Presenting a live 90-minute webinar with interactive Q&A
Structuring M&A and Private Equity
Sales Involving ESOPs: Alternative
Strategy in a Down Market
Evaluating Advantages and Risks, Best Practices for Structuring the Deal
TUESDAY, NOVEMBER 1, 2016
1pm Eastern
|
12pm Central | 11am Mountain
|
10am Pacific
Today’s faculty features:
Anthony J. Jacob, Partner, Hinshaw & Culbertson, Chicago
David R. Johanson, Partner, Hawkins Parnell Thackston & Young, Napa, Calif.
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Structuring M&A and Private
Equity Sales Involving ESOPs:
Alternative Strategy in a Down
Market
Strafford Live Webinar
|
November 1, 2016
|
1:00 p.m. – 2:30 p.m. EDT
David R. Johanson
Senior Partner | HAWKINS PARNELL THACKSTON & YOUNG LLP
Email:
Direct:
Cell:
[email protected]
707.299.2470
707.225.2986
Anthony J. Jacob
Partner | HINSHAW & CULBERTSON LLP
Email:
Direct:
[email protected]
312-704-3105
6
Presentation Overview

Alternative Exit Strategies

Plan Design Considerations

Criteria for Evaluating Alternatives

What is a “Repurchase Obligation”?

Introduction to ESOPs

Corporate v. ERISA Fiduciary Standards

Profile of an Ideal ESOP Candidate

General Regulatory Framework

ESOP Corporate Governance

ESOPs and Other Retirement Plans

How Does an ESOP Work?

Summary of Pros and Cons of an ESOP
7
Alternative Exit Strategies
Sell to a
Strategic Buyer
Sell to a
Financial
Buyer
Sell to an ESOP
8
Alternative Exit Strategies
Purchase
Price
Tax
Considerations
Legacy
Form of
Consideration
Alignment of
Initiatives
Diversification and
Liquidity Concerns
Time to Close
9
An ESOP is an employee benefit
plan subject to the applicable
provisions of the Internal Revenue
Code of 1986, as amended (the
“Code”), the Employee Retirement
Income Security Act of 1974, as
amended (ERISA), and the
regulations issued thereunder.
10
Introduction to ESOPs
Designed to invest primarily in employer securities
(“Company Stock”):

Not subject to the 10% limitation in investments in employer securities that
apply to other ERISA plans; but

Participants have diversification rights under either Section 401(a)(28) or
401(a)(35) of the Code.
11
Introduction to ESOPs
Not subject to the minimum funding requirements under
Section 412 of the Code:

Although planning for future payment obligations to terminated employees is
highly recommended.
12
Introduction to ESOPs
Subject to certain conditions, selling shareholders of a C
corporation may elect to defer taxes on the sale of
Company Stock to an ESOP under Section 1042 of the
Code.

If the seller makes a Code Section 1042 tax-deferral election, then certain
allocations to the ESOP Accounts of the selling shareholder in a transaction to
which Code Section 1042 applies, his family members, and any other 25% or
more shareholder are then prohibited under Section 409(n) of the Code.
13
Introduction to ESOPs
ESOPs can be leveraged, which effectively doubles the
limit on deductible contributions (for C corporations
only):
Contributions for general plan administration are deductible under Section
404(a)(3) of the Code
 Contributions to enable an ESOP to service its Company Stock acquisition debt
are deductible under Section 404(a)(9) of the Code
 Not subject to the minimum funding requirements under Section 412 of the
Code, although planning for future repurchase obligations with respect to
terminated vested ESOP participants is highly recommended

14
Introduction to ESOPs
BENEFITS TO PARTICIPATING EMPLOYEES

No deduction from their wages is required or permitted

Value of their ESOP benefits may grow over time

Potential retirement benefit based upon performance of Company Stock
15
Introduction to ESOPs
BENEFITS TO PARTICIPATING EMPLOYEES


Participating Employees only have a “beneficial ownership” interest in shares
of Company Stock allocated under the ESOP.

ESOP Trust is the legal or record owner.

ESOP is not a direct stock purchase plan.

ESOP is not an Employee Stock Purchase Plan (“ESPP”) under Section 423 of the Code.
The ESOP is not a stock option plan (which grants participants the rights to
acquire Company Stock at a future date).
16
Advantages of Selling to an ESOP
SELLING SHAREHOLDER

Non-recognition of gain on sale for C corporation


If a 1042 election is made, the plan must own at least 30% of the company’s stock immediately
following the sale to the ESOP
Facilitate partial or complete ownership transition
17
Advantages of Selling to an
ESOP
C CORPORATION
Tax deductible funds transfers to the ESOP Trust



Tax savings can be used productively – debt repayment, capex, acquisitions, etc.
Employer Contributions deductible under:

Section 404(a)(3) of the Code
 Up to 25% of the eligible “Compensation”
 Aggregated with employer contributions to other defined contribution plans

Section 404(a)(9) of the Code




Up to 25% of the eligible “Compensation”
Only if contribution used to make exempt loan payments
Interest payments excluded
Dividends deductible under Section 404(k) of the Code
 Subject to certain conditions and restrictions
18
Advantages of Selling to an
ESOP
S CORPORATION

Future corporate income is “passed through” to the ESOP Trust (tax-exempt)

Tax deductible funds transfers to the ESOP Trust

Tax savings can be used productively – debt repayment, capex, acquisitions, etc.

Only the deduction for employer contributions under Section 404(a)(3) of the Code is
available

S Corporation distributions may still be declared, and the ESOP Trust may use such
proceeds to make exempt loan payments, however, the S distributions are not
deductible.
19
Advantages of Selling to an
ESOP
EITHER C OR S CORPORATION
Positive impact on corporate cash flow:



Employer Contributions to the ESOP may be made in shares of Company Stock

Employer Contributions to the ESOP used to acquire shares of Company Stock
(pre-tax dollars) in lieu of stock redemption proceeds (after-tax dollars) may
significantly impact the Company’s cash flow availability on a post-transaction
basis
Particularly helpful if the Company is trying to maximize tax deductions while
complying with any financial covenants with senior lenders.
20
Advantages of Selling to an
ESOP
EMPLOYEES

Retirement plan with substantial benefits

Typically, independent studies have shown that ESOP corporations provide
greater compensation and benefits

Aligns incentives of management and employees through ownership interestpowerful tool for recruitment and retention
21
Profile of an Ideal ESOP
Candidate
SELLING SHAREHOLDER CHARACTERISTICS

Desires Fair Market Value

Seeks personal wealth diversification

Would like to take some value out of corporation on a tax-deferred basis

Seeks to preserve corporation and employee legacy

Wishes to provide employees with economic benefits
22
Profile of an Ideal ESOP
Candidate
SPONSORING CORPORATION AND EMPLOYEE CHARACTERISTICS

Sufficient balance sheet strength to absorb ESOP acquisition debt (if any
anticipated)

Sufficient cash flow from operations to cover all ESOP acquisition debt and
other long-term debt service requirements

Historical and projected profitable operating performance (i.e., revenue
generation and profit margins)
23
Profile of an Ideal ESOP
Candidate
SPONSORING CORPORATION AND EMPLOYEE CHARACTERISTICS

Sufficient payroll to meet contribution requirements

15 to 20 employees or more

Management depth and established plan for succession

Participatory management environment

Effective communications exist between employees and management

S corporation or C corporation
24
Corporate Governance in an ESOP Corporation
ESOP TRUSTEE
BOARD OF
DIRECTORS
NON-ESOP
SHAREHOLDERS
BOARD OF
TRUSTEES
ESOP ADVISORY
COMMITTEE
ESOP TRUST
OFFICERS


Shareholders elect Board of Directors
Board of Directors appoints officers and appoints ESOP Board of Trustees
25
Description of Respective Roles
ESOP TRUSTEE

Elects Board of Directors

Responsible for ESOP Administration

Establishes Fair Market Value for Company Stock
26
Description of Respective Roles
BOARD OF DIRECTORS

Responsible for Major Corporate Actions

Strategic Planning

Appoints Officers and Board of Trustees
27
Description of Respective Roles
CORPORATE OFFICERS

Responsible for Day-to-Day Management of the Corporation
28
Description of Respective Roles
ESOP ADVISORY COMMITTEE (OPTIONAL)

Responsible for learning how ESOP functions and communicating that to
Corporation Employees
29
Description of Respective Roles
OTHER RECOMMENDED COMMITTEES OF THE BOARD OF DIRECTORS (OPTIONAL)

Nominating Committee – Evaluating current directors and identifying and vetting
potential new directors

ERISA Fiduciary Committee – Selection and monitoring of ERISA fiduciaries of all
employee benefit plans that the company maintains

Audit Committee – Oversight of the annual audit of the company’s financial statements
(if applicable)

Executive Compensation Committee – Evaluation of the compensation packages
awarded to executives (including the engagement of an independent analyst)
30
Corporate Governance
ESOP-owned corporations have up to two additional
governance layers:
1.
ESOP Trustee (Board of Trustees or institution)
2.
ESOP Committee or Independent Fiduciary
31
Corporate Governance
ERISA Governs the ESOP Trust
Employees have expectations as beneficial owners of the corporation
through the shares of Company Stock held in their ESOP Accounts
The interaction between governance systems can enhance value
32
Corporate Governance
Success in an ESOP-owned corporation encompasses:

Business survival and growth

Increase in Company Stock value

Repurchase of Company Stock from departing employees

Adequate provision for employee retirement

Employee fulfillment of operational improvement initiatives to increase
quality, productivity, profitability and value
33
How Does an ESOP Work?
(Non-Leveraged)
Terminated
EmployeeParticipants
Other Shareholders
2
Corporation
1
Save: IRA
Spend
4
3
2
ESOP Trust
1.
2.
3.
4.
ESOP Accounts
Corporation makes annual tax deductible cash and/or stock contributions to ESOP Trust; and/or
ESOP Trust uses cash contributions to acquire stock from existing shareholders or the Corporation.
ESOP Trust allocates stock or cash to Participant accounts and tells employees how much stock
has been allocated to their accounts and how much such stock is worth.
Employees receive stock or cash when they leave Corporation and must sell stock back to
Corporation, which must purchase such stock.
34
How Does an ESOP Work?
(Leveraged)
Terminated
EmployeeParticipants
Other Shareholders
Corporation
2
1
Save: IRA
Spend
4
2
3
1
ESOP Trust
ESOP Accounts
3
Bank
1.
2.
3.
4.
5.
Bank loans funds to the Corporation, which loans funds to the ESOP Trust.
ESOP Trust uses loan proceeds to acquire stock from existing shareholders or the Corporation.
Corporation makes annual tax deductible cash contributions to the ESOP Trust; ESOP Trust makes payments on the loan;
Corporation makes payments on the Bank loan.
ESOP Trust allocates stock to Participant accounts and tells employees how much stock has been allocated to their
accounts and how much such stock is worth.
Employees receive stock or cash when they leave Corporation and must sell stock back to Corporation, which must
purchase such stock.
35
Code Section 1042 Tax-Deferred
Transaction
▪ A shareholder of a “closely held” C corporation may sell qualified employer
securities to an ESOP and defer the taxation of gain to the extent that he or
she reinvests in securities of other corporations (“qualified replacement
securities”) and defer taxes on the sale of the securities
▪ In the hands of the original seller, the qualified replacement securities have a
carry-over basis from the stock sold to the ESOP. However, as an estate
planning matter, if sellers were to hold on to the replacement securities until
the sellers’ death, it would pass to their heirs with a stepped-up basis for tax
purposes.
36
Qualified Replacement Property
▪ Generally, “qualified replacement securities” must be securities of U.S.
operating companies whose passive investment income does not exceed 25%
of gross receipts.
▪ The replacement securities are defined to include equity (stocks) and debt
(bonds) of U.S. corporations, either public or private, including common stock,
preferred stock, corporate notes and bonds, convertible bonds and floating
rate notes.
▪ Qualified replacement property does not include U.S. government municipal
securities, foreign securities, mutual funds, interests in limited partnerships,
REITs, passive investments, or the stock of the corporation (or its affiliates)
that is the subject of the ESOP transaction.
37
Qualified Replacement Property
▪ Some brokerage and investment firms offer products that essentially allow the
sellers to borrow against the replacement securities
▪ Floating rate note QRP securities (“FRNs”) are designed specifically to address
this leverage opportunity
▪ The FRNs are designed specifically to be held until death of the selling
shareholder
38
Section 1042 Tax-Deferred
Transaction
TRANSACTIONS MUST HAVE 5 CHARACTERISTICS
1
It must be one that would otherwise
result in long-term capital gain
(LTCG) to the shareholder
39
Section 1042 Tax-Deferred
Transaction
TRANSACTIONS MUST HAVE 5 CHARACTERISTICS
2
The shareholder’s holding period for
the stock must be at least 3 years
40
Section 1042 Tax-Deferred
Transaction
TRANSACTIONS MUST HAVE 5 CHARACTERISTICS
3
The shareholder must not have
received the stock from a qualified
employee plan (such as an ESOP),
by exercising a stock option or
through an employee stock purchase
program
41
Section 1042 Tax-Deferred
Transaction
TRANSACTIONS MUST HAVE 5 CHARACTERISTICS
4
The qualified replacement securities
must be purchased within the 15month period that begins 3 months
before and ends 12 months after the
sale of the company stock to the
ESOP
42
Section 1042 Tax-Deferred
Transaction
TRANSACTIONS MUST HAVE 5 CHARACTERISTICS
5
After the sale, the ESOP must own
(in a fully diluted basis) at least 30%
of the common equity of the
employer that sponsors the ESOP
43
Prohibited Allocations if Capital Gains
Deferred Under Section 1042
50% excise tax if allocation occurs (generally within 10
years of transaction) of company stock acquired from
the selling shareholder to :

Taxpayer who received tax deferral (selling shareholder);

Individual related to selling shareholder; and

Any person owning more than 25% of any class of outstanding stock of the
sponsoring corporation
* Note: Children/Grandchildren of the selling shareholder may receive 5% in the aggregate under certain
conditions.
44
Tax-Deferred Reinvestment under
Section 1042 of the IRC C Corporations Only
Cash / Note
Selling
Shareholder
ESOP Trust
Qualifying Employer
Securities
Qualified
Replacement
Property
(“QRP”)
QRP: Debt or Equity in a Domestic
Operating Corporation (Stepped-up basis
upon death). QRP Excludes:
•
REITs
•
Mutual Funds
•
Passive Investment Companies
•
Municipal Bonds
45
Comparison of Stock Sale
Structures
Corporate Redemption or Sale to Third-Party/S
Corporation
Sale to ESOP with TaxDeferral
Long-Term
Federal: 15% or 20%, depending on the selling
Capital Gains shareholder’s tax bracket.
Tax
Plus the long-term capital gains tax rate of the state of
residence of the selling shareholder
Deferred until subsequent
disposition of QRP
Affordable
Care Act
Medicare
Investment
Tax (ACA
Tax)
3.8% on the lesser of:
(a) Net investment income (mostly passive
investments, unless material participation exception
applies), or
(b) Modified AGI (e.g., amount over $250,000 for
married joint filers)
N/A
Result
Net Proceeds = Purchase Price – Combined Federal and
State taxes
Net Proceeds = Purchase
Price – QRP Acquisition Cost;
QRP Acquisition Cost is
46
invested
Comparison of Stock Sale
Structures
EXAMPLE
Sale for $1,000,000 in cash payment :
Federal LTCG (20%)
New York (8.82%)
Medicare surtax (3.8%)
$1,000,000 x 0.20 =
$200,000
$1,000,000 x 0.0882 =
$88,200
$1,000,000 x 0.038 =
$38,000
Federal Tax Deduction of State Income Tax
(37.6%)
($33,163)
Total Federal and New York Taxes
$293,037
Net Proceeds to Selling Shareholder
$706,963
47
Code Section 1042 Alternative
Using a tax-deferred Code Section 1042 sale to an
ESOT, the seller receiving the $1,000,000 may invest
the $1,000,000 in QRP and avoid taxation.
EXAMPLE WITHOUT LEVERAGE
Sale for $1,000,000 in cash payment
$1,000,000 in QRP acquired
$1,000,000 in QRP has carryover basis (often negligible)
If the $1,000,000 in QRP is sold after death, the capital gains is measured by the stepped basis or
fair market value basis at death
If the value at death is $1,500,000, the basis is stepped to $1,500,000 at death and no tax is
applied
48
Code Section 1042 Alternative
EXAMPLE WITH LEVERAGE
Sale for $1,000,000 in cash payment
$1,000,000 in QRP acquired as FRNs for $200,000 and $800,000 margin
$1,000,000 in FRN QRP will generate interest income to pay the margin interest on the $800,000
margin loan
$800,000 is available is for other investments
$1,000,000 in QRP has carryover basis (often negligible)
If the $1,000,000 in QRP is sold after death, the capital gains is measured by the stepped basis or
fair market value basis at death
If the value of the FRNS at death is $1,000,000, the basis is stepped to $1,000,000 at death and
no tax is applied
49
Installment Sales
▪ Tax Rates – Notes Regarding Installment Reporting (Internal Revenue Code
Section 453):
▪ Installment reporting is the default method for installment sales.
▪ Each payment is included in income in the year of receipt.
▪ This means that each installment payment is subject to the Federal LTCG rate
prevailing for the year of payment.
▪ The Seller may “opt out” of installment reporting (Schedule D) and pay taxes
on the entire purchase price in the year of the sale at the then current rates.
▪ $5M caveat
50
Point for Analysis
A partial Code Section 1042 election and installment
sale is permissible; however, the IRS requires the
allocation to be based on the entire selling price.
EXAMPLE WITHOUT LEVERAGE
$1,000,000 sale; $200,000 received in cash and $800,000 seller note
$200,000 of QRP acquired under Code Section 1042
The cash received is treated as 20% subject to Code Section 1042 tax-deferral and 80%
reportable under the installment method (i.e., no ability to match the cash and the 1042)
51
Qualifying Employer Securities
▪ Not readily tradable on an established securities market, and:
▪ Common stock (best dividend and best voting rights); or
▪ Convertible preferred stock
▪ Selling shareholder did not receive pursuant to an incentive program
▪ Long-term capital gain
▪ Three-year holding period
52
Illustration of Potential Tax Savings

Assuming the conditions of Section 1042 of the Code are satisfied, and the
purchase price listed below:
Purchase Price
To the Company or Third
Party
To the ESOP with 1042
Election
$1,000,000
$1,000,000
Combined Federal and State ($370,000)
Long-Term Capital Gains
Taxes (assumed blended
rate of 37%)
N/A
Down Payment on QRP
(assumed 18% required)
N/A
($180,000)
Net Proceeds
$630,000
$820,000
Additional Benefits
None
QRP to pass to heirs on a
stepped-up basis
53
Seller Financed Transaction
Promissory Note ($1.0M)
Corporation
ESOT
Selling
Shareholder
100% Equity in Company
20% Warrant as
Consideration for
Seller Financing
Corporation
Net of $1.0M
less
$326,200 of
Taxes
54
ESOT Stock Acquisition Warrant
A warrant is a security similar to a
stock option that entitles the holder
to buy the underlying stock of the
issuing company at a fixed exercise
price for a specified period of time.
55
ESOT Stock Acquisition Warrant
▪ The warrant is additional consideration that would be considered in
conjunction with the seller financing.
▪ The warrant is priced into the fairness of the transaction.
▪ The warrant permits the Selling Shareholder to acquire stock at the posttransaction price and appreciation will be taxed on the long-term capital gains
rate.
▪ The ESOT’s independent, discretionary, and institutional Trustee and
independent appraiser will determine what is fair in this respect.
▪ Assume 20% Warrant for planning purposes
56
Post-Closing
Party
Net Gains/Losses
Corporation
• Use $1.0M of profits to finance purchase of equity from Selling
Shareholder;
• ESOP as vehicle for future tax deductions;
• Equity incentives to employees; and
• Business succession underway.
ESOT
• $1.0M owed on Promissory Note to Selling Shareholder;
• 100% of the issued and outstanding shares of Company Stock
Selling
Shareholder
• $1.0M worth of proceeds from the sale to the ESOT;’
• $326,200 of capital gains not ordinary income tax consequences;
• Warrant exercisable for 20% of Company stock – estimated to be worth
$400K in ten years; and
• 25% of equity in form of ESOP participation – estimated to be worth
$500K in ten years.
57
Potential Tax Liability
Potential Tax Liability Without 1042 Election
Selling Shareholders’ realized gain
$1,000,000
Highest marginal tax rate for Federal
long-term capital gains
$200,000 (20%)
New York Income Tax
$88,200 (8.82%)
Federal Excise Taxes under the
Affordable Care Act
$38,000 (3.8%)
Total Taxes (excluding NYC taxes)
$326,200
58
Assumptions and Disclaimers
▪ This presentation is intended to illustrate the flow of funds of a potential stock
transaction, assuming a 100% sale of a $1,000,000 valued company at a purchase price
of $1,000,000 for an Employee Stock Ownership Trust (“ESOT”) sponsored by Company
A, a New York corporation (“Company”).
▪ The actual dollar amounts will depend on a number of factors, including without
limitation, the final, negotiated purchase price with an independent, institutional, and
discretionary ESOT Trustee, an independent appraiser and financial advisor for the ESOT,
and the limits on tax deductible contributions under the Internal Revenue Code of 1986,
as amended (the “Code”).
▪ The content of this presentation is intended for information purposes and is not
intended as an offer to sell, a solicitation, or a recommendation of any particular
transaction structure, investment alternative, product, or services.
59
Plan Design Considerations
Feasibility study recommended to evaluate:
Eligibility to participate
(broad base or narrowly
tailored?)
Minimum age cannot be
set above 21
Service requirement
cannot exceed 1 year (with
1,000 hours of service)
Gradual, immediate, or
cliff vesting?
Leveraged or
non-leveraged?
Internal board of trustees
or institutional /
independent trustee?
Independent
fiduciary?
What will the repurchase
obligation be under the
different variables?
60
Repurchase Obligation
Obligation of a corporation to
provide a market for employer
securities that are allocated under
and distributed or distributable from
the ESOP.
61
Repurchase Obligation
If the employer securities are publicly traded:
▪ A market exists and the corporation does not have to repurchase Company
Stock distributed to ESOP Participants.
In all other cases:
▪ The employer or the ESOP Trust must repurchase the employer securities under
“a fair valuation formula”. Section 409(h)(1)(B) of the Code.
62
Fiduciary Standards: Corporate v. ERISA
Corporate Law:
▪ Generally presumes good faith by members of the Board of Directors making a
Business Judgment, applying a gross negligence standard of review.
ERISA:
▪ Holds fiduciaries to the highest standards of prudence, skill and care; ERISA
fiduciaries must act solely in the interests of plan participants and beneficiaries.
63
Fiduciary Standards: Corporate v. ERISA
▪ A person serving as both a member of Board of Directors and an ESOP
Fiduciary remains subject to the corporate standards when acting as a
“grantor” – terminating or amending a plan – or when reviewing purely
corporate functions.
▪ This is not a bright line rule.
▪ ERISA fiduciaries are personally liable for breaches of their ERISA duties.
▪ ERISA Fiduciary Insurance a Must
▪ Indemnification of ERISA Fiduciaries not enforceable in many jurisdictions
64
ERISA Fiduciaries
▪ Named “fiduciary” in the plan document or trust instrument.
▪ ESOP Trustee(s): Directed and independent or insiders.
Anyone who exercises any discretionary authority & control over management or
disposition of plan assets. Section 3(21) of ERISA. In theory, this could include:
▪ Board of Directors
▪ ESOP Advisory Committee
▪ Plan Administrator
▪ Corporation Executives (not typically)
▪ Outside advisors (but only if s/he makes a fiduciary decision
65
ERISA Fiduciaries
ERISA FIDUCIARY DUTIES
▪ Follow the Plan document (unless ERISA requires fiduciary to override the Plan)
▪ Protect the Plan from non-exempt prohibited transactions by being sensitive to
potential and real conflicts of interest
▪ Assure that the ESOP Trust pays no more than fair market value for company
stock (or any other asset that the ESOT acquires)
▪ Ensure that the ESOP is administered fairly without discrimination as provided
by the Code and ERISA
66
ERISA Fiduciaries
ERISA FIDUCIARY DUTIES (CONT.)
▪ Ensure that ESOP participants receive all required information and disclosures
as provided by the Code and ERISA
▪ Ensure that the ESOP and ESOP Trust obtain and retain their legal qualifications
under the Code and are amended as required under applicable laws and
regulations, from time to time
▪ Vote the shares of company stock held by the ESOP Trust when not required to
be “passed-through” to ESOP participants
67
Conflicts of
Interest
Conflicts of interest may arise between:
Corporation and the ESOP
Managers and the ESOP
Board of Directors’ members and the ESOP
Other Shareholders and the ESOP
68
Conflicts of
Interest
When and how does it arise?
Why do people overlook it?
Ways to address it include:
Resignation of conflicted
individuals
Appointment of
independent advisors,
outsiders, or committees
Abstention from
action
69
General Regulatory
Framework
Tax Matters
Fiduciary and Other Matters
Agency
U.S. Department of Treasury
(“DOT”)
U.S. Department of Labor (“DOL”)
Primary
Division
Internal Revenue Service (“IRS”)
Employee Benefits Security
Administration (“EBSA”)
Primary
Sources
Code (Title 26 of the United States
Code) and case law
ERISA (Title 29 of the United States
Code) and case law
Secondary
Sources
Treasury Regulations, IRS Notices,
Revenue Rulings, and Revenue
Procedures
IRS Technical Advice Memos,
General Counsel Memos, Private
Letter Rulings (Not Precedential)
Labor Regulations, Interpretive
Bulletins, Field Assistance Bulletins,
Administrative Exemptions
Advisory Opinions (Not
Precedential)
70
General Regulatory
Framework
CONFIRMATION OF TAX QUALIFICATIONS OF ESOP
▪ IRS is the sole responsible agency
▪ Not absolutely required but highly recommended
▪ Consequences if the ESOP is not qualified or treated as disqualified:





Loss of deductions for contributions and distributions to the ESOP;
Loss of rollover eligibility of ESOP distributions;
Immediate inclusion in income of all ESOP account balances for each participant;
Excise taxes; and/or
Penalties and interest thereon.
71
General Regulatory
Framework
CONFIRMATION OF TAX QUALIFICATIONS OF ESOP
▪ IRS issues a “Determination Letter” for individually-designed plans:

5-year application cycle (based on sponsor’s EIN)

Application Fee (may be waived under certain circumstances)
72
General Regulatory
Framework
ANNUAL RETURN (FORM 5500 SERIES)
▪ Due by the last day of the 7th month following the end of the plan year, unless
Form 5558 is filed by such date for the automatic 2.5 month extension
▪ E-filing has been mandatory since 2009 (www.efast.dol.gov)
▪ Regulated by the DOL Office of the Chief Accountant
▪ Sanctions for late or non-filing but may be reduced or abated under certain
circumstances
73
General Regulatory
Framework
OTHER REQUIRED DISCLOSURES
▪ Summary Plan Description
▫ Upon plan implementation, then periodically thereafter, depending on
frequency and substance of plan amendments;
▪ Summary Annual Report (summary of Form 5500)
▪ Annual statement of accounts (aka “Participant Statement”)
▪ Plan Documents and certain related documents with a reasonable period of
time upon written request
▪ EBSA provides regulatory oversight through its general investigative authority
74
General Regulatory
Framework
PROHIBITED TRANSACTIONS
▪ Both the Code and ERISA generally prohibit transactions between certain
parties and the ESOP that directly or indirectly involve ESOP assets unless
exempted. Section 4975(c) of the Code; Section 406 of ERISA.
▪ Penalties for prohibited transaction violations include:
▫
▫
▫
▫
▫
Plan Disqualification;
Excise Taxes on parties to the transaction;
Civil and/or criminal sanctions on the plan sponsor;
Corrective contribution to the ESOP (or rescission of the transaction); and/or
Interest on any the taxes and penalties above.
75
General Regulatory
Framework
EXEMPTIONS
▪ Statutory: Section 4975(d) of the Code and Section 408 of ERISA
▪ Regulatory: The DOL regulations promulgated thereunder
▪ Administrative: On an individual or class basis as granted by the DOL in its sole
discretion
76
General Regulatory
Framework
CORRECTIONS PROGRAMS AVAILABLE
▪ IRS Employee Plans Compliance Resolution System, Rev. Proc. 2013-12, as
amended by 2015-27:
▫ Self-Correction Program
▫ Voluntary Correction Program
▫ Audit Closing Agreement Program (“Audit CAP”)
▪ DOL Delinquent Filer Voluntary Compliance Program (“DFVCP”)
▫ Form 5500 late or non-filers
▪ DOL Voluntary Fiduciary Correction Program (“VFCP”)
▪ 19 listed transactions
▪ Updates pending
77
ESOPs and Other Retirement Plans
ESOPs can be in addition to other retirement plans or
part of a hybrid plan. Compatibility with other plans:
▫ Combined with Money Purchase Pension Plans (prior to 2002, due to a
change in the deductibility of ESOP contributions);
▫ Combined with 401(k) Plans (“KSOP”); or
▫ Separate from the 401(k) Plan, but accepting matching contributions (to
satisfy 401(k) Plan safe harbor requirements) made to the ESOP
▪ Arrangements must satisfy limitations under the Code, so careful coordination
with record keepers is required
78
Summary of ESOP Pros and Cons
Shareholder’s Perspective
Pros
Cons
• Potential Tax Deferral for
electing, selling shareholder (C
corporation only)
• Dilution to shareholders (if less
than 100% is sold to the ESOP)
• Viable Exit Strategy
• Permits Gradual Transfer of
Management Responsibilities
79
Summary of ESOP Pros and Cons
Corporation’s Perspective
Pros
Cons
• Tax Deductions
• Employer Contributions
• Certain Dividends (C
corporations only)
• Plan Administration Costs and
Expenses
• Typically higher than for other
retirement plans due to need
for independent ESOP
advisors and independent
valuation of Company Stock
• A good to exceptional tool for:
• Cash Flow Management
• Recruitment and Retention
of Employees
• Balance Sheet Impact
• Business Succession
• Contra equity account
Planning
(leveraged ESOPs only)
• Mergers & Acquisitions
80
Summary of ESOP Pros and Cons
Participating Employee’s Perspective
Pros
• Benefits provided without wage
reductions or deductions
• Opportunity to provide input on
certain corporate matters
• ESOP Voting Requirements
• Open book management
(potentially)
• Benefit payments eligible for
favorable tax treatment upon
distribution (rollover to an IRA or
other eligible retirement plan)
Cons
• Value of benefits subject to
fluctuations of the Fair
Market Value of Company
Stock
81
Concluding Remarks
If, after careful analysis, the corporation’s Board of
Directors decides to implement an ESOP:
▪ Establish and document procedural prudence in all decisions
▪ Educate key decision-makers with respect to corporate and ERISA fiduciary
standards
▪ Consult experts (legal, accounting, valuation, etc.), as needed
▪ Maintain adequate directors’ and officers’ and ERISA fiduciary liability insurance
▪ Read and understand the ESOP plan documents
82
David R. Johanson
Brief Bio
David R. Johanson, the Partner-in-Charge of the Napa office and a Partner in the San Francisco, Los Angeles, and
New York offices of Hawkins Parnell Thackston & Young LLP, has helped hundreds of corporations form ESOPs and
create effective employee ownership through other equity incentives during the past almost 30 years. Mr.
Johanson assists clients in designing ESOP and equity incentive plans and accomplishing ESOP-related transactions,
including mergers and acquisitions of all kinds. Mr. Johanson also defends ERISA fiduciary actions in Federal Courts
throughout the U.S and is actively involved in defending regulatory and enforcement actions by the Internal
Revenue Service and the U.S. Department of Labor. Recognized nationally for his experience and expertise in the
ESOP and executive compensation field, Mr. Johanson is a past chair (1993-1995 and 2005-2007) of the legislative
and regulatory advisory committee of The ESOP Association. He also is a past chair of The ESOP Association’s
advisory committee chairs council and is a former member of its board of directors. Mr. Johanson was honored at
the 17th annual conference of The ESOP Association as the outstanding committee chair for 1993-94. Mr. Johanson
served for more than ten years as General Counsel to The National Center for Employee Ownership and on its
board of directors. Mr. Johanson writes and speaks frequently about employee ownership throughout the U.S.
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Contact Information
David R. Johanson
Partner-in-Charge, Napa Office
Hawkins Parnell Thackston & Young LLP
Cell: 707.225.2986
Email: [email protected]
New York
Napa
600 Lexington Avenue
8th Floor
New York, NY 10022
(212) 897-9655
1776 Second Street
Napa, CA 94559
(707) 226-8997
Los Angeles
San Francisco
445 S. Figueroa Street
Suite 3200
Los Angeles, CA 90071
(213) 486-8010
345 California Street
Suite 2850
San Francisco, CA 94104
(415) 766-3238
84
hptylaw.com
Anthony J. Jacob
Brief Bio
Anthony Jacob practices law in the areas of business law, banking and commercial finance law and real estate law.
Mr. Jacob is engaged in general corporate practice, including various aspects of private merger, acquisition,
divestiture and employee benefit matters. In addition, Mr. Jacob’s practice includes secured and unsecured lending
transactions, asset securitization and structured finance, ESOP loans, initial debt and equity offerings, primary and
secondary debt offerings, corporate reorganizations and restructuring, joint ventures and syndicated commercial
financing transactions. His clients include domestic and foreign corporations, limited liability companies and
partnerships, and banks and other commercial lending institutions. Additionally, Mr. Jacob represents real estate
developers with real estate acquisitions, divestitures, and condominium conversions. He serves as outside general
counsel to certain real estate development companies, assisting with their construction, development and liability
protection strategies. Mr. Jacob also practices Illinois election law. He counsels local and state elected officials and
their political committees. He also represents the political action committees of corporations, not for profit
corporations, partnerships, associations and other business entities. Mr. Jacob formerly represented the Friends of
Blagojevich political committee.
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Contact Information
Anthony J. Jacob
Partner
Hinshaw & Culbertson LLP
Direct: 312-704-3105
Email: [email protected]
Chicago
New York
222 North LaSalle Street
Suite 300
Chicago, IL 60601
800 Third Avenue,
13th Floor
New York, NY10022
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