Strategy in a Down Market Evaluating Advantages and Risks, Best - - PowerPoint PPT Presentation

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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

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUESDAY, NOVEMBER 1, 2016

Anthony J. Jacob, Partner, Hinshaw & Culbertson, Chicago David R. Johanson, Partner, Hawkins Parnell Thackston & Young, Napa, Calif.

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Strafford Live Webinar | November 1, 2016 | 1:00 p.m. – 2:30 p.m. EDT

Structuring M&A and Private Equity Sales Involving ESOPs: Alternative Strategy in a Down Market

David R. Johanson

Senior Partner | HAWKINS PARNELL THACKSTON & YOUNG LLP Email: djohanson@hptylaw.com Direct: 707.299.2470 Cell: 707.225.2986

Anthony J. Jacob

Partner | HINSHAW & CULBERTSON LLP Email: ajacob@hinshawlaw.com Direct: 312-704-3105

6

• Alternative Exit Strategies
• Criteria for Evaluating Alternatives
• Introduction to ESOPs
• Profile of an Ideal ESOP Candidate
• ESOP Corporate Governance
• How Does an ESOP Work?
• Plan Design Considerations
• What is a “Repurchase Obligation”?
• Corporate v. ERISA Fiduciary Standards
• General Regulatory Framework
• ESOPs and Other Retirement Plans
• Summary of Pros and Cons of an ESOP

Presentation Overview

7

Sell to a Strategic Buyer Sell to a Financial Buyer Sell to an ESOP

Alternative Exit Strategies

8

Alternative Exit Strategies

Purchase Price Form of Consideration Diversification and Liquidity Concerns Tax Considerations Alignment of Initiatives Time to Close Legacy

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

• nly):
• 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

• 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

Introduction to ESOPs

BENEFITS TO PARTICIPATING EMPLOYEES

15

• Participating Employees only have a “beneficial ownership” interest in shares
• f 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).

BENEFITS TO PARTICIPATING EMPLOYEES

Introduction to ESOPs

16

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

Advantages of Selling to an ESOP

17

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

Advantages of Selling to an ESOP

18

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.

Advantages of Selling to an ESOP

19

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.

Advantages of Selling to an ESOP

20

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 interest-

powerful tool for recruitment and retention

Advantages of Selling to an ESOP

21

• 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

SELLING SHAREHOLDER CHARACTERISTICS

Profile of an Ideal ESOP Candidate

22

• Sufficient balance sheet strength to absorb ESOP acquisition debt (if any

anticipated)

• Sufficient cash flow from operations to cover all ESOP acquisition debt and
• ther long-term debt service requirements
• Historical and projected profitable operating performance (i.e., revenue

generation and profit margins)

SPONSORING CORPORATION AND EMPLOYEE CHARACTERISTICS

Profile of an Ideal ESOP Candidate

23

• 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

SPONSORING CORPORATION AND EMPLOYEE CHARACTERISTICS

Profile of an Ideal ESOP Candidate

24

BOARD OF DIRECTORS BOARD OF TRUSTEES

• Shareholders elect Board of Directors
• Board of Directors appoints officers and appoints ESOP Board of Trustees

ESOP TRUSTEE ESOP TRUST OFFICERS NON-ESOP SHAREHOLDERS ESOP ADVISORY COMMITTEE

Corporate Governance in an ESOP Corporation

25

• Elects Board of Directors
• Responsible for ESOP Administration
• Establishes Fair Market Value for Company Stock

ESOP TRUSTEE

Description of Respective Roles

26

• Responsible for Major Corporate Actions
• Strategic Planning
• Appoints Officers and Board of Trustees

BOARD OF DIRECTORS

Description of Respective Roles

27

• Responsible for Day-to-Day Management of the Corporation

CORPORATE OFFICERS

Description of Respective Roles

28

• Responsible for learning how ESOP functions and communicating that to

Corporation Employees

ESOP ADVISORY COMMITTEE (OPTIONAL)

Description of Respective Roles

29

• 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)

OTHER RECOMMENDED COMMITTEES OF THE BOARD OF DIRECTORS (OPTIONAL)

Description of Respective Roles

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)

1 2 2 3 4

1. Corporation makes annual tax deductible cash and/or stock contributions to ESOP Trust; and/or 2. ESOP Trust uses cash contributions to acquire stock from existing shareholders or the Corporation. 3. 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. 4. Employees receive stock or cash when they leave Corporation and must sell stock back to Corporation, which must purchase such stock.

Other Shareholders ESOP Trust ESOP Accounts Terminated Employee- Participants Save: IRA Spend Corporation 34

How Does an ESOP Work? (Leveraged)

1 2 2 4

1. Bank loans funds to the Corporation, which loans funds to the ESOP Trust. 2. ESOP Trust uses loan proceeds to acquire stock from existing shareholders or the Corporation. 3. 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. 4. 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. 5. Employees receive stock or cash when they leave Corporation and must sell stock back to Corporation, which must purchase such stock.

1 3 3

Corporation Bank ESOP Trust Other Shareholders Terminated Employee- Participants ESOP Accounts Save: IRA Spend 35

▪ 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.

Code Section 1042 Tax-Deferred Transaction

36

▪ Generally, “qualified replacement securities” must be securities of U.S.

• perating companies whose passive investment income does not exceed 25%
• f 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.

Qualified Replacement Property

37

▪ 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

Qualified Replacement Property

38

Section 1042 Tax-Deferred Transaction

TRANSACTIONS MUST HAVE 5 CHARACTERISTICS

It must be one that would otherwise result in long-term capital gain (LTCG) to the shareholder

1

39

Section 1042 Tax-Deferred Transaction

TRANSACTIONS MUST HAVE 5 CHARACTERISTICS

The shareholder’s holding period for the stock must be at least 3 years

2

40

Section 1042 Tax-Deferred Transaction

TRANSACTIONS MUST HAVE 5 CHARACTERISTICS

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

3

41

Section 1042 Tax-Deferred Transaction

TRANSACTIONS MUST HAVE 5 CHARACTERISTICS

The qualified replacement securities must be purchased within the 15- month period that begins 3 months before and ends 12 months after the sale of the company stock to the ESOP

4

42

Section 1042 Tax-Deferred Transaction

TRANSACTIONS MUST HAVE 5 CHARACTERISTICS

After the sale, the ESOP must own (in a fully diluted basis) at least 30%

• f the common equity of the

employer that sponsors the ESOP

5

43

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

* * Not

• te:

: Children/Grandchildren of the selling shareholder may receive 5% in the aggregate under certain conditions.

Prohibited Allocations if Capital Gains Deferred Under Section 1042

44

Tax-Deferred Reinvestment under Section 1042 of the IRC C Corporations Only

QRP: Debt or Equity in a Domestic Operating Corporation (Stepped-up basis upon death). QRP Excludes:

• REITs
• Mutual Funds
• Passive Investment Companies
• Municipal Bonds

Qualifying Employer Securities Cash / Note

Selling Shareholder Qualified Replacement Property (“QRP”) ESOP Trust

45

Corporate Redemption or Sale to Third-Party/S Corporation Sale to ESOP with Tax- Deferral

Long-Term Capital Gains Tax Federal: 15% or 20%, depending on the selling shareholder’s tax bracket. 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 invested

Comparison of Stock Sale Structures

46

Comparison of Stock Sale Structures

Sale for $1,000,000 in cash payment :

EXAMPLE

Federal LTCG (20%) $1,000,000 x 0.20 = $200,000 New York (8.82%) $1,000,000 x 0.0882 = $88,200 Medicare surtax (3.8%) $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.

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

EXAMPLE WITHOUT LEVERAGE

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

▪ 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

• n the entire purchase price in the year of the sale at the then current rates.

▪ $5M caveat

Installment Sales

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.

$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)

EXAMPLE WITHOUT LEVERAGE

51

▪ 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

Qualifying Employer Securities

52

• Assuming the conditions of Section 1042 of the Code are satisfied, and the

purchase price listed below:

To the Company or Third Party To the ESOP with 1042 Election Purchase Price $1,000,000 $1,000,000 Combined Federal and State Long-Term Capital Gains Taxes (assumed blended rate of 37%) ($370,000) 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

Illustration of Potential Tax Savings

53

Promissory Note ($1.0M)

Corporation ESOT Corporation

20% Warrant as Consideration for Seller Financing

Selling Shareholder Net of $1.0M less $326,200 of Taxes

100% Equity in Company

Seller Financed Transaction

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

▪ 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 post- transaction 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

ESOT Stock Acquisition Warrant

56

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.

Post-Closing

57

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

Potential Tax Liability

58

▪ 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

• f $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.

Assumptions and Disclaimers

59

Plan Design Considerations

Eligibility to participate (broad base or narrowly tailored?) Service requirement cannot exceed 1 year (with 1,000 hours of service) Gradual, immediate, or cliff vesting? Minimum age cannot be set above 21 Leveraged or non-leveraged? Independent fiduciary? What will the repurchase

• bligation be under the

different variables? Internal board of trustees

• r institutional /

independent trustee?

Feasibility study recommended to evaluate:

60

Obligation of a corporation to provide a market for employer securities that are allocated under and distributed or distributable from the ESOP.

Repurchase Obligation

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

▪ 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

Fiduciary Standards: Corporate v. ERISA

64

▪ 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

ERISA Fiduciaries

65

▪ 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

ERISA Fiduciaries

ERISA FIDUCIARY DUTIES

66

▪ 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

ERISA Fiduciaries

ERISA FIDUCIARY DUTIES (CONT.)

67

Conflicts of interest may arise between:

Conflicts of Interest

Corporation and the ESOP Managers and the ESOP Board of Directors’ members and the ESOP Other Shareholders and the ESOP

68

When and how does it arise? Why do people overlook it? Ways to address it include:

Conflicts of Interest

Resignation of conflicted individuals Abstention from action Appointment of independent advisors,

• utsiders, or committees

69

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)

General Regulatory Framework

70

▪ 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.

CONFIRMATION OF TAX QUALIFICATIONS OF ESOP

General Regulatory Framework

71

▪ 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)

CONFIRMATION OF TAX QUALIFICATIONS OF ESOP

General Regulatory Framework

72

▪ 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

ANNUAL RETURN (FORM 5500 SERIES)

General Regulatory Framework

73

▪ 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

OTHER REQUIRED DISCLOSURES

General Regulatory Framework

74

▪ 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.

PROHIBITED TRANSACTIONS

General Regulatory Framework

75

▪ 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

EXEMPTIONS

General Regulatory Framework

76

▪ 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 CORRECTIONS PROGRAMS AVAILABLE

General Regulatory Framework

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)

• Viable Exit Strategy
• Permits Gradual Transfer of

Management Responsibilities

• Dilution to shareholders (if less

than 100% is sold to the ESOP)

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Pros Cons

• Tax Deductions
• Employer Contributions
• Certain Dividends (C

corporations only)

• A good to exceptional tool for:
• Cash Flow Management
• Recruitment and Retention
• f Employees
• Business Succession

Planning

• Mergers & Acquisitions
• 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

• Balance Sheet Impact
• Contra equity account

(leveraged ESOPs only)

Summary of ESOP Pros and Cons Corporation’s Perspective

80

Pros Cons

• 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

• ther eligible retirement plan)
• Value of benefits subject to

fluctuations of the Fair Market Value of Company Stock

Summary of ESOP Pros and Cons Participating Employee’s Perspective

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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

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Dav avid id R. Johans Johanson

• n, 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.

David R. Johanson Brief Bio

hptylaw.com

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Contact Information

David R. Johanson

Partner-in-Charge, Napa Office Hawkins Parnell Thackston & Young LLP

Cell: 707.225.2986 Email: djohanson@hptylaw.com

New York

600 Lexington Avenue 8th Floor New York, NY 10022 (212) 897-9655

Napa

1776 Second Street Napa, CA 94559 (707) 226-8997

Los Angeles

445 S. Figueroa Street Suite 3200 Los Angeles, CA 90071 (213) 486-8010

San Francisco

345 California Street Suite 2850 San Francisco, CA 94104 (415) 766-3238 hptylaw.com

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Ant Anthony Ja Jacob cob 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.

Anthony J. Jacob Brief Bio

hinshawlaw.com

85

Contact Information

Anthony J. Jacob

Partner Hinshaw & Culbertson LLP

Direct: 312-704-3105 Email: tjacob@hinshawlaw.com

Chicago

222 North LaSalle Street Suite 300 Chicago, IL 60601

New York

800 Third Avenue, 13th Floor New York, NY10022 hinshawlaw.com

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