Employee Ownership Legal Update [Executive Summary]

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Employee Ownership Legal UpdateExecutive
Summary
18th Annual Ohio Employee Ownership
Conference April 16, 2004, 1030 am to 1200
NoonAkron/Fairlawn Hilton, Akron, Ohio
Presented By

• David R. Johanson
• Johanson Berenson LLP
• 707.226.8997
• drj_at_esop-law.com

Joseph E. Marx The Principal Financial
Group 877.262.4608 marx.joseph_at_principal.com
James G. Steiker SES Advisors 866.316.ESOP(3767)
x22 jim_at_sharedequity.com
Moderator Ed Schmitt, Riesbeck Food Markets, Inc.
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Significant Areas of Attention During Past
Several Years

• S Corporation Anti-Abuse Regulations
• Abusive S Corporation ESOPs
• S Corporation Distributions and IRAs
• Sarbanes Oxley Act of 2002
• The Jobs and Growth Tax Relief Reconciliation Act
  of 2003
• Proposed ADP/ACP Regulations
• Scope of ESOP Fiduciary Duty
• ESOP Loan Refinancing
• Repayment of ESOP Loan
• FASB Statement 150
• Payment of Plan Expenses
• Unanswered Questions

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What We Have Learned

• S Corporation Anti-Abuse Regulations
• Issued on July 21, 2003
• Extraordinarily broad definition of Synthetic
  Equity includes ordinary deferred compensation
• Normal buy-sell arrangements among existing
  shareholders not synthetic equity

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What We Have Learned

• Any right to receive compensation for services
  performed for S corporation (or certain related
  entities) that is deferred beyond 2½ months after
  year in which services are performed is
  considered synthetic equity.
• To determine synthetic equity equivalent of
  non-qualified deferred compensation, temporary
  regulations provide that present value of
  deferred compensation is converted into number of
  shares of stock in corporation based on fair
  market value of S corporation shares on
  determination date, which may be any date during
  plan year. This calculation must be made on
  annual basis.

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What We Have Learned

• By requiring a synthetic equity calculation of
  non-qualified deferred compensation on an annual
  basis, a company could unwittingly run afoul of
  Section 409(p) of IRC in year in which its stock
  price suffers substantial decline in value.
• Non-qualified deferred compensation would equate
  to much larger number of shares that could push
  disqualified persons over the 50 limit.

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What We Have Learned

• Regulations also emphasize that right to acquire
  interests in related entity is deemed to be
  synthetic equity. An entity is considered
  related entity if it is only significant asset
  of S corporation and S corporation is only
  significant holder of stock of related entity.
• Synthetic equity is counted only if it would
  cause individual to be disqualified person, or
  company to have nonallocation year.

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What We Have Learned

• Status of each individual tested without regard
  to other individuals synthetic equity holdings.
• Regulations applicable for plan years ending
  after October 20, 2003.
• Section 409(p) of IRC was grandfathered and is
  not applicable until plan years ending after
  December 31, 2004, for S corporation ESOPs in
  effect prior to March 14, 2001.
• Regulations provide another grandfathering rule
  which provides that if any non-qualified deferred
  compensation is paid out by July 21, 2004, it
  will not be treated as synthetic equity for
  purposes of testing anti-abuse provision.

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What We Have Learned

• Abusive S Corporation ESOPs
• On January 23, 2004, in Revenue Ruling 2004-4,
  U.S. Treasury Department and IRS issued
  comprehensive ruling to shut down certain
  identified abusive transactions involving S
  corporation ESOPs.
• Revenue Ruling 2004-4 also makes these
  transactions listed transactions for
  tax-shelter disclosure purposes.

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What We Have Learned

• Benefit of S Corporation ESOPs cannot accrue
  primarily to shelter deferred executive
  compensation
• IRS views S Corporation ESOPs as potential tax
  shelters that can be easily abused
• Apparently, compliant arrangements at edge of
  line will be attacked
• More than insubstantial benefits must be provided
  to ESOP participants

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What We Have Learned

• S Corporation Distributions and IRAs
• IRS will permit S Corporation stock
  distribution to IRA and immediate sale back to
  company w/o endangering S Corporation Status
• Revenue Procedure 2003-23
• Requirements
• ESOP participant elects to have stock directly
  rolled over to IRA,
• terms of ESOP require S Corporation to
  immediately repurchase stock from IRA,
• S Corporation actually repurchases stock on
  same day as distribution, and
• no income, loss, deduction or credit attributable
  to S corporation stock is attributed to IRA.

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What We Have Learned

• Structuring and Limiting Warrants For Sub Debt in
  an S Corporation
• Lenders that agree to be subordinated to
  companys senior lender usually demand much
  higher interest rate on their loans. In addition,
  to enhance their rate of return on these loans,
  the sub debt lender usually demands an equity
  kicker for the extra risk they take. Often, the
  equity kicker is in form of warrant to buy stock
  for nominal purchase price (0.01).

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What We Have Learned

• Synthetic Equity and S Corporation Single Class
  of Stock
• Use of warrant to enhance rate of return creates
  two planning challenges. First, structure must
  not create second class of stock for S
  corporation purposes. Second, structure must be
  designed to avoid IRC Section 409(p) excise tax.

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What We Have Learned

• Sarbanes Oxley Act
• Corporate Governance for Private Companies
• Public Companies going Private
• Blackout Notice Requirements
• Accelerated SEC Reporting Requirements (Public
  Companies Only)

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What We Have Learned

• The Jobs and Growth Tax Relief Reconciliation Act
  of 2003
• Reduced maximum income tax rate imposed on
  long-term capital gains
• Applies to dividends paid by most domestic and
  foreign corporations
• Exception for dividends described in Section
  404(k) dividends distributed from qualified
  retirement plans (e.g. 401(k) plans, IRAs, etc.)
• These exceptions continue to be taxed at ordinary
  income tax rates
• Generally, applies to taxable years beginning
  after December 31, 2002

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What Have We Learned

• Proposed ADP/ACP Treasury Regulations
• Issued July 17, 2003
• Under present law ESOPs are required to be
  disaggregated
• Proposed regulations eliminate required
  disaggregation for purposes of ADP/ACP testing.
• Disaggregation still applies for other
  nondiscrimination testing
• Effective no sooner than first plan year
  beginning 12 months after publication of final
  regulations

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What We Have Learned

• Scope of ESOP Fiduciary Duty the Case Law
• No general affirmative duty to diversify out of
  company stock
• Unclear whether company officers or board members
  will be considered fiduciaries
• Directed fiduciaries generally exculpated unless
  following instructions violates ERISA
• Empty head and pure heart still not enough

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What We Have Learned

• Focus on process not taken under time or
  third-party pressure
• Evolving law on duty of trustees with inside
  information conflict between ERISA and SEC
• Duty to follow plan terms
• Duty to monitor actions of board of directors
• Fiduciary status of independent appraisers,
  financial advisors directed trustees

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What We Have Learned

• Existing case law generally protective of ESOP
  fiduciaries and directed fiduciaries
• Post-Enron environment seems more hostile cases
  pending may point the way in the future

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What We Have Learned

• ESOP Loan Refinancings
• On September 26, 2002, U.S. Department of Labor
  (the DOL) released its first Field Assistance
  Bulletin (FAB), which addresses refinancing of
  ESOP loans.
• The DOL announced that FABs would be used in
  future to publicize technical guidance that it
  provides to its field enforcement staff.

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What We Have Learned

• In FAB 2002-1 (the FAB), the DOL addressed
  obligations of plan fiduciary under Sections
  404(a) and 408(b)(3) of Employee Retirement
  Income Security Act of 1974, as amended
  (ERISA), when considering refinancing of an
  ESOPs existing securities acquisition loan.
• DOL focuses on ensuring that ESOP loan
  refinancings benefit plan participants.

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What We Have Learned

• Loan extensions that delay stock allocations
  while good under traditional finance theory
  (longer loans are better for borrower) viewed as
  bad for ESOP participants because they reduce
  company contributions
• Consider whether company has contribution
  obligation

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What We Have Learned

• The FAB identifies various inducements commonly
  offered in ESOP loan refinancings
• (1) event protection which means that shares
  of company stock that are held in the ESOP loan
  suspense account longer than they would have
  under terms of original loan may not be sold and
  proceeds used to repay outstanding portion of
  ESOP refinanced loan if ESOP is terminated

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What We Have Learned

• (2) additional diversification rights to ESOP
  participants
• (3) increased employer contribution to either
  ESOP or another employer plan or
• (4) payment of dividend make-whole to
  compensate ESOPs participants and beneficiaries
  for dividends to repay ESOP loan after original
  maturity date of loan.

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What We Have Learned

• Repayment of ESOP Loan With Proceeds of Sale of
  Company Stock
• Typically company stock purchased with exempt
  loan serves as collateral
• Even if unallocated company stock is not
  collateral, the courts view is that can still
  repay ESOP loan with proceeds of sale of company
  stock that was purchased

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What We Have Learned

• FASB 150
• On May 15, 2003, the Financial Accounting and
  Standards Board (FASB) issued Statement No. 150
• Recently promulgated rules that thought might
  apply to ESOP puts
• Liability vs. Equity
• Generally does not apply to ESOP stock
• Future rules may change this result

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What We Have Learned

• Payment of Plan Expenses
• Field Assistance Bulletin 2003-3
• IRS Revenue Ruling 2004-10
• Proper Reasonable Expense
• What does the Plan Document SPD say?
• Individual vs. General Plan Expenses
• Significant Detriment

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Some Things We Would Like to Know

• Scope of Prohibited Transaction Analysis when
  ESOP Acts as Shareholder
• EGTRRA Determination Letter Applications
• Effect of Cash Build-up on ESOP Status

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Some Things We Would Like to Know

• Boundaries on ESOP Loan Terms and Effect on
  Distributions
• Diversification Time Frames and Compliance with
  Statutory Requirements
• Segregation of Terminated Participant Accounts
• Rebalancing of Participant Accounts