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Legal, Valuation & Planning Considerations for S Corporation ESOPs

Presented by:

Mark R. Kossow, Schatz Brown Glassman

Kossow, LLP

Peter Aliferis, Pendo Advisors, LLC

Richard A. Heeter, Capital Trustees, LLC

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Introduction

S Corporations are a very common type of entity for closely-held businesses

Many business owners have utilized or are considering using an employee stock ownership plan (ESOP) as an exit/transition strategy

The combination of an S Corporation and ESOP can provide tremendous benefits

Flexible transaction structure and financing Tax benefits to company and selling

shareholders Employee retirement benefits

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Introduction

Important to understand S Corporation requirements Considerations for switching to S Corporation

status ESOP rules and benefits

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Overview of Topics to be Covered S qualification, election and other

issues Planning for stock sales to ESOPs S Corporations partially owned by

ESOPs (partial-ESOP S corporations)

Valuation consideration Miscellaneous

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S Qualification, Election and Other Issues Limitations on eligible shareholders and

100 shareholder limit Ineligible shareholders: IRAs, nonresident

aliens, corporations, LLCs, partnerships, and many trusts may not own shares

ESOP trust only counts as one shareholder ISSUE: Partial-ESOP S corporations need

to protect S corporation status through shareholder agreements

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S Qualification, Election and Other Issues Single class of stock requirement

S corporations may have only one class of stock outstanding

Under the corporation’s governing provisions all outstanding shares must confer identical rights to distributions and liquidation proceeds

Governing provisions include the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements that affect distribution / liquidation proceeds

Differences in voting rights are permissible

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S Qualification, Election and Other Issues Single class of stock requirement (cont’d)

ISSUE: Options, warrants, shareholder agreements, etc. can inadvertently create second classes of stock, and must be carefully structured

Nominal exercise prices on warrants to lenders / selling shareholders may cause warrant to be treated as a disqualifying second class of stock

TEST: Taking into account all facts and circumstances

(A) is the warrant/option substantially certain to be exercised; and

(B) does it have a strike price substantially below FMV of the underlying stock on the issue date

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S Qualification, Election and Other Issues

Election Issues Made prior to beginning of tax year, or Made within 2 ½ months after start of

tax year Retroactive to beginning of tax year Corporation must be eligible during entire

retroactive period ISSUE: With a retroactive S election it is

critical to coordinate timing of sale when a 1042 election is intended

Must be prior to effective date of S election

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S Qualification, Election and Other Issues Election Issues (cont’d) All shareholders at the time of the election

must consent to the election New shareholders need not consent after

election NOTE, for a retroactive election each person who

was a shareholder at ANY time during retroactive period before the election is made (and who is not a shareholder at the time the election is made) must also consent to the election

Trustee of the ESOP can consent on behalf of the ESOP

Shareholder consent is binding and may not be withdrawn after a valid election is made

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S Qualification, Election and Other Issues Tax Year Issues

Issue: S corporation’s tax year must be a calendar year unless corporation:

Establishes a business purpose for a year other than the calendar year

Agrees to make a refundable interest-free deposit with the IRS to eliminate the benefit of any tax deferral

If the ESOP owns 100% of the company and ESOP trust has non-calendar fiscal year, the S corporation can adopt the same tax year (principal shareholder exception)

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S Qualification, Election and Other Issues Qualified Subchapter S Subsidiaries (QSUBs)

Must be 100% owned subsidiary Must elect S status for QSUB QSUB treated as a disregarded entity (tax

treatment of the QSUB is ultimately passed through to the shareholders of the parent S corporation)

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S Qualification, Election and Other Issues S Distributions

S corporation having earnings & profits (E&P) Tax-free to extent distribution does not exceed AAA Taxable as dividend to extent distribution exceeds

AAA but does not exceed E&P Remainder treated as return on basis (not taxable)

and any excess over basis taxed as capital gain NOTE: company can make an election to distribute

E&P first. Requires the consent of all affected shareholders

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S Qualification, Election and Other Issues Distributions (cont’d)

S corporations having no E&P The distribution is first applied against basis If amount of distribution exceeds the

adjusted basis of the stock, excess shall be treated as a capital gain

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S Qualification, Election and Other Issues Termination of S status

Revocation – shareholders holding more than ½ of shares of stock must consent

Retroactive to beginning of the tax year if made before the 15th day of the 3rd month

Effective on the 1st day of the following tax year if made after the 15th day of the 3rd month and revocation does not otherwise specify a prospective revocation date

If specified, revocation is effective on such date

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S Qualification, Election and Other Issues Termination of S status

By corporation ceasing to be a small business corporation

Effective as of the date in which termination event occurs

Termination by reason of excess passive investment income

Only applies to S corporations that used to be C corporations

Passive investment income in excess of 25% of gross receipts for 3 consecutive years

Effective on the first day of the first taxable year following such 3 consecutive year period

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C Corporations that Become S Corporations

ISSUE: Built-In Gains (BIG) Tax Exposure to corporate level tax on net

realized built-in gains for 10 [5 years for 2013] years after S election

Appraising assets at the time of election helps manage this tax

Accounts Receivable – (accrual method rule) cash basis corporation subject to BIG tax on collections after conversion

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C Corporations that Become S Corporations

Presence of C corporation E&P raises issues

ISSUE: potential taxable dividends if distributions exceed AAA

AAA - aggregate, undistributed taxable income of the S corporation

(i.e., previously taxed S corporation earnings)

Must monitor distributions to ensure that taxable dividends are not inadvertently paid

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C Corporations that Become S Corporations ISSUE: LIFO recapture tax

Reserve resulting from LIFO (Last-in, First-out) inventory accounting must be recaptured and taxed when switching from C to S

LIFO recapture amount is amount by which inventory computed on the FIFO (First-in, First-out) method exceeds inventory computed on the LIFO method

Tax is computed on last C corporate tax return and is paid in four equal annual installments

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Planning for Stock Sales to ESOPsIncome Tax Deferral 100% ESOP-owned S corporation has

significant tax saving opportunities No corporate-level federal tax on annual S

corporation income (most states mirror this provision)

Although income will be passed through to the shareholder (the ESOP), no shareholder level tax will be imposed because the ESOP is a tax-exempt entity

The income tax liability will effectively be deferred until the participants in the ESOP receive their benefits

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Planning for Stock Sales to ESOPsIncome Tax Deferral (cont’d)ESOP owns Less than 100%

Tax exclusion in proportion to ESOP ownership ESOP entitled to its share of S-distributions paid if

corporation makes distributions to non-ESOP shareholders to cover payment of taxes on the passed through corporate income

Example ESOP owns 30% of company 2012 taxable income was $1 million Non-ESOP shareholder income allocation = $700,000.

Corporation distributes $245,000 to cover federal tax liability Corporation also required to distribute $105,000 to the ESOP Cash in ESOP can be used for ESOP debt service, repurchase

obligation or to purchase additional shares If cash from S distributions builds up in ESOP, it may not

be available to company for investment or expansion

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Planning for Stock Sales to ESOPs ISSUE: Capacity of a leveraged ESOP to carry

purchase debt (Code Section 404 Limits) C corporation - contributions for principal

payments on ESOP debt limited to 25% of eligible compensation, but generally no limits on contributions used to pay interest

S corporations – contributions for both principal and interest payments count toward limitation

Amount of debt service an S corporation’s payroll can support will be less than if it were a C corporation

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Planning for Stock Sales to ESOPs 415 annual addition limits

Generally, 415 limit is the lesser of (a) 100% of participants compensation and (b) $50,000. Includes employer contributions, employee contributions and forfeitures

For C corporations only – if no more than 1/3 of the employer contributions to the ESOP which are used to pay down an ESOP loan are allocated to the accounts of HCEs, then the general 415 rules do not apply with respect to annual additions attributable to forfeitures and interest payments on an exempt loan

This rule does not apply to S corporations and therefore may limit the capacity of an ESOP to carry debt

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Planning for Stock Sales to ESOPs Stock Redemption Transactions in S

corporation ESOP companies Helps obtain capital gain / installment sale

treatment for owners of non-1042 transactions

ISSUE: Need to ensure that the redemption qualifies under 302 as a sale or exchange and not a 301 dividend

Reduces value of corporation and stock for sale to ESOP

Seller Financing (with warrants attached) permit sellers to participate in future growth

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Planning for Stock Sales to ESOPs S corporation converts to C corporation to

allow for 1042 election (with intent to eventually convert back to S status)

ISSUE: Will 1042 transaction qualify? Shares sold to ESOP must be qualified employer

securities 3 year holding period 30% rule – immediately after the sale, ESOP must

own at least 30% of each class of outstanding stock or at least 30% of the total value of all outstanding stock

Conversion to C corporation may block S status for 5 years

Built-In Gains (BIG) tax exposure upon later S election

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Sale of Stock to an ESOP vs. Taxable Sale

ESOP Federal Tax Savings of Sale to an ESOP

$30,000,000$25,000,000Net Proceeds

$0$5,000,000TAX @20%

$25,000,000$25,000,000Appreciation

5,000,0005,000,000Basis

$30,000,000$30,000,000Sale Price

ESOP SaleTaxable Sale

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Financing IssuesFinancing Issues

One of the most critical elements to implementing an ESOP is the ability to obtain financing for the transaction

There are several potential sources of debt financing Senior Lenders – Asset Based Senior Lenders – Cash Flow Based Mezzanine Funds B Loan Lenders Seller Financing (To be discussed further)

General Lender Considerations Collateral Base (real estate, inventory, receivables,

etc.) Cash Flow Character Strength of the management team

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Financing Issues (cont’d)Additional Considerations for ESOP Transactions

ESOP transaction is a highly leveraged transaction

Unlike debt financing for operations, the proceeds of the loan “leave the company”

Enhanced cash flow available for debt service from ESOP tax benefits

If the Company elects S corporation tax status, more cash may be available to service debt

A 100% ESOP-owned S corporation does not pay federal income tax

Lenders usually increase availability to ESOP-owned S corporations

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Seller Financing as Part of the Transaction Selling shareholders receive a note as payment for all or part of sale price

Alternative to bank financing when costs, covenants or availability may be a consideration

In conjunction with bank financing to fill gap in capital structure

May comprise 100% of financing when it is difficult to obtain traditional senior financing

May allow seller to receive greater overall consideration than if transaction is financed 100% with outside financing Sellers generally desire an appropriate return for the risk inherent in supporting senior credit

Combination of cash pay interest, payment in kind (PIK) interest and warrants

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Synthetic Equity as Part of the Transaction

Consider providing additional post-transaction incentives to the key members of management of the combined enterprise. Use of synthetic equity as a benefit above and beyond the ESOP can be a complementary motivating instrument

Stock appreciation rights Phantom stock Incentive or non-qualified stock options

Warrants can be used as part of seller financing portion to induce seller to move toward a transaction

Watch for S corporation non-allocation rulesAll synthetic equity would be subject to fiduciary review when looking at the transaction as a whole

Second class of stock issues related to synthetic equity and S corporation anti-abuse issues (don’t do anything that would jeopardize tax status!!!)

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Valuation IssuesComparable Companies

(Public Comps)

Comparable Transactions(M&A Comps)

Discounted Cash Flow

(DCF)

Leveraged Buyout Analysis

(LBO)

Description: Identify the key publicly-traded comparable companies for the company and calculate and apply multiples of Revenues, EBITDA, and EBIT.Comment: A widely accepted valuation technique that provides current, market-based valuation information. Multiples are discounted for liquidity and size.

Description: Identify key comparable transactions for the company, and where possible, calculate and apply multiples of Revenues, EBITDA and EBIT.Comment: Precedent multiples are dependent on market conditions at the time of the transaction.

Description: Model the free cash flows resulting from the company’s financial projections and discount using an appropriate cost of capital.Comment: Arguably the most sophisticated valuation technique, providing real insight into divisional valuation drivers. Highly sensitive to numerous key assumptions.

Description: Using the same projections as the DCF, apply a suitable leveraged capital structure and solve the valuation using a 20 – 40% target equity rate of return.Comment: A useful alternative perspective since it implies a valuation level at which a private equity investor would typically be prepared to bid for the company.

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Valuation Issues (cont’d) Determine Present and Future Value

Understand the value of the company today to satisfy immediate planning considerations

Assess the value trajectory over time to: Address long-range planning scenarios Evaluate company performance

Characteristics of ESOP valuation As the multiples of pretax earnings, EBIT

and EBITDA increase, so does the company’s general growth

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Valuation Issues (cont’d) Control and Marketability Dictate Value Whole Companies

Total control Possible strategic buyer fit Highly flexible tax and structural options

Partial Ownership Limited voting control only

Non-Marketable fractional minority interests Minimal control Uncertain returns Minimal marketability - if any

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Valuation Issues (cont’d) ESOP Considerations

The Company’s equity value will be different before and after the ESOP transaction

The Company will have more debt directly following the deal

This will reduce the equity value As the debt is repaid over time, the equity

value recovers

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Valuation Issues (cont’d) Fair Market Value (FMV) versus Economic

Value (EV) FMV assumes C-corp. tax status EV captures expected tax savings FMV is the standard in most instances

ESOP cannot pay more than FMV ESOP cannot pay for future S benefits (but can

for value that has already accrued pre-transaction)

Participant transactions also at FMV In sale scenario, trustee should consider both

FMV and EV. (EV may be in participants’ best interest)

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Partial ESOP S Corporations ISSUE: Tax funding needs of non ESOP

shareholders may require distributions, which also must be made to the ESOP, potentially skewing allocations between younger and older employees and former participants

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Partial ESOP S Corporations Use of S distributions to make loan payments

Allocated Shares – Must be replaced with shares with fair market value at least equal to the allocated S distributions used for debt service

Unallocated Shares - Company Stock to be allocated as a consequence of repayment of an outstanding Acquisition Loan by S Corporation Distributions on unallocated shares generally allocated in the same manner as Company Contributions

ESOP loan documents and / or ESOP plan document may prohibit using S distributions on allocated shares to make loan payments

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Miscellaneous ESOP Distribution Rules

Generally, participants in an ESOP are entitled to demand their benefits be distributed in the form of stock

This general rule raises issue of involuntary termination of S election (e.g., rollover to IRA would terminate S election as would exceeding 100 shareholder rule)

The 1997 Tax Act resolved this problem. This act permits an S corporation to require the participants to take their benefits in cash (or in the form of stock, subject to a mandatory/immediate put)

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MiscellaneousAnti abuse rules for S corporation ESOPs Enacted in 2001 - Designed to eliminate two perceived abuses of S corporation ESOPs

First – ESOP benefits only one or a few employees E.g., a highly paid professional might defer taxes indefinitely

by forming an S corp and transferring all of his stock to an ESOP

Against public policy of promoting broad-based employee ownership

Second – ESOP set up to create a “tax holiday” Stock options (and other forms of equity interests) granted to

executives and outside investors that substantially dilute the ESOP’s ownership.

The equity interests of the executives could be designed to defer their recognition of income over several years, during which time all of the corporate earnings escape taxation (the tax holiday)

If ESOP will be substantially diluted after the stock options are exercised, the ESOP will have served only to avoid taxes and not to promote broad-based employee ownership

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MiscellaneousAnti abuse rule for S corporation ESOPs (cont’d) Anti abuse rules (Code Section 409(p)) are

designed to eliminate abuses Under 409(p), an ESOP that holds shares of an S

corporation is prohibited from allocating or accruing employer securities to disqualified persons during any nonallocation year (which is defined as a year in which disqualified persons own at least 50% of the outstanding shares of the company)

Violation of this rule has devastating effects

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Questions ?Peter Aliferis

Managing DirectorPendo Advisors, LLC

Chrysler Building - 26th Floor405 Lexington Ave.New York, NY 10174

(212) 907-6666 peter.aliferis@pendoadvisors.com

Mark R. KossowPartner

Schatz Brown Glassman Kossow LLP

250 Mill StreetSuite 309-311

Rochester, NY 14614(585) 512-3414, Ext. 8121mkossow@esopplus.com

Richard A. HeeterManaging Director

Capital Trustees, LLC17 S. Second Street - Suite 301

Harrisburg, PA  17101 (717) 919-5172

Rich@CapTrustees.com

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Schatz Brown Glassman Kossow LLP, Pendo Advisors, LLC, Capital Trustees, LLC and Empire Valuation Consultants, LLC are not affiliated companies.

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the aforementioned companies are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.