1. 2 what is an esop? how can you benefit? presented by timothy j. cleary vp - consulting the...

2

What is an ESOP?How can you benefit?

Presented byTimothy J. ClearyVP - ConsultingThe Principal Financial Group®

(952) 543-0980 x318

3

ESOP Opportunities

in Estate and Business Succession Planning

• Sample opportunities• What is an ESOP• How does an ESOP transaction work• Benefit for owners to sell to ESOP• Benefit for company – tax savings• S corporation benefit• Common objections• Combining with a GRAT• Review and candidate profile

4

ESOP Success – No Successor, Inc.

• Small distribution company, owner in late-50s• Bought business 20 years ago• Corporation is primary asset - $7 million• No children in business

• Interested in retiring in 3 – 5 years• Want to take care of employees• Interested in ESOP

Facts:

Goals:

5

ESOP Success – No Successor, Inc.

• Sold 30% to ESOP, deferred tax on sale• Gave 10% over 5 years to key employees• Sell rest in 5 – 7 years• Started including key employees on strategic decisions

Solution:

6

ESOP Success – Big Private Co.

• 30 year old business valued at $185 million• Owned by 2nd generation in late 60’s• 2 sons in business, 2 daughters outside • Strong management• Father and one son value employees• Other son wants as much as he can get

• Ready to retire• Management team including sons in control• Liquidity for daughters & life-time• Charitable giving

Facts:

Goals:

7

ESOP Success – Big Private Co.

• Sold 100% of stock to ESOP for $135 million • Gave $50 million to sons & management over 15 years• Set up estate plan to provide equal value to daughters

Solution:

8

ESOP Success – Eggs in 1, Inc.

• 5 year old marketing firm valued at $8 million• Owned by 2 conservative men in early 40’s• Worth more than dreamed of• Questioning should they sell; don’t want to• No buy sell insurance • Protection for family • Diversification• Golden handcuffs/Ownership for key employees

Facts:

Goals:

9

ESOP Success – Eggs in 1, Inc.

• Sold 40% to ESOP to get liquidity• Diversified investment for family protection• Sold 5% to key management• Hold the rest of the stock and have fun again

Solution:

10

What is an ESOP?

• Employee Stock Ownership Plan• Retirement plan protected by ERISA• Similar to profit sharing or 401(k) match• Two differences:

– Primarily invested in company stock– Can borrow money to buy stock

• Flexible tax-advantaged tool for many corporate finance transactions!

11

ESOP Success – ABC, Inc.

• Owned by John and Mary Jones, both in early-60s• Founded business 25 years ago• Corporation is primary asset• Pillar of community

• Interested in retiring in 3 – 5 years• Want Child 1 to take over business• Want equal value for Child 2 outside of business• Want to take care of employees and local charities

Facts:

Goals:

12

Contemplating the Exit

ESOP

Selling Shareholders

Third Party

Family

13

Third Party Sale


Third Party

• Owner pays capital gain tax

• Buyer pays with after-tax earnings

• Owner likely loses control

• Corporate identity?

• Fate of employees?

14

Family Sale


Family

• Owner pays capital gain tax

• Buyer pays with after-tax earnings

• Family retains control

• Business retains identity

• Retain employees

15

Benefits for you and your clients

• Liquidity tax free • Retain control until retirement• Corporate tax savings pay for liquidity • Employees own part of business and not pay taxes until retirement• Client and key employees protected/insured

• Have a very happy client • Get commissions from several sources

Client Benefits:

Intermediary Benefits:

16

ESOP Transaction

ESOPESOP

Bank

Tax Deferred Reinvestment

Company

Buy

Stock

Loan 1

Loan 2Selling Shareholders

17

Requirements for Tax Advantage

• The company is a closely-held C corporation at the time of the sale

• The seller owned the stock for at least 3 years• The seller didn’t acquire the stock through an

option or other compensation situation • The ESOP owns at least 30% immediately after

the sale

18

Sellers’ Advantages

• Seller has to reinvest in replacement securities

• Tax on capital gain deferred• Tax eliminated if hold reinvestment for lifetime• Products available to hold reinvestment for

lifetime– Still have use of up to 100% of proceeds

• Savings maybe in excess of 20% of value!

19

ESOP Transaction

ESOPESOP

Bank

Tax Deferred Reinvestment

Company

Buy

Stock

Loan 1

Loan 2Selling Shareholders

20

C Corporation – Deduction for Principal

ESOPESOP

Bank Company

Loan Payment

Deductible Contribution

Loan Payment

Company receives tax deduction for providing shareholder

liquidity!!!

In other words, tax savings pay 40% of debt!!!

21

Allocation of Stock

Stock

4 6 8 10 12 20181614 Year 2

Participant Accounts

ESOP Trust

For financial professional use only.

22

It gets better . . .

S corporation advantage

23

S Corporation – Tax Elimination

Company

ESOPESOP

Tax on shareholderportion only

S dividenddistributions

Loan payment

Non-ESOP Shareholders

NO TAX!!!

Tax savings pay 100% of debt!!!

24

Common Objections• “If it sounds too good to be true, it probably is.”

– Answer: This time it is true. Congress intentionally set up benefits to encourage employers to provide retirement benefits and align shareholder and employee interests. ESOPs are favored by both parties.

• “I don’t want to lose control.”– Answer: Owner can retain control as trustee and vote all

of the shares in the ESOP on most issues.

• “I don’t want to disclose everything to employees.”– Answer: Only disclosure required to employees is

standard retirement plan statement – shares and value in participant’s account.

25

Estate Planning . . .

Combine ESOP with GRAT

26

Perfect time for GRAT

• GRAT – Grantor retained annuity trust• Gift asset = retained annuity to grantor• No gift tax • S distributions for tax on S income count as

annuity• If annuity insufficient, transfer part of stock back• Want to gift when stock value is low, transfer

back when stock value is high

27

Use of GRAT with ESOP Sale

Company

ESOP GRAT for Family

51% 49%

28


• Valuation for GRAT immediately after ESOP transaction:– Reduce for ESOP debt– Add back small amount for tax advantage of ESOP– Reduce 49% transferred to GRAT for minority discount

29

Value for GRAT

Pre-ESOP company value $100

Less ESOP debt ($51)

Plus add back for ESOP $15

Post-sale company value $64

49% value $31

Minority discount 30% ($9)

Discounted 49% value $22

30


• Since transfer value is low, S distributions may equal annuity

• If not:– Valuation increases as outside debt is repaid– Outside debt repaid over 5-7 years so value likely to be

higher at end of GRAT period

31

ESOP Uses in Private Companies

• Heavy lifting in an exit succession strategy while providing continuity of management and control

• Partial or complete liquidity for inactive shareholders

• Create a market for closely held stock• Acquisition strategy• Combine with a GRAT in family business• Reward, retain and attract employees• Create tax efficient employee-owned company

32

Who is a Typical

ESOP Candidate?

• Closely-held C or S corporation• One or more owners nearing retirement or

wanting liquidity• History of profitability ($1,000,000 or more)• Successor management in place or in wings• Available corporate credit• Comfortable with sharing value with employees• Minimum 50 employees

33

Review . . .

Great opportunity for you and your clients!

34

ESOP Advantages

• Seller – Friendly buyer for all or part of the stock – Tax on capital gain deferred– Tax eliminated if hold reinvestment for

lifetime– Seller retains control– Control fate of company and employees– Better protection from various risks– More complete estate plan

35

ESOP Advantages

• Employees – Ownership at no cost– No tax until receive distribution from ESOP or

IRA• Company

– Tax savings pay for all or part of the seller’s liquidity

– Retain, reward, attract and motivate employees

36

ESOP Transaction

Process:Building Value

Preliminary Design

Comprehensive Design

Comprehensive Financial Analysis

Seller Investment & Planning

Documents

Financing

Valuation

Administration

Communication

37

Thank You.

When you think ESOPThink The Principal

Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of thePrincipal Financial Group, Des Moines, IA 50392.

©2004 Principal Financial Group®, Des Moines, Iowa 50392-0001

All rights reserved. No part of this presentation may be reproduced or used in any form or by any means, electronic or mechanical, including photocopying or recording, or by any information storage and retrieval system, without prior written permission from the Principal Financial Group.