Steven M' Burke

1
Employee StockOwnership Plans and
TrustsBenefits for Closely Held Businessesand
Business Owners

• Presented By
• Steven M. Burke
• McLane, Graf, Raulerson Middleton, Professional
  Association

2
TAX AND LEGAL ISSUES

• Legal Definitions of an ESOP (Plan and Trust)
• ESOP is a qualified retirement plan which is
  designed to invest primarily in the employers
  securities
• ESOP may also borrow money and enter into other
  transactions
• Specific provisions ERISA and the Code create
  very distinct tax incentives for employers to
  adopt ESOPs

3
TAX AND LEGAL ISSUES

• ESOP is basically a Stock Bonus Plan which is a
  qualified retirement plan under Section 401(a) of
  the Code
• A Stock Bonus Plan is similar to a Profit Sharing
  Plan except that the benefits in a Stock Bonus
  Plan are distributable in employer stock

4
TAX AND LEGAL ISSUES

• the investments of a Stock Bonus Plan are usually
  made primarily in employer securities
• a Stock Bonus Plan is exempt from any "fair
  return" requirement with respect to investment
  employer stock
• benefits from a Stock Bonus Plan must be
  distributable in stock of the employer

5
TAX AND LEGAL ISSUES

• General Requirements of ESOPs
• IRC Section 401(a) Requirements
• An ESOP generally must meet all of the qualified
  plan requirements under Section 401(a) of the
  Code
• Designed to Invest in Employer Securities
• While there is no specific definition for "design
  to invest primarily in employer's securities," it
  is generally believed that an ESOP must permit
  the plan trustees to invest or hold the major
  portion of the plan's assets into the employer's
  securities

6
TAX AND LEGAL ISSUES

• Voting Rights
• participant has the right to direct the vote of
  employer's stock allocated to his or her account
  in the plan
• then the ESOP must permit each participant to
  direct the voting of the securities of the
  employer allocated to his or her account
• then the ESOP must permit each participant to
  direct the voting of the securities of the
  employer allocated to his or her account

7
TAX AND LEGAL ISSUES

• If the ESOP does not have registration-type class
  of securities, the only voting rights required to
  be given to participants is that the participants
  must be allowed to direct the vote of stock
  allocated to the account with respect to any
  corporate matter involving the voting of shares
  for or against corporate mergers, consolidations,
  sale of all or substantially all the
  corporation's assets, recapitalization,
  reclassifications, liquidations, dissolutions, or
  such similar transactions

8
TAX AND LEGAL ISSUES

• Whether or not stock has been allocated to a
  participant's account, not whether the
  participant is vested in their account, that
  determines whether and the extent to which a
  participant may vote employer stock

9
TAX AND LEGAL ISSUES

• PUT Option
• A participant must be given the right to receive
  a distribution from the plan in the form of
  Employer's securities
• Unless employer stock is traded on an established
  securities market, the participants must be given
  the right to require the employer to repurchase
  the shares at fair market value
• It is important to note that the ESOP itself is
  not required to purchase the shares

10
TAX AND LEGAL ISSUES

• Right of First Refusal
• An employer adopting an ESOP which holds
  non-publicly traded stock, may provide that the
  employer has a right of first refusal on stock
  held by the ESOP or distributed from the ESOP to
  participants
• The selling price and other terms under a right
  of first refusal must not be less favorable to
  the seller than fair market value of the stock or
  purchase price and other terms offered by a buyer
  making a good faith offer

11
TAX AND LEGAL ISSUES

• Distribution Requirements
• An ESOP must contain provisions that allow
  distributions to a participant of the vested
  interest in their account to begin not later than
  one year after the end of the plan year during
  which the participant terminates employment
  because of retirement on or after the plan's
  normal retirement age, disability or death

12
TAX AND LEGAL ISSUES

• Further, if a participant is terminated (either
  voluntarily or involuntarily) distributions must
  be made not later than one year after the end of
  the fifth plan year following the plan year
  during which the termination occurs
• If a participant's account balance exceeds
  500,000.00 discretions may be over a longer
  period

13
TAX AND LEGAL ISSUES

• The distribution requirements discussed above do
  not apply to a participant's account balance
  which consist of employer's securities acquired
  with the proceeds from an ESOP securities
  acquisition loan until the end of the plan year
  in which the entire loan is repaid

14
TAX AND LEGAL ISSUES

• A closely held company which has adopted an ESOP
  must consider the liquidity requirements that
  these provisions will impose on the employer at
  the time a participant either retires or
  terminates employment with an account in the ESOP
  with a significant amount of employer's
  securities. The employer must plan carefully at
  the time the ESOP is established

15
TAX AND LEGAL ISSUES

• employer establish some type of sinking fund or
  designated account to meet these repurchase
  requirements

16
TAX AND LEGAL ISSUES

• Independent Appraiser
• An ESOP that holds employer's securities which
  are not readily tradeable on a securities market
  must have all valuations of those securities made
  by an independent appraiser
• the independent appraiser should be a person who
  does not perform any other services for a party
  whose interest may be adverse to the ESOP and who
  would be impartial

17
TAX AND LEGAL ISSUES

• the value assigned to employer stock contributed
  to the ESOP is critical
• If the ESOP trustees cause the plan to purchase
  stock at a price greater than it's true value,
  the purchase will be a violation of the trustee's
  fiduciary duty, possibly rendering the trustees
  personally liable to participants for the amount
  of the overpayment

18
TAX AND LEGAL ISSUES

• Diversification
• Qualified employees must be allowed to have a
  portion of their account invested in assets other
  than employer's securities
• "Qualified employees" are those employees who are
  at least 55 years of age and who have at least 10
  years of participation in the plan

19
TAX AND LEGAL ISSUES

• ESOPs must permit qualified participants to
  diversify their investment of at least 25 of
  their ESOP account during the six year period
  commencing with or after the plan year in which
  the participant reaches age 55 (or if later, the
  plan year in which the participant completes ten
  years of participation)

20
TAX AND LEGAL ISSUES

• Requirements that Plan be Designated as an ESOP
• The ESOP plan document must specifically provide
  that a plan is an ESOP.
• The plan document must also provide that
  participants have certain protections with
  respect to assets acquired with the proceeds of
  an exempt loan.
• No security acquired with the proceeds of an
  exempt loan may be subject to a put, call or
  other option while held by the plan.

21
TAX AND LEGAL ISSUES

• An exception to this rule is for the put options
  that ESOPs must grant to participants and for the
  right of first refusal that an ESOP may grant in
  favor of the employer or the ESOP

22
TAX AND LEGAL ISSUES

• Loan Requirements
• The prohibited transaction provisions of the Code
  generally prohibit any qualified retirement plan
  from receiving a loan from a disqualified person
  or from receiving a loan which is guaranteed by a
  disqualified person
• An exception to this rule is granted for
  leveraged ESOPs

23
TAX AND LEGAL ISSUES

• In order to qualify for this exemption
• The loan proceeds must be used within a
  reasonable time after their receipt to acquire
  qualified employer securities or to repay the
  loan of a prior exempt loan
• The loan must be without recourse against the
  ESOP, except to the extent of employer securities
  acquired with loan proceeds
• The loan must be a term loan, not a demand loan
• The loan's terms must be at least as favorable to
  the ESOP as the terms of a comparable loan
  resulting from arms-length negotiations between
  independent parties and it must bear a reasonable
  rate of interest

24
TAX AND LEGAL ISSUES

• Tax Benefits Accrue to
• An employer that establishes an ESOP
• Participants of an ESOP
• Shareholders selling stock to an ESOP

25
TAX AND LEGAL ISSUES

• The benefits include
• Deductibility (in effect) of principal and
  interest payments on ESOP loans
• The deferred recognition of gain on the sale of a
  closely held company to an ESOP
• The deductibility of certain dividends on stock
  held by an ESOP

26
TAX AND LEGAL ISSUES

• Leveraged ESOP Buy outs
• There may be a limited market for stock in a
  closely held corporation
• A leveraged ESOP essentially is a special type of
  ESOP that finances the acquisition of the
  employer stock with borrowed money

27
TAX AND LEGAL ISSUES

• A successful ESOP buy out provides at least the
  following benefits
• It permits the transfer of the shareholders
  ownership interest without recognition of taxable
  income
•  Provides employees with both retirement benefits
  and added incentive in holding an ownership
  interest of business

28
TAX AND LEGAL ISSUES

• A leveraged ESOP buy out generally includes the
  following steps
• The employer establishes an ESOP
• The majority shareholder enters into an agreement
  with ESOP to sell its shares to the ESOP at an
  agreed upon price
• The ESOP borrows money from a financial
  institution
• The leveraged ESOP uses the loan proceeds to pay
  the selling shareholder for the shares it has
  purchased

29
TAX AND LEGAL ISSUES

• Over time, the employer makes contributions
  and/or dividend payments to the leveraged ESOP in
  the amount needed to repay principal and interest
  in the loan. The employer receives, in effect, a
  deduction of principal and interest on the loan
  since the contribution to the ESOP is deductible
• The shares purchased by the ESOP are held in a
  "suspense account" and allocated to participant
  accounts in the plan as the loan is repaid by the
  ESOP
• To be eligible for benefits plan must meet
  Section 401 requirements

30
TAX AND LEGAL ISSUES

• Deduction of Employer Contributions
• Limited imposed by Section 404 of the Code
• Apply to contributions made to an ESOP
• ESOP, and may deduct up to 15 of the
  compensation of all participants for that plan
  year (25 for plan years beginning after
  12/31/01)
• In addition, employer contributions to an ESOP
  that are used to repay interest on a loan used by
  the ESOP to acquire employer securities are fully
  deductible and employer contributions used to
  repay the loan are deductible up to 25 of total
  compensation

31
TAX AND LEGAL ISSUES

• Deduction of Employer Dividend Payments
• Corporations are generally not permitted to
  deduct dividends to shareholders
• Dividends paid on shares held by an ESOP
• Used to repay the loan incurred to purchase
  employer securities
• Allocation of Contributions
• The plan document must provide a definite formula
  for allocation of employer contributions and
  forfeitures

32
TAX AND LEGAL ISSUES

• May not discriminate in favor of highly
  compensated employees

33
TAX AND LEGAL ISSUES

• Tax Deferred Rollover Treatment
• A shareholder realizes gain from the sale of
  stock to an ESOP may elect to defer recognition
  of the gain if the requirements set forth below
  are satisfied
• Stockholder sells qualified securities to an
  ESOP
• Makes the appropriate election
• Gain is generally not recognized if the following
  conditions are met

34
TAX AND LEGAL ISSUES

• The ESOP must own at least 30 of either (a) each
  class of outstanding stock or (b) the total value
  of all the corporation's outstanding stock
• The sale must otherwise qualify for long term
  capital gain treatment
• The shareholder held the securities for at least
  three years prior to the sales of the ESOP
• Within the 15-month period beginning three months
  before the sale date, the seller purchases
  "qualified replacement property" and files a
  certain written statement with the IRS

35
TAX AND LEGAL ISSUES

• Making the Election
• A  1042 to election is made by a shareholder on
  a timely filed return (including extensions)
  filed for the year of sale
• The taxpayer must also file a written statement
  in which the employer whose employees are covered
  by the ESOP consents to the application of
    4978 and 4979A

36
TAX AND LEGAL ISSUES

• A notarized statement of purchase must be timely
  filed by a taxpayer when a qualified replacement
  property is acquired
• 30 Ownership
• The 30 threshold (discussed above) may be met by
  several shareholders as a part of a single
  transaction under a prearranged agreement among
  the shareholders

37
TAX AND LEGAL ISSUES

• Gain and Holding
• Section 1042(a) provides that any long term
  capital gain realized in a sale of stock to ESOP
  is recognized only to the extent that the
  proceeds exceed the cost of the qualified
  securities purchased with the proceeds of the
  sale
• If more than one item of replacement property is
  acquired, basis is allocated among the items
  purchased

38
TAX AND LEGAL ISSUES

• The holding period of the employer securities
  sold to the ESOP will be tacked to the holding
  period of the replacement property
• Statute of Limitations
• A special 3-year statute of limitations applies
  if tax free roll over treatment under  1042 is
  elected

39
TAX AND LEGAL ISSUES

• Qualified Securities
• Section 1042 requires that the stock to the ESOP
  the "qualified securities.
• "qualified securities" the stock must meet the
  following important criteria
• It must be common stock with voting and dividend
  rights at least equal to the classes of common
  stock having the greatest dividend and voting
  rights of the employer
• to the stock must be issued by domestic
  corporation with no stock which is readily
  tradeable on an established securities market

40
TAX AND LEGAL ISSUES

• Qualified Replacement Property
• Generally is any security issued by certain
  domestic operating corporations
• "Security" includes corporate stock, rights to
  subscribe to stock or bonds, debentures, notes,
  certificates or other evidence of indebtedness
  issued by a corporation
• Qualified replacement property may be comprised
  of more than one piece of property

41
TAX AND LEGAL ISSUES

• The Code provides that the corporation issuing
  the qualified replacement securities must not
  have had passive investment income exceeding 25
  of its gross receipts in the tax year preceding
  the year of the replacement property was
  purchased
• Additionally, more than 50 of the corporation's
  assets must be used in the active conduct of a
  trade or business

42
TAX AND LEGAL ISSUES

• Premature Disposition of Securities
• If within 3 years after acquiring a qualified
  security under  1042 transaction, the ESOP
  disposes of them, the employer is liable for a
  10 excise tax on the amount realized if either
  of the following occur
• The total number of shares held by the ESOP after
  the disposition is less than before the
  disposition
• If the value of the employers securities held by
  the ESOP falls below 30 of the value of all
  employers securities as of the date of
  disposition

43
TAX AND LEGAL ISSUES

• Prohibited Allocation Rule
• An ESOP acquiring securities in a  1042
  transaction is prohibited from allocating plan
  assets attributable to the securities to
• An electing seller
• The electing seller's family
• Any more than 25 shareholder

44
TAX AND LEGAL ISSUES

• Lineal decedents of the seller may be eligible
  for such allocations, provided the total amount
  allocated to all such lineal decedents of all
  sellers is no more than 5 of the  1042
  securities attribution to such sellers

45
S CORPORATIONS AND ESOPS

• Subchapter S Corporations and ESOPs
• Prior to 1997, ESOPs could not hold stock in
  Subchapter S corporations
• Small Business Job Protection Act of 1996 amended
  the Code to allow qualified retirement plans,
  including ESOPs, to hold stock in Subchapter S
  corporations

46
S CORPORATIONS AND ESOPS

• However, not all tax benefits available to ESOPs
  holding stock in Subchapter C corporations are
  available to ESOPs holding Subchapter S
  corporation stock

47
S CORPORATIONS AND ESOPS

• Benefits of S Corporation ESOPs
• Subchapter S status allows a corporation to avoid
  paying federal income tax at the corporate level
• All earnings of the company allocated to
  Subchapter S corporation shares held by an ESOP
  would go untaxed since the ESOP is a tax-exempt
  entity
• Elimination of the federal tax liability clearly
  enhances the cash flow of an S corporation owned
  by an ESOP

48
S CORPORATIONS AND ESOPS

• Note of caution
• In 2001, the Code was amended to provide that for
  plan years beginning after December 31, 2004, an
  ESOP established by an S corporation must provide
  that no portion of the ESOPs assets attributable
  to employer securities can accrue for the benefit
  of a "disqualified person."
• In the case of an ESOP established after March
  14, 2001, or an ESOP established on or before
  that date that was not an S corporation on the
  date, the effective date of the Act with respect
  to plan years ending after March 14, 2001.
• Congress intended these rules to limit the
  establishment of ESOPs by S corporations to those
  that provided broad-based employee coverage and
  benefits rank and file employee.

49
S CORPORATIONS AND ESOPS

• C Corp ESOPs Still May Be the Way to Go
• Benefits of C Corporation ESOPs include
• Sellers of employer's securities continue to
  qualify for Section 1042 rollover
• C Corporations are allowed to deduct dividends
  paid on ESOP shares
• The company may convert from Subchapter C
  corporation to Subchapter S corporation
  election must be made within two and one-half
  months of the end of the corporation's fiscal
  year to be effective as of the first day of the
  plan fiscal year

50
S CORPORATIONS AND ESOPS

• The company may change from an S corporation to
  an ESOP to allow for Section 1042 rollover
  eligibility
• Shareholders of Subchapter S corporation cannot
  utilize the Section 1042 provisions
• Sellers of shares to ESOP must determine whether
  to convert to S corporation or C corporation
  prior to the transaction tax implications to
  sellers, remaining owners, corporations and
  participants must all be considered

51
ERISA

• Fiduciary Rules
• Exclusive Purpose and Prudence
• Plan fiduciaries discharge their duties with
  respect to the plan

52
ERISA

• Solely in the interest of the participants and
  beneficiaries
• For the exclusive purpose of providing benefits
  to participants and beneficiaries of the ESOP and
  defining reasonable expenses of administering the
  plan
• The care, skill, prudence and diligence under the
  circumstances then prevailing that a prudent
  person acting in a like capacity and familiar
  with such matters would use in the conduct of an
  enterprise of like character and with like aim

53
ERISA

• Fiduciaries with respect to an ESOP are generally
  those individuals that exercise any discretionary
  authority or control with respect to the
  management of the ESOP or the disposition of
  assets
• A fiduciary may be personally liable and removed
  as a fiduciary for breaches of the
  responsibilities and obligations imposed under
  ERISA

54
ERISA

• A co-fiduciary may be held liable for the breach
  of another fiduciary if he or she knowingly
  participates or conceals a breach by the
  co-fiduciary, and does not make reasonable
  efforts to remedy the breach
• Therefore a co-fiduciary must take reasonable
  steps to remedy a breach by a fiduciary

55
ERISA

• Fiduciaries may not be able to resign to avoid
  co-fiduciary liability because such resignation
  could itself be a fiduciary breach
• A fiduciary may not be relieved of their
  fiduciary obligations under ERISA by the terms of
  an agreement

56
ERISA

• Prohibited Transaction Rules
• ESOPs are prohibited from entering into
  transactions with parties in interest with
  respect to the plan under ERISA
• These transactions include the sale of property
  and the lending of money or other extension of
  credit between the ESOP and a party in interest

57
ERISA

• Generally prohibit an ESOP from purchasing
  employer securities from the employer
  corporation, or an employee, officer or director
  or 10 stockholder of the corporation or
  obtaining a loan from, or guaranteed by, such
  parties in interest

58
ERISA

• Major exemptions from these rules
• First exception - the acquisition or sale of
  employer securities by a leveraged ESOP is exempt
  from the prohibited transaction rules if the
  acquisition or sale is for adequate consideration
  and no commission is charged
• In the case of a security that's not freely
  tradeable on an established market, fair market
  value is determined in good faith by the trustee
  of the ESOP or the named fiduciary

59
ERISA

• Fair market value
• The price of a willing buyer and willing seller
  in an arms length transaction
• Determine as of the applicable date of the sale
• Reflected in a written document meeting
  Department of Labor regulations.
• The second exemption relates to an ESOP exempt
  loan
• An exempt loan must be made without recourse
  against the ESOP and the collateral for the loan
  must consist only of employer securities acquired
  with the proceeds of the loan or that or used as
  collateral on a prior exempt loan

60
ERISA

• Independent Counsel and Advisors
• ERISA requires that plan fiduciaries discharge
  their duties with respect to the plan solely in
  the interest of participants and beneficiaries of
  the ESOP and for the exclusive purpose of
  providing benefits to the participants and
  beneficiaries of the ESOP
• Interests may conflict with those interests of
  the participants
• This issue is readily apparent where an ESOP is
  deciding whether to sell employer securities

61
ERISA

• There are no specific statutory requirements
  under the ERISA fiduciary rules that there be
  independent trustees or investment advisors for
  the ESOP
• Courts have held that where the interests of
  fiduciaries irreconcilably conflict with the
  interests of plan participants and beneficiaries,
  the fiduciaries should obtain the benefit of
  independent, legal, financial and investment
  counsel
• Other courts have suggested that it may be
  desirable for the fiduciaries with conflicts to
  resign and be replaced by independent fiduciaries