Katten - ESOP Fact Sheet

8/8/2019 Katten - ESOP Fact Sheet

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Employee Stoc Ow ers p Pla sFact S eet

W at ollows s des g ed to be a troduct o to ESOPs. Ma y spec fc acts must be co s dered determ g w et er a ESOP s su table or your employer. T ere ore, t s Fact S eet s ould ot beco s dered as legal adv ce.

ESOP

ESOP stands for employee stock ownership plan. ESOPs are like pro t sharing plans, but must be invested primarily inemployer stock, and offer special tax advantages to the employer sponsor, its employees and stockholders. One major advan -tage is its ability to borrow money to purchase employer stock. This is called a leveraged ESOP.

Leveraged ESOPs

1. Employer establishes ESOP plan and trust.

2. Bank loans money to ESOP, generally with Employer guaranteeing loan (or lender loans money to Employer, which makessimultaneous back-to-back loan to ESOP).

3. ESOP uses loan proceeds to purchase stock from Employer or its existing Stockholders. The stock may then be used as col -lateral for loan to ESOP. Employer or Stockholders may use proceeds for any purpose.

4. Employer makes annual tax-deductible contributions to ESOP, which uses them to pay off loan.

5. As loan is repaid, a proportional amount of stock is allocated to accounts of Employees. Employees receive stock (or valueof stock in cash) when they retire or terminate employment.

Stockholders Employer

ESOP

Employees

Bank

3.

2.

2.4.

5.

1. 4.


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ESOP Trustee

All ESOP shares are held in a trust. The ESOP trustee hasthe power to use ESOP funds (the ESOP loan proceeds) topurchase stock. The trustee generally votes the shares of ESOP stock held in the trust (although in some situationsthe vote must be passed through to participants). The ESOPcan provide for the trustee to be directed by a committee,and the trustee must then follow the committees directions(including voting directions), except where to do so wouldviolate its duties under the law. An ESOP trustee is governedby strict duciary standards and must act solely in theinterest of participants and bene ciaries of the ESOP.

Tax Adva tages o ESOPs

1. Use of a leveraged ESOP allows a corporation to borrow

and then deduct both principal and interest, rather thaninterest only, as is the case under a conventional loan.This is because the corporations contributions to theESOPwhich are used to pay off the ESOP debtaredeductible as contributions to a retirement plan.

2. Sale of stock in a closely held corporation to an ESOPprovides liquidity for the owners. If an ESOP acquires30% of the stock of a non-public corporation (other thanan S corporation), the stockholder(s) who sold stockto the ESOP may roll over the proceeds, tax-deferred,into other securities. Such a rollover is a Section 1042transaction.

3. While dividends paid by a corporation are normally notdeductible by the corporation, dividends paid on stockheld in an ESOP are deductible if they are used to payoff the ESOP loan or are paid to the ESOP participantseither directly or through the ESOP. Dividends are alsodeductible if they are used at a participants election topurchase additional employer stock.

4. S corporation ESOPs are not taxed on their share of cor -

porate earnings.The tax-advantaged borrowing potential and liquidity of ESOPs may make them attractive to owners of closely heldcorporations.

Tax De erred Requ reme ts

1. There must be a sale of quali ed securities to an ESOP .The proceeds from the sale must then be used by theseller to purchase quali ed replacement property within the replacement period . Section 1042 treatmentmust be elected properly by the taxpayer within thetime frame for ling the tax return for the year of thesale to the ESOP. Section 1042 is an elective provision,not an automatic or mandatory one.

2. The ESOP must own at least 30% of the corporationsstock following the sale. To reach this 30% threshold,sales from different stockholders may be treated as onesale if they are part of a single, integrated transactionunder a prearranged agreement between those stock -holders. Once the ESOP satis es the 30% requirement,

subsequent sales of additional amounts of stock maybe made by stockholders; those stockholders may alsotake advantage of Section 1042. Provided that the 30%requirement is satis ed, a stockholder is not requiredto sell his entire interest in the corporation to the ESOP.In addition, if several stockholders are aggregated tosatisfy the 30% requirement, each of them may sepa -rately elect whether or not to make a Section 1042election.

3. The ESOP must prohibit allocations to the stockholder

who sold securities and elected nonrecognitiontreatment in the 1042 transaction, members of thatstockholders family, and any other person who ownsmore than 25% of the corporations stock. However,allocations to the stockholder or a family member maybe made after the later of: (a) the date 10 years after thesale or (b) the date any ESOP loan incurred in the 1042transaction is paid off.

Qual fed Secur t es

Quali ed securities generally refers to the common stock

(and certain convertible preferred stock) of a U.S. operat -ing corporation which has no publicly traded stock. Theperson who sells the quali ed securities to the ESOP musthave held them for at least three years. In addition, theymust not have been received as a distribution from a tax-quali ed retirement plan, through the exercise of a stockoption, under a grant of restricted stock or under a similararrangement.


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Qual fed Replaceme t Property

Quali ed Replacement Property generally refers to anysecurity of a domestic operating corporation that didnot have passive investment income exceeding 25% of itsgross receipts during the year preceding the Section 1042transaction. The major exclusions are government securi -ties and mutual funds. An operating corporation is anycorporation that uses more than 50% of its assets in theactive conduct of a trade or business and includes banksand insurance companies. Securities of an employer thatis a member of the same controlled group of corporationsas the corporation whose shares were sold to the ESOP arenot quali ed replacement property.

Replaceme t Per od

The replacement period is the period beginning threemonths before the date of the sale to the ESOP and ending12 months after that date. For example, if a taxpayer pur -chases $1 million of securities which meet the de nitionof quali ed replacement property in September 2009 andthen sells his 35% interest in a closely held corporation tothat corporations ESOP in October 2009 for $1 million,he can designate the securities purchased in Septemberas his replacement property and will not recognize gainon the sale to the ESOP, provided that the other require -ments of a Section 1042 transaction are satis ed. He could

also invest the $1 million from the ESOP over 12 monthsfollowing the ESOP transaction, designating each batch of securities purchased as replacement property.

Tec cal Rules or Re vestme t

1. The basis of the property is its cost, minus a propor -tionate share of the gain that was not recognizedas a result of the application of Section 1042. Uponthe subsequent death of a person who has engagedin a Section 1042 transaction, the basis of the quali -

ed replacement property is stepped up to its fairmarket value on the date of death. This results inavoidance of any tax on the gain that was not recog -nized in the Section 1042 transaction.

2. The holding period of the property includes the periodin which the taxpayer held the stock he sold to theESOP.

3. Upon the subsequent sale of any quali ed replace -ment property, the gain that was not recognized as aresult of Section 1042 is recaptured. Therefore, turn -over should be minimized in the portfolio of securitiesthat are purchased with the proceeds of a Section1042 sale to an ESOP and designated as the replace -ment property.

F a c g Source

A corporation can fund an ESOP internally by making aloan to the ESOP in return for the ESOPs note if it hadsuf cient funds. Otherwise, a Section 1042 transaction willgenerally involve a loan by a third-party bank to the ESOP,usually guaranteed by the corporation, with the ESOPthen using the loan proceeds to purchase the stock, asdescribed earlier.

S z g t e ESOP Loa

The Internal Revenue Code sets the upper limit on thedeductible annual payments that a corporation can maketo fund an ESOP loan. These upper limits can be deter -mined for the corporation, then compared to its cash owprojections. These projections of amounts necessary tofund the proposed loan (whether it is from the corporationor from an outside bank), versus the amounts that will beavailable over the term of the proposed loan, are integralto the corporations ESOP feasibility study.

A 100% ESOP buyout may be dif cult to nance. Bankswant to see the seller taking back some debt, or purchasesof stock by others besides the ESOP (such as managers). Abank may seek to have the selling stockholder pledge hisreplacement property as additional security for the ESOPloan. These issues may be negotiated.

Value Determ ed

A sale to an ESOP must be for adequate consideration.An independent third-party appraiser must determine thisvalue in the case of a closely held company in accordancewith U.S. Department of Labor regulations. The appraisersreport is a key element in the ESOP trustees decisionto purchase stock from a selling stockholder. Any non-public corporation that maintains an ESOP is required toobtain an annual valuation of its stock for purposes of planaccounting and repurchases.


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Ot er Pote t al F a c al L ab l t es

Stock of a non-public corporation that is purchased withthe proceeds of an ESOP loan may, but need not, be subjectto a right of rst refusal in favor of the ESOP or the corpo -ration. In addition, stock of a non-public corporation in anESOP must be subject to a put at fair market value (deter -mined by the annual appraisal described above) when it isdistributed to a participant upon retirement, terminationof employment, etc. Therefore, a corporation must projectits ESOP repurchase liability. This involves a projection of how much stock will be distributed to participants in futureyears at retirement, termination of employment, etc., andwill be a function of factors such as age, mortality andturnover for that employee group. The corporation mustconsider whether it will have suf cient current funds ormust create a reserve to satisfy these future repurchaseobligations once these projections are made.

Tax De erred Ca d dates

Stockholders of a closely held corporation might considera Section 1042 transaction under several circumstances. If,for example, the corporation has one or more stockhold -ers who, together, own at least 30% of the corporationsstock, and those stockholders want to terminate or reducetheir investments in the corporation but do not intend totransfer their stock to family members, a Section 1042 sale

may be useful. Or, a 100% stockholder may wish to makepart of his investment more liquid by selling some stockto an ESOP and rolling over the proceeds while still retain -ing control. If an ESOP feasibility study suggests that thecorporation could support an ESOP of a size suf cient topurchase the stock of those stockholders, then a Section1042 transaction may be appropriate.

S Corporat o ESOPs

S corporations may establish ESOPs. An S corporationESOP may not take advantage of certain ESOP incen -tives, such as Section 1042. However, S corporationESOPs can utilize the special tax advantages of leveragedESOP nancing, which creates a tax deduction for bothprincipal and interest on a loan used to acquire employersecurities. This allows the S corporation ESOP to becomea tax-advantaged purchaser of shares of other S corpo -ration stockholders, or of newly issued shares of the Scorporation.

Furthermore, there is no tax paid by the ESOP on its pro -portionate share of corporation taxable income becausethe ESOP is a tax-exempt stockholder.

It may be possible to change from S to C corporationstatus without adverse tax consequences if a corporationwants to take advantage of all the ESOP advantages.However, the corporations advisors must thoroughlyanalyze the impact of changing its status and weigh thisagainst the bene ts of an ESOP.

Recent legislation places restrictions on ESOP transac -tions involving S corporations to prevent unintended useof ESOPs. Anyone considering the use of an ESOP by anS corporation should consult with legal counsel to obtainan up-to-date analysis.


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ESOP CAnDiDATE ChECkLiSTYES NO

____ ____ 1. The employer is a corporation in the normal manner. Please check type of corporation.

C Corp. ___ S Corp. ___ Professional Corp. ___ Other ___

____ ____ 2. The employer is closely held, or publicly traded with signi cant ownership in afew hands.

____ ____ 3. The employer has sales and payroll adequate to support an ESOP; current andprojected payroll as a percentage of sales is 20% or greater.

____ ____ 4. The employer has a strong earnings or cash ow record over the previous veyears.

____ ____ 5. The employer expects to pay substantial federal income taxes over the nextfew years.

____ ____ 6. The employer has paid substantial federal income taxes during the past threeyears.

____ ____ 7. At least some stockholders have a reason why they might be interested inselling some stock; e.g., planning for retirement, liquidating an estate, enteringa new business venture, children not involved in business, etc.

____ ____ 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 employer customarily makes payments to a pro t sharing or otheremployee bene t plan that could in the future be diverted to an ESOP.

____ ____ 10. The owners are psychologically willing to share ownership with their employ -ees, assuming an attractive deal can be arranged. (Dif cult to assess inadvance, but critical.)

No mechanical approach can be perfect, but this list is a good start. An employer with six or moreYes answers is a good candidate.


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ESOPS AS FinAnCiAL TOOLS

An ESOP invests primarily in employee stock. Assuming for comparison purposes that each individual stockholder andthe corporation have an effective combined income tax rate of 40% of their taxable income, following are several differentobjectives that stockholders of a privately held corporation might have which can be achieved through use of an ESOP and

the comparative income tax cost of using an ESOP as opposed to a more common method of achieving the same objective.Interest was ignored because under either alternative, interest would be owed.

GOAL COMPARISON OF ALTERNATIVE SOLUTIONS

1 Secure funds to buy out one of two Cost to Redeem Stock by Corporationequal stockholders of a corporation Before-Tax Dollars Needed to Repay $6M Loan $10,000,000with a value of $12,000,000 for Taxes (40%) 4,000,000$6,000,000. After-Tax Dollars Needed to Repay $6M Loan 6,000,000

Total Cost (Purchase Price Plus Taxes) $10,000,000

Use of ESOPDollars Needed to Repay $6M Loan $6,000,000Total Cost (Purchase Price) $6,000,000

Total Savings from ESOP $4,000,000

2 Sale of stock of corporation by father Cost of Sale of Stock to Childrento children active in business to Who Are Active in Businessprovide $4,000,000 of funds to give Sale Price $4,000,000or bequeath children who are inactive State and Federal Capital Gain Tax on Sale (20%) 800,0001in business.Stock owned: $8,000,000 Income Children Must Earn to Pay for Stock 6,666,666Stock to be sold: $4,000,000

Total Cost to Children and Father $7,466,666

Use of ESOPContribution of Stock to ESOP $4,000,000Tax Deduction (40%) (1,600,000)

Net Cost 2,400,000

Tax Savings from ESOP $5,066,666


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GOAL COMPARISON OF ALTERNATIVE SOLUTIONS

3 Acquisition of new business Corporation Buys Business with(privately held) for $3,000,000. $3,000,000 LoanUse of ESOP would permit selling Before-Tax Dollars Needed to Repay $3M Loan $51,000,000stockholders of corporation to own Taxes (40%) 2,000,000new business by investing funds After-Tax Dollars Needed to Repay $3M Loan 3,000,000from sale.

Total Cost (Purchase Price Plus Taxes) $5,000,000

Use of ESOPDollars Needed to Purchase Business $3,000,000Total Cost (Purchase Price) $3,000,000


4 To obtain $6,000,000 from Borrow $9,000,000 from Corporationcorporation by stockholders to use for to Diversifydiversi cation of investments. Before-Tax Dollars Needed to Repay $9M Loan $15,000,000

Taxes (40%) 6,000,000After-Tax Dollars Needed to Repay $9M Loan 9,000,000

Total Cost (Loan Plus Taxes on Funds $15,000,000to Repay Loan)

Use of ESOPDollars Needed to Purchase Business $9,000,000Total Cost (Purchase Price) $9,000,000



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Co tact Us

For more information on our ESOP Practice, please contact:

Gregory K. Brown312.902.5404 / [email protected]

Kathleen Sheil Scheidt312.902.5335 / [email protected]

Gary W. Howell312.902.5610 / [email protected]

Ann M. Kim312.902.5589 / [email protected]

Daniel B. Lange312.902.5624 / [email protected]

Nancy Laethem Stern312.902.5353 / [email protected]

About t e F rm

Katten Muchin Rosenman LLP is a full-service law rm with more than 600 attorneys in locations across the United Statesand an af liate in London. The rms business-savvy professionals provide clients in numerous industries with sophisticated,high-value legal services, with a focus on corporate, nancial services, litigation, real estate, commercial nance, intellectualproperty and trusts and estates. Among our clients are a wide range of public and private companies, including a third of the Fortune 100, as well as a number of government and nonpro t organizations and individuals. For additional information,visit www.kattenlaw.com.

CHARLOTTE CHICAGO IRVING LONDON LOS ANGELES NEW YORK WASHINGTON, DC

Published as a source of information only. The material contained herein is not to be construed as legal advice or opinion.

2010 Katten Muchin Rosenman LLP. All rights reserved.

Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannotbe used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Katten Muchin Rosenman LLP is an Illinois limited liability partnership including professional corporations that has elected to be governed by the Illinois Uniform Partnership Act (1997). London af liate: Katten Muchin Rosenman Cornish LLP.

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Documents

Katten - ESOP Fact Sheet