturing

71% of ESOP’s are in companies with fewer than 250 employees

At least 75% of ESOP’s are or were leveraged, i.e. they used borrowed funds to acquire stock bought by the ESOP

As small as a few dozen employees and as large as 40,000

(Source: The ESOP Association)

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What is an ESOP?

An ESOP is a Tax Qualified, Defined Contribution, Employee Benefit Plan (ERISA)

• Invests primarily in the stock of the sponsoring company

• “Qualified” in that sponsoring company and selling shareholder receive various tax benefits

• Technique of corporate finance

• May use debt to purchase employer securities

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What is an ESOP? (continued)

An Employee Stock Ownership Plan (ESOP) is a very flexible financial and equity incentive instrument that uses corporate tax-deductible or tax-free dollars to achieve a variety of individual and corporate objectives, including shareholder liquidity, perpetuation, raising working capital, and charitable giving

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Answers the question, “What are my alternatives for business perpetuation and creating liquidity?”

Sale to Third Party Merger Sale to Management Corporate Stock Redemption Initial Public Offering Gift or Other Transfer to Heirs Wind-Up Business and Liquidate Leveraged Recapitalization Sale to Employee Stock Ownership Trust (potentially tax

deferred with “tax-free” dollars)

Creates liquidity, in part or whole, enabling the business owner(s) to diversify their portfolios

Why ESOPs ?

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ESOP Uses for Your Clients

Provide a market (at fair-market value as determined by an independent appraiser) for partial or complete sale by existing shareholders with “tax-free” rollover treatment if ESOP ownership in a C Corporation is 30% or greater (IRC 1042)

Borrow from a bank, the sponsoring company, or sellers to purchase a block of stock

Make corporate tax-deductible contributions, including loan principal and interest payments via the ESOP (25% of Payroll + C Corporation Interest)

Gain a corporate tax deduction for C Corporation dividends passed through the ESOP to employees, or used to repay ESOP debt (excluded from 25% limit)

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Income attributable to S Corporation stock owned by an ESOP is not subject to federal income tax

Raise working capital (Dilutive)

Charitable giving

Going private

401(k)/ESOP combination plans

ESOP Uses for Your Clients (continued)

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The Mechanics

Non-Leveraged

andLeveraged

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Non – Leveraged

(1) Company sets up an ESOP Trust

(2) Company makes annual tax-deductible contributions in cash or stock to the ESOP

(3) Cash is used to buy stock from current shareholders

(4) Shares are allocated to the accounts of eligible employees within the ESOP based on salary

(4) ESOP holds stock for employees and annually notifies them of how much they own and how much the stock is worth

(4) Employees receive stock or cash after they retire or leave the company, a vesting schedule applies

Employees

ESOP (1) ESOP (1)

CompanyShareholders

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Leveraged ESOPs

The ESOP receives a loan and uses the proceeds to purchase stock from current shareholdersThese shares are held in trust and are released

into employee accounts at a rate corresponding to debt amortization

Lender

Leveraged ESOP

(1) Lender lends to company(2) Company lends to ESOP(3) ESOP buys stock from existing shareholders(4) Company makes annual tax-deductible contributions to ESOP. (5) The ESOP then in turn repays lender(6) Employees receive stock or cash when they retire or leave (vesting applies)

Cash

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Cash

Contri

butio

n

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Note

1Cash

Stock

3

Shareholders

ESOP

Company

Annua

l Pay

men

t5

Note

2

6Stock or Cash

UP-FRONT FLOWS

FUTURE FLOWS

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ESOP Lenders

Owner/Selling Shareholder Take back a note in exchange for shares Taxed on principal upon receipt at capital gains and interest as ordinary income (if

installment sale treatment is elected) Advantage: Entitled to higher interest rate; subordinated to bonding company and bank Disadvantage: 1042 Tax Free Roll over requires proceeds to be reinvested within 12

months Bank

Loan is to the company which makes “mirror” loan to ESOP Typically 7 years Assessment of company credit Advantage: Selling shareholder ends up with cash up front Disadvantage: Lenders look to collateralize short fall with proceeds, Bank will not

subordinate to bonding company The Company

Cash rich company can make loan to the ESOP Advantage; Company repays itself with market rate of interest

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Perpetuation Planning C CorporationIRC 1042 “Tax-Free” Rollover

Seller can elect to defer gain on C Corporation shares sold to ESOP by reinvesting all or any portion of the sale proceeds in Qualified Replacement Property (“QRP”)QRP is stock or debt instruments of a domestic

operating corporationQRP must be acquired within 12-months of the

ESOP sale (or 3 months before)After the sale, ESOP must own at least 30% of

company

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* QRP must be evaluated by an experienced investment advisor to ensure compliance guidelines are met.

* *Eligible issuer must have:• more than 50% of its assets used in the active conduct of a trade or business• no more than 25% of its gross income from passive sources

Eligible** Not Eligible

Common Stock

Convertible Bonds

Corporate Fixed Rate Bonds

Corporate “Floating Rate Notes”

Municipal Bonds

US Government Bonds

Mutual Funds

Foreign Securities

REITs

Bank CDs

Qualified Replacement PropertyGeneral Guidelines*

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Perpetuation Planning C CorporationIRC 1042 “Tax-Free” Rollover (continued)

Seller must have owned stock for at least three years prior to sale: Seller cannot have acquired the stock in a

compensatory stock option plan or any other section 83 transaction, nor from a qualified retirement plan

Seller, certain related individuals, and greater-than-25% owners generally cannot participate in ESOP allocations

10% excise tax applies if ESOP disposes of stock within three years, except for normal benefit distribution

Above rules do not apply, if seller does not elect the “tax-free” rollover

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Tax Status Conversion

C to S or S to C IRC 1042 “tax-free” rollover as C Corporation

transaction, then convert to S Corporation S Corporation convert to C for “tax-free”

Rollover – five-year wait to convert to S 100% shareholder approval for S Corporation

election

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Comparison of After-Tax Proceeds

90%

8%

50%

40%

100% 100%

100%

75%

50%

25%

0%

IPO Recap Stock Swap ESOP

Percent available to invest in diversified portfolio

Percent remaining in company stock

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Assume: $500,000 pretax income

10% growth rate

40% effective tax rate

1 2 3 4 5Pretax Income 500,000 550,000 605,000 665,500 732,050

Tax Savings 200,000 220,000 242,000 266,200 292,820

Total Tax Savings $1,221,020 = more than 2x’s current income!

100% ESOP – Five-Year Value of Tax-Free Operations By Electing S Corporation Status

(The ESOP can own less than 100%, with a proportional reduction in tax-free income.)

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“Outside” Equity incentives for ESOP S Corporations Attacked!

House Ways and Means Committee Proposes Cutback in outside equity incentives (Stock options, Stock Appreciation Rights (SARs), Warrants, Phantom Stock, etc.)

Legislation introduced 10/25/07 by Chair of the House Ways and Means Committee, Charles Rangel [D-NY], has as a so-called loophole closer, a provision that impacts an S ESOP corporation’s granting equity incentives to employees by assessing additional taxes that could exceed 100%.

Existing Structures to be grandfathered.

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Advantages for the Company

Substantial tax savings (40% to 100%) Corporate perpetuation Cash flow increased Pre-tax dollars repay debt S Corporation stock owned by an ESOP is not subject to

federal tax (California and most states mirror) Tax-deductible C Corporation dividends Justifies accumulated retained earnings

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Advantages for Stockholders

Creates liquidity at fair market value (as determined by an independent appraiser)

Control maintained (if desired)

“Tax-Free” rollover treatment available to sellers in closely-held C Corporation (IRC 1042)

Establishes value and provides liquidity for estate planning

Selling shareholders excluded from ESOP participation can be “made whole” by the corporation (deferred compensation)

Additional equity incentives still available (stock option, bonus, purchase, phantom stock, etc.)

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Advantages for Employees

Employees share directly in equity growth of company

ESOP employer contributions tend to be larger than profit sharing contributions

Proven motivator and builds unity and team spirit Retains key employees (25 years of studies) Accounts accumulate tax-free and are tax-favored

at distribution Employees can realize dividend income Buy/sell agreements ensure future employee

ownership through the ESOP

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Creating an ESOP

Preliminary Analysis Preliminary Assessment Questionnaire

Phase I Preliminary Valuation

Feasibility Study (“Decision Package”)

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Creating an ESOP (continued)

Phase II ~ Implementation Plan design

Financing

Employee communication

Repurchase obligation planning/funding

Independent transaction valuation

Phase III ~ Ongoing Administration

Annual valuation

Communications

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Yes/No___/___1. The entity is a corporation taxed in the normal

manner. Please check type of corporation."C" Corp. ___ "S" Corp. ___ Professional Corp. ___

___/___2. The company is closely held, or if publicly traded has a significant concentration of ownership

___/___3. The company has payroll adequate to support an ESOP (Minimum $500,000)

___/___4. The company has a strong pretax, pre-distribution/bonus earnings and cash flow over the previous few years ($1,000,000 +)

Is an ESOP Right for You?ESOP Candidate Checklist

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Yes No___/___5. The company expects to have strong pretax, pre-

distribution/bonus earnings over the next few years ($1,000,000+)

___/___6. The company has paid substantial federal income taxes during the past few years

___/___7. At least some stockholders are motivated to sell some stock; e.g., planning for retirement, liquidating an estate, entering a new business venture, children not involved in business, etc.

Is an ESOP Right for You?ESOP Candidate Checklist (Continued)

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Yes No___/___8. If one or more principal executives will be departing

in connection with the sale, there is strong management available to take their place(s)

___/___9. The company customarily makes payments to a 401(k) or profit sharing or other employee benefit plan that could in the future be made to an ESOP

___/___10. The owners are psychologically willing to share ownership with their employees, assuming an attractive transaction can be arranged

Is an ESOP Right for You?ESOP Candidate Checklist (Continued)

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ESOP Services, Inc.www.esopservices.com

Founded in 1984, ESOP Services, Inc. responds to the needs of business owners to understand and analyze the ESOP’s impact on the company, shareholders, and employees, focusing on the financial aspects of cash flow, tax savings, shareholder liquidity, and employee benefits. We specialize in all aspects of Employee Stock Ownership Plans for both private and public companies throughout the United States and internationally. Our unique approach emphasizes the financial aspects of ESOPs, while coordinating the many diverse elements necessary to successfully establish an ESOP.

P.O. Box 420563 251 Albevanna LaneSan Diego, CA 92142 Scottsville, VA 24590 Phone: 858.292.4819 Phone: 434.286.3130Fax: 858.565.0764 Fax: 434.286.3815paige@esopservices.com esop@esopservices.com