ABC's of ESOPs

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The ABCs of Employee Stock Ownership Plans

Ohio Employee Ownership CenterSouthwest Ohio ESOP Forum

June 17, 2010

David A. Whaley, Esq. Dinsmore & Shohl LLP

© 2010 Dinsmore & Shohl LLP

What is an ESOP?

A retirement plan A way to build wealth A way for employees to participate in ownership


Characteristics of an ESOP

It is a “defined contribution” plan– Employees become “participants”

– A “trustee” holds plan assets

– Each participant has an “account” in the trust

– Assets stay in the trust until they are distributed

– 401(k) plans are also “defined contribution” plans


Characteristics of an ESOP

It is different from other defined contribution plans– Must invest primarily in employer stock

– May borrow money to buy stock

– May enter into transactions with related parties

– May delay distributions

– Must pass through certain votes to participants


How does an ESOP work? Employer establishes an ESOP trust Trust buys shares of the company

– From the company

– From another shareholder

Where does the trust get the money?– From the employer

– From a bank

– From the selling shareholder


How Does an ESOP Work?

ESOPCompany

(1) $

Shareholder

Lender

(3) Stock

Suspense Suspense Stock 100%Stock 100%

Allocated Allocated Stock 0%Stock 0%

(2) $

(3) $

Sample Transaction - Initiation

(1) Lender makes a loan to Company.(2) Company lends money to the ESOP.(3) ESOP purchase shares from the shareholder


How does an ESOP work?

Employer makes annual contributions to the ESOP Contributions are used to repay a loan Shares are allocated to participants


How Does an ESOP Work?

ESOPCompany

(2) $

Lender

Suspense Suspense Stock 95%Stock 95%

Allocated Allocated Stock 5%Stock 5%

(1) Contribution

(3)Stock is released

• The Company makes a contribution which is used for the debt payment from the ESOP

• Company makes debt payment to the lender• Stock is released from suspense and allocated to participants as debt is

repaid

Sample Transaction - 1st year

(1) Debt Payment


How does an ESOP work?

What happens when the employee leaves?– Shares may be distributed

– ESOP may distribute cash in some cases

– Employee may sell shares to the company or the ESOP

– Distribution may be delayed until loan repayment


Why set up an ESOP?

The law gives some advantages to a selling shareholder Section 1042 allows deferral of gain on the sale Strict requirements

– ESOP must own at least 30% of shares– Must be a C corporation– No allocation to owner or relatives– Seller must buy replacement property


Advantages to the Selling Shareholder Buy out shares of an existing owner

– Section 1042 allows the deferral of gain

$

$ StockStock

JACKOWNER$3 million$3 millionQUALIFIED

REPLACEMENTPROPERTY

COMPANY

Lender

ESOP30% HOLDER

$


The S Corp. Advantage

If the corporation makes an S election, then the profits

of the business become wholly or partially nontaxable


The S Corp. Advantage

BANKBANK

IRS

Loan Payment

Distribution

Taxes

4

COMPANY

SHAREHOLDERSBANK

ESOP

IRS

PARTICIPANTSAllocatedShares

Loan Payment

1

1

2

3

BANKBANK

IRS

Loan Payment

Distribution

Taxes

44

COMPANY

SHAREHOLDERSBANK

ESOP

IRS

PARTICIPANTSAllocatedShares

Loan Payment

11

11

22

33


Advantages for the Employees An ESOP can reward employees who have produced the employer’s

success

ESOPs can be used to assist with a buyout strategy

Research shows employees of ESOP companies have better benefits and pay

ESOPs are a way for a working person to build wealth


Some areas of confusion Do employees “own” the stock?

– Not directly – the shares are legally owned by the ESOP trust

Who votes the shares?

– The trustee

– Employees may direct voting in limited circumstances


Some areas of confusion

Who runs the company?

– Like other corporations, company is run by

Board of directors

Management


Corporate Structure and Fiduciary Obligations

Board of DirectorsBoard of Directors

OfficersOfficers

Managers

Shareholders

ESOP Trust

TrusteeEmployees ESOP Admin. Committee


Laws Governing Retirement Plans

Employee Retirement Income Security Act (ERISA)

Internal Revenue Code


Government Enforcement

U.S. Department of Labor – Employee Benefits Security Administration (EBSA – formerly Pension and Welfare Benefits Administration)

Internal Revenue Service – TE/GE Division


Settlor vs. fiduciary functions

What is a “settlor” function?

– Generally relates to formation rather than administration or management of a Plan.

– Generally settlor functions are not subject to ERISA’s fiduciary rules.

– Termination of a Plan is a settlor function.

– Exception: appointment of trustee is a fiduciary function.


Who is a fiduciary?

ERISA Section 3(21) – Any person who:

– Has discretionary authority or control over management of the plan or plan assets;

– Provides investment advice for a fee; or

– Has discretionary control or responsibility over plan assets.


Who is a fiduciary?

Formal title is irrelevant

Depends on actual control/responsibility

“If it walks like a duck and talks like a duck” analogy


Consequences of Fiduciary Status

A fiduciary must comply with the fiduciary provisions of ERISA:

– Prudent person rule

– Exclusive purpose rule

– Prohibited transaction rules (similar, but not identical, provisions in the Code)


ERISA Fiduciary Standards

ERISA Prudence requirements

– Prudent person rule

Fiduciary must act with the “care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use”

“[ERISA’s] test of prudence…is one of conduct and not a test of the result of performance of the investment. The focus of the inquiry is how the fiduciary acted in his selection of the investment and not whether his investments succeeded or failed.” Donovan v. Cunningham, 716 F. 2d 1455, 1457 (5th Cir. 1983).



Exclusive purpose rule

– Fiduciaries must discharge their duties for the exclusive purpose of providing benefits to participants and their beneficiaries



Plan document rule

– A fiduciary must follow the plan documents to the extent that they are consistent with ERISA

– The overall rule of prudence prevails in that if it is imprudent to follow the plan documents, then the fiduciaries need not follow the plan document.


ERISA Fiduciary Standards Overall, the basic requirements are prudent

management, ongoing monitoring and documentation.

Process is the key


Important Fiduciary Decisions in an ESOPBuying shares

Selling shares

Voting shares

Determining value

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David A. Whaley, Esq. Dinsmore & Shohl, LLP255 E 5th St., Suite 1900Cincinnati, OH 45202(513) 977-8554 | [email protected]://www.linkedin.com/in/davidwhaley

ABC's of ESOPs

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