J. Michael Keeling, president of The ESOP Association, moderates a discussion on the outlook for ESOPs in 2013 between Greg Brown, a partner at Katten Muchin Rosenman LLP,  Steven M. Burke, director at McLane, Graf, Raulerson, & Middleton, and Ken Serwinski, CEO at Prairie Capital Advisors, Inc.

Keeling: What are the key advantages of using an ESOP structure? In the United States, will an altered tax environment affect these benefits?

Brown: The key advantages to an ESOP are tax advantages: the tax deferral for a selling shareholder and tax deductions for the employer for contributions to the ESOP to repay ESOP debt. In addition, where an ESOP owns all of the outstanding stock of the employer that has elected to be treated as an S Corporation, neither the ESOP nor the employer pays any federal income taxes. The cash flow enhancements to the employer often mean better loan terms for leveraged ESOPs. Other advantages include the possibility of enhanced employee productivity and the existence of a friendly market for the company owners who seek liquidity, diversification, controlled ownership succession, and so on. With the long-term capital gains rates effectively increased from 15 percent to 23.8 percent, the tax deferral for C Corporation ESOPs has become more attractive.

Burke: An ESOP is a powerful tool for rewarding and incentivising employees while at the same time creating liquidity for business owners. It enables employees to accumulate tax-deferred retirement benefits without requiring any employee contributions – unlike most IRA or 401(k) plans. As the shares in the ESOP appreciate, employees benefit from their contribution to the growth in the value of the company. At the same time, an ESOP creates a market for otherwise illiquid company shares. By using an ESOP, the company can bear the cost of buying out its owners – including through tax-advantaged borrowing – and, if it is a C Corporation, can deduct those costs. No such deduction is available to an S Corporation, but the portion of the corporation's earnings allocable to the ESOP is completely untaxed. Recent increases in US individual income tax rates have made these advantages even more impressive.

Serwinski: ESOPs are used to create liquidity events in part or in full for selling shareholders. They are used in situations where a company wishes to remain independent and allow itself to recapitalise in order to move ownership of shares to the next generation. In some cases, they are also used to create liquidity events for private equity firms where there is a question as to the investment's marketability. In all cases, there are advantages for the company, shareholders and employees that vary based on the company's tax status. In the case of C Corporation taxation, selling shareholders may enjoy a capital gains tax deferral if the ESOP acquired at least 30 percent of the outstanding stock. This deferral requires sellers to move the basis in their company stock to a portfolio of qualified US replacement securities within one year of the sale. The sponsoring company will be able to borrow money and repay the debt associated with ESOP, with pre-tax dollars rather than after-tax dollars as is the case with any other loan. Finally, the advantage to the employee is simple − no money to repay this loan comes from the employees. The company uses future cash flow and profits to repay the loan. The S Corporation shareholder sees some significant differences. There is no tax deferral available to these shareholders and they are taxed at current capital gains tax rates. The company and its employees enjoy the same benefits as the C Corporation but there is one significant advantage. The S Corporation ESOP company is tax exempt for its portion of taxable income. Therefore, a 100 percent S Corporation ESOP pays no taxes on income either at the federal or state level. This provides a distinct economic advantage by retaining all cash flow. In January 2013, tax rates increased related to capital gains with these rates increasing by 5 percent to 20 percent.

Keeling: What factors should companies consider before implementing an ESOP?

Burke: There are many factors to consider before implementing an ESOP, including cash flow – before and after the transaction, management succession, regulatory compliance, effect on existing contracts and loans, and effect on employee morale and corporate culture. For instance, if an ESOP uses leverage to purchase shares, the company should analyse its projected operational results to verify that it will have sufficient cash flow to meet operational needs and fund loan payments. Companies should also consider how an ESOP might change the relationship between the owners and the board of directors, since an ESOP is an owner who must act in a fiduciary capacity on behalf of the employees. Furthermore, the implementation of an ESOP requires compliance with regulatory matters that must be analysed early in the process. Lastly, a company should consider its workforce and determine whether an ESOP will achieve the intended goals of increasing moral and improving productivity.

Serwinski: The most critical consideration in implementing an ESOP is the honest evaluation of the company's operating model. Remember that, first and foremost, the company is going to create significant leverage that is non-productive in nature. The soundness of the operating model, therefore, needs to be in place. A critical portion of the analysis necessary to determine the feasibility of an ESOP is to understand the future working capital and capital expenditure needs over the next several years, and integrate that along with the cash flow demands of the ESOP. Certainly, in the case of the S Corporation, the tax-free status that the company will enjoy is critical in the analysis prepared for shareholders and their lending institutions.

Brown: We strongly recommend that companies have a feasibility study done before implementing an ESOP. Such a study will review historical financial performance and projections, the employee compensation base and financing prospects, the lending base, future repurchase obligations, corporate contingencies – lawsuits, environmental and tax issues – and the projected value of the company's stock. By reviewing all of these issues, the company, its owners, management and board will be in a position to make a reasoned and informed decision.

Keeling: To what extent are you seeing large corporations taking advantage of the ESOP structure of smaller family-owned businesses, as an exit strategy?

Serwinski: Though some larger companies have utilised an ESOP strategy, the bulk of transactions are smaller private companies that have values in the $20m to $100m range. Larger value companies tend to attract strategic purchasers due to a number of reasons including better capitalisation, management depth, diversified product/service offerings and a shareholder base less likely to want its culture and company to survive through the next generation. Recently, there has been an increase in smaller, thinly-traded public companies looking to create an alternative liquidity strategy. This is also true with other regulated businesses such as regional and community banks that have had significant shareholder liquidity issues since the last recession.

Brown: Over the last several years I have seen several large private companies turn to the ESOP structure as an exit strategy for its shareholders. The tax advantages are certainly a factor, but often keeping the company independent with the family name attached is at least as important. These companies are usually well capitalised and liquid, thus financing for the ESOP transaction is relatively easy.

Burke: While ESOPs are more common in smaller businesses, we do see some larger closely held corporations exploring ESOPs. Large corporations can realise significant tax advantages and provide employee incentives by using an ESOP. A selling shareholder of a C Corporation can defer US income taxation on certain sales proceeds, if they are reinvested in securities of US operating companies. A C corporation can also deduct reasonable dividends paid on ESOP-held stock and contributions to the ESOP up to 25 percent of covered payroll. Moreover, a large corporation that is considering growth via acquisition may find that having an ESOP as a shareholder provides it a tax advantage over other non-ESOP owned companies that could be bidding on the same targets, both in pricing for the transaction and its post-closing profitability.

Keeling: Has there been an increase of government enforcement with respect to ESOPs? Which areas and issues are in the spotlight?

Brown: During the last three years we have experienced increased enforcement activities by the US Department of Labor with respect to ESOPs. The key issue is valuation and whether the final projections used in completing the valuations are reasonable.

Burke: Yes, there has been an increase. The DOL has increased the frequency with which it reviews valuations establishing an ESOP's stock purchase price and the ESOP trustee's role in accepting the valuation. We believe this will be a continued focus of the DOL. Additionally, the Internal Revenue Service continues to audit ESOPs and their operations. Its focus is on ensuring that highly compensated employees do not benefit disproportionately from the ESOP. Under Internal Revenue Code Section 409(p), an ESOP established by an S Corporation must provide that no portion of the ESOP's assets can accrue for the benefit of a disqualified person during a non-allocation year. This section prevents excess accumulation of benefits to larger stockholders in an S Corporation that has an ESOP. Violation of Section 409(p) can be catastrophic for a company and its employees.

Serwinski: As ESOPs are qualified retirement plans, their oversight is performed by both the Internal Revenue Service and the US Department of Labor (DOL). Though both groups focus on a variety of issues, it is the DOL that has caused anxiety in their investigations (audits) of ESOP plans and their sponsors. Their focus tends to be on valuations and possible self-dealing at the point of the transaction. Though self-dealing is reprehensible on all levels, valuation issues have been more problematic. Their reviews occur subsequent to the closing of transaction with some occurring years later. Some investigations include companies that did transactions prior to the recession and, subsequently, suffered a drop in share price. These 'stock drop' cases allege that financial advisors to trustees should have known that the recession would adversely affect company performance and, therefore, overvalued the company. Needless to say, crystal balls are not provided to MBAs at graduation − if they were, homes would have been sold and 401ks would have been liquidated prior to the market collapse. It remains to be seen how this will be resolved, but this is a real issue at this time.

Keeling: What are the features of the sale of S and C Corporations to an ESOP?

Burke: The ESOP structure allows a C Corporation to use pre-tax dollars to fund the purchase of shares from selling shareholders. Additionally, a selling C Corporation shareholder can defer US federal income tax on shares sold to the ESOP if the ESOP ends up with at least 30 percent ownership in the company and the selling shareholder buys qualified replacement securities. Multiple selling shareholders can combine their sales in a single transaction to enable the ESOP to meet the 30 percent threshold. Although S Corporation shareholders cannot benefit from this deferred taxation, to the extent an ESOP owns an S Corporation, the Corporation's income will be exempt from US federal income taxes. Thus, both S and C Corporations can utilise ESOP ownership to manage tax liability.

Brown: Where the sale of an S Corporation to an ESOP is involved, we often see a combination of third-party and seller financing, so that the ESOP can achieve 100 percent ownership with the related tax efficiency. If the ESOP owns less than 100 percent, then the company will normally need to make distributions to the non-ESOP shareholders to enable them to make estimated tax payments but must also make distributions to the ESOP because of the one-class of stock requirement for S Corporations. Where C Corporation stock is being sold to an ESOP, normally the initial sale is designed to have the ESOP acquire at least 30 percent of the company's stock to allow the selling shareholders to elect to defer gain on the sale. The ESOP loan amortisation schedule is designed to balance the timing of contributions for tax deductions and to control repurchase liability.

Keeling: What regulatory and legislative developments do you anticipate in 2013?

Serwinski: As part of a comprehensive plan spearheaded by the DOL to tighten regulations on all retirement plans, ESOPs have been targeted in the area of private securities valuation and its impact on the transaction at the point of share purchase. The DOL has proposed regulations that would make financial advisory firms that provide trustees with valuations, fairness and adequate consideration opinions, fiduciaries. This is an aggressive position with no precedent. Trustees of ESOPs are charged with making the investment decision to acquire the shares of stock based on their due diligence, as well as opinions from their legal and financial advisors. The proposed regulations will be resubmitted for comments sometime in early summer 2013. It remains likely that the DOL will continue to seek this fiduciary change, but is unlikely to provide guidance as to how fiduciary responsibility will be split between financial advisor and trustee. It is also anticipated that serious discussions on tax reform will begin this spring. Any time tax reform has occurred in the past, retirement plans come under review and are at risk from changes that can create tax revenue.

Brown: We expect to see the US Department of Labor re-propose a regulation that would make ESOP appraisers, at least in some instances, fiduciaries subject to all of ERISA's fiduciary duty and liability provisions. We have already seen Congress increase the rate for long-term capital gains from 15 percent to 23.8 percent, thereby making tax-deferred sales to ESOPs more attractive.

Burke: The US Department of Labor (DOL) has recently filed several actions alleging failure by ESOP trustees to review valuation reports adequately in connection with sales of stock to ESOPs, allegedly causing the ESOPs to overpay for shares. We anticipate that the DOL will continue to focus its attention in this area. Additionally, the DOL continues its work on proposing regulations expanding the scope of people who qualify as fiduciaries for pension plans. Of particular importance to the ESOP community, the first draft of the proposed regulations included appraisers who provide valuation reports for ESOPs as fiduciaries. Despite determined opposition from the ESOP community and some members of the US Congress, and subsequent withdrawal of the draft proposed regulation, the DOL may still seek to expand the definition of fiduciary to include valuation experts. The issue remains unresolved.

Keeling: How have ESOPs been received in jurisdictions outside of the US? What specific challenges has adoption of ESOPs faced in these regions?

Brown: ESOPs, as conceived in the US, have been viable on a case-by-case basis in the UK and Ireland, but certainly are not universal. Extending a US-based ESOP to employees at foreign subsidiaries and affiliates can be very complicated, involving employer and employee tax issues, employment law, securities law and foreign exchange law issues. More likely to be established are programs such as a UK Share Incentive Plan or a UK Tax Favored Share Option Scheme.

Burke: Although ESOP-like structures are uncommon outside the US, non-US owners of businesses with operations in the US can attain the same benefits from an ESOP as a US business owner would. A non-US person cannot own stock in an S Corporation, but the tax advantages and employee relations benefits of establishing an ESOP for a C Corporation apply regardless of the nationality of the historical owners. Since non-US owners are typically less familiar with the ESOP structure, the challenge for advisors is to explain the benefits of ESOPs and dispel myths. For instance, many owners fear that selling to an ESOP will cause them to lose management control. In fact, historical owners can maintain control after sale to an ESOP by limiting the size of the stake held by the ESOP, using mechanisms like rights-of-first-refusal to repurchase shares, and limiting issues on which employees can vote their shares.

Serwinski: Under US law, employees working outside the country cannot be included in this retirement plan. Since many countries maintain their own pension schemes, US companies have established phantom share plans that mimic their ESOP. The plans, unlike the broad-based ownership plan in the US, can be discriminatory and are taxed at regular income tax rates upon a liquidity event. In the last few years, employee ownership plans have seen higher levels of interest in the UK, Canada and Australia. These plans do not carry the level of tax benefits that are available in the US.

Keeling: Do you except to see an increase in the use of ESOPs over the coming year? What factors might be set to influence this trend?

Burke: The leading edge of the baby boomer generation is transitioning from their working lives to retirement. This generational shift is going to involve a massive transition of wealth, and we expect that ESOPs will be a popular tool for financing the exits of historical owners. ESOPs will be attractive for two reasons. First, in a down market, strategic buyers may be difficult to find. An ESOP can provide an alternative market for the historical owners' shares. To the extent credit is difficult to obtain, shareholder loans can provide internal financing for an ESOP purchase. This is particularly important for many service-oriented businesses that lack hard assets. Second, many business owners value the culture they have created within their companies. The use of an ESOP allows them to transition ownership to people who share their history and values, thereby maintaining the established corporate culture.

Serwinski: The short answer is 'it depends'. History tells us business owner confidence, availability of financing, and successful operating performance will be the measures for continued ESOP implementations. The banks continue to seek loans and have become measurably more aggressive in seeking earning assets. However, the biggest barometer is the unknown of US economic growth. Should a prolonged recession in Europe and Asia continue through the second quarter, private company business owners may take their historical conservative views and hold back from entering into any ownership transition plans. Through the first two months of 2013, however, activity remains strong with the ESOP community believing that the year will mirror 2012, a successful year for new transactions.

Brown: Yes, we definitely expect to see expanded use of ESOPs during 2013. This is because many companies have deferred ownership succession issues over the past five years and now most companies have seen their value restored or increased since the Great Recession, and leveraged funds are available at favourable interest rates and terms. With the increase in long-term capital gains rates, the tax deferrals available on sales of stock to ESOPs have become more attractive.

Originally published in Financier Worldwide TalkingPoint, March 2013

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