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ESOPs: Savvy Strategy for Tax Management, Succession, and Continuity

ESOPs: Savvy Strategy for Tax Management, Succession, and Continuity

Scott D Miller

ISBN: 978-1-937-35054-3 May 2017 224 Pages


In Stock



Changing demographics, impending changes in taxation, and challenging economic conditions have made ESOPs a creative strategy to ensure organization survival and success. This publication defines issues that must be fully considered before installing an ESOP, and highlights the common attributes of successful installations. Use this book to chart a course through succession issues and transition ownership issues with a minimum impact to financial results.  The book offers you practical strategies to deal with current economic realities and taxation challenges, including the following: 

  • Increasing tax rates in the near future will make ESOPs a tax efficient option for business owners. 
  • In recessionary times ESOPs control the succession process versus letting probate and inheritance taxes jeopardize the survival of their organization. 
  • Financing for almost any business transaction is difficult; ESOPs are very seller finance friendly. 
ESOPs represent an effective exit vehicle for Baby Boomer owners.
Introduction ix

Chapter 1: Employee Stock Ownership Plan History and Background

Overview of Employee Ownership and Employee Stock Ownership Plans 1

Underlying Philosophy of ESOPs 1

Legislative History  2

Employee Retirement Income Security Act of 1974  3

Revenue Act of 1978  3

The Chrysler Loan Guarantee Act of 1979  3

The Economic Recovery Tax Act of 1981  3

Deficit Reduction Act of 1984  4

Tax Reform Act of 1986  4

Small Business Job Protection Act of 1996  4

Taxpayer Relief Act of 1997 4

The Economic Growth and Tax Relief Reconciliation Act of 2001 5

Jobs and Growth Tax Relief Reconciliation Act of 2003  5

Impact on ESOPs  5

ESOPs Today 6

Summary  7

Chapter 2: Significant Events and Organizations

Regulations and Government Agencies  9

Employee Retirement Income Security Act of 1974  9

IRS  11

Securities and Exchange Commission  13

DOL  14

General ERISA Fiduciary Considerations  16

Proposed DOL Regulations Specifi c to ESOP Valuations 19

Major Exceptions to ERISA for the Benefi t of ESOPs  20

ESOP and ERISA Litigation  21

Summary  22

Industry Organizations and Standards  22

The AICPA  22

The ESOP Association  26

National Center for Employee Ownership (NCEO)  28

Ohio Employee Ownership Center  30

Appendix 2A—IRS Form 5309, Application for Determination of Employee Stock Ownership Plan  31

Chapter 3: Employee Stock Ownership Plan Transaction Mechanics

Traditional Uses of an ESOP  35

Provide Liquidity and Diversifi cation for Shareholders  36

Provide a Means of Capital Formation  36

Finance Corporate Acquisitions  36

An Incentive to Increase Employee Productivity and Retain Personnel  36

Provide a Succession Plan  37

Provide Liquidity in Divorce Situations  37

Provide Negotiating Leverage for Any Proposed Transaction  37

Summary  38

Alternatives to an ESOP  38

Sell or Transition the Business to Family Members  38

Sell to Management or Key Employees  38

Sell or Merge With a Third Party—Financial Buyer  38

Sell or Merge With a Third Party—Strategic

or Investment Buyer  39

Sell Stock Through an Initial Public Offering  39

Liquidate the Business  39

Summary  39

Basic Features of ESOPs 40

Operating Considerations of an ESOP  40

Contributions to an ESOP Are Tax Deductible Within Statutory Limits  44

Contributions to an ESOP Based on Dividends (C Corporation)  50

Contributions to an ESOP Based on Distributions (S Corporation)  52

IRC Section 1042 Tax-Free Rollover (C Corporation)  54

Nontaxable Income Related to ESOP Stock (S Corporation)  58

Assets in ESOP Remain Untaxed Until Retirement  59

Appendix 3A—Sample Documents Relating to the Internal Revenue Code Section 1042 Election  61

Sample Statement of Election  62

Sample Statement of Consent for ABC, Inc  63

Sample Statement of Purchase  64

Chapter 4: Employee Stock Ownership Plan Transactions and C Corporations

Sample Facts—ABC, Inc (C Corporation)  65

Abbreviated Financial Statements  66

FMV of Common Stock for the Purposes of an ESOP  67

Common Entities in Transactions  68

Example—Stock Contributed to ESOP (Capital Formation ESOP)  69

Example—Leveraged ESOP With IRC Section 1042 Rollover  70

IRC Section 1042 Restrictions  71

Example—Prefunded ESOP With IRC Section 1042 Rollover  72

IRC Section 1042 Restrictions  74

Example—Leveraged ESOP With IRC Section 1042 Rollover and Control  75

Example—Leveraged ESOP With IRC Section 1042 Rollover, Multiple Classes of Stock, and Control  78

Summary  83

Chapter 5: Employee Stock Ownership Plan Transactions and S Corporations

Sample Facts—ABC, Inc (S Corporation)  85

Abbreviated Financial Statements  86

FMV of Common Stock for the Purposes of an ESOP  87

Common Entities in Transactions  88

Example—Stock Contributed to ESOP (Capital Formation ESOP)  89

Example—Leveraged ESOP (Paying Capital Gains)  90

Example—Prefunded ESOP With No Bank Debt  92

Example—Convert to C Corporation—Leveraged ESOP With IRC Section 1042 Rollover and Control  94

IRC Section 1042 Restrictions  98

Example—Leveraged Sale of 100 Percent to the ESOP in a Single Transaction  100

Summary 103

Chapter 6: Advanced Employee Stock Ownership Plan Applications

Mergers and Acquisitions—Buying a Target Company With Pretax Dollars 106

Purchase of Stock  106

Purchase of Assets  107

Mergers and Acquisitions—Extending the Internal Revenue Code Section 1042 Rollover to a Target Company  107

Extending the IRC Section 1042 Rollover to an Investment in Another Closely Held Company 108

Multiple Investor ESOPs 108

Charitable Giving and ESOPs 109

Contributions of Closely Held Stock to Charities  109

Charitable Remainder Income Trusts and ESOPs  110

Summary  110

Chapter 7: Valuation Issues and Considerations

Issues Regarding ESOP-Based Valuations 112

Identify the Client  112

Standard of Value 113

IRS  113

DOL  115

Valuation Independence and SOX 119

Impact of SOX  119

AICPA Newsletter: CPA Expert, Summer 2003  119

Valuation Perspective on the Repurchase Obligation and the Put Option 120

Valuation Report Date and Events 121

Opinion of Value at a Point in Time  123

Approaches to Establishing Value 123

Initial Valuation: C Versus S Corporation Considerations 123

Income Approach  125

Market Approach  127

Asset Approach  128

Lack of Marketability Adjustment (Discount)  129

Ownership Characteristics 129

Minority and Control Positions 129

Multistage Transactions  130

Dilution Considerations and Outstanding Shares  131

Dilution With the ESOP Contribution of Newly Issued Stock  132

Leveraged ESOPs—Initial Valuation and Annual Updates 133

Annual ESOP Update Issues 134

Fluctuations in Value Between Years  134

Valuation Methodology—Issue of Consistency  135

Increasing Value With Time  136

Multi-Investor ESOPs and Allocation Considerations 136

Multiple Classes of Stock in C Corporation ESOP Transactions  137

Practical Valuation Considerations 139

Chapter 8: Administration and Transaction Considerations

Initial Considerations and ESOP Feasibility Study 141

Team of Advisors  142

Team of Advisers Summary—Have a Transaction “Quarterback”  145

Feasibility Study  146

Informal Planning Process  146

Written ESOP Feasibility Study  146

Feasibility Summary  147

Strategic ESOP Design Considerations 148

Contribution and Addition Limits to Qualified Plans Expanded  148

Maintaining Both an ESOP and a 401(k) Plan  148

Creation of a Preferred Stock or Super Common Stock for the ESOP in a C Corporation  149

Compatibility With the S Corporation Election  150

Senior Management Compensation and Incentives  150

Special S Corporation Considerations  152

ESOP Trustee and Transaction Considerations  152

Benefits of an Independent Fiduciary  154

ESOP Fairness Opinion  155

Fairness From Only a Financial Viewpoint  155

Common Components of the Fairness Opinion  155

Rights of ESOP Participants  156

Right to Demand Employer Securities  156

ESOP Participant Voting Rights  156

Written Materials  158

Dispute Settlement  158

Diversification Requirements  158

Stock Repurchase Obligation  159

Practical Insights  159

Repurchase Studies  160

Funding the Repurchase Obligation  161

Election: Redeeming the ESOP Stock Back to the ESOP  162

Election: Redeeming the ESOP Stock to the Company Treasury  163

ESOP Termination  163

Plan Termination With Outstanding ESOP Debt  164

Disadvantages of ESOPs  165

Complex Regulatory Environment  165

Fiduciary Responsibilities  166

Initial Cost and Ongoing Expenses  166

Repurchase Obligation  167

Employees Fail to Understand and Appreciate the ESOP  167

Summary  168

Chapter 9: Financial Considerations

Financing Overview for ESOPs 169

ESOP Loan Exemption  170

Financing an ESOP—Internal Sources  171

Financially Successful Employer (Plan Sponsor)  171

Prefunding the ESOP  171

Stock Contributions to the ESOP  172

Inside Loan From the Company to the ESOP  173

Financing an ESOP—Seller Financing  173

S Corporation Application  173

C Corporation Application  174

Leveraged QRP Solution  174

Floating Rate Note  175

Financing an ESOP—Third-Party Financing (Bank Debt) 176

Historical Note—Repeal of ESOP Loan Interest Exclusion  176

Overview of General Banking Concerns  176

Common Loan Mechanics  177

C Corporation ESOPs  178

S Corporation ESOPs 178

Summary  179

Chapter 10: Litigation and Significant Cases

The Employee Retirement Income Security Act of 1974 and ESOPs  181

The Importance of Court Cases  182

The IRS  182

The DOL  183

Significant Court Cases  183

Court Case: Donovan v Cunningham  184

Court Case: Hines v Schlimgen  185

Court Case: Las Vegas Dodge, Inc v US  186

Court Case: Gary L Eyler v Commissioner  187

Court Case: William R Davis v Torvick, Inc  190

Court Case: Delta Star v Patton  191

Chapter 11: Practical Considerations and Employee Stock Ownership Plan Resources

Qualifying ESOP Candidates  195

Qualities of Successful ESOP Candidates  196

Characteristics of Less Successful ESOP Candidates  196

Practical Insights Summary  198

Overview of ESOP-Related Resources  198

The EA Publications  198

NCEO Publications  199

The Ohio Employee Ownership Center  199

Other ESOP Resources  200