Quantitative Methods of Data Analysis Natalia Zakharova, TA Bill Menke, Instructor.
Menke & Associates, Inc. - Amazon Web...
Transcript of Menke & Associates, Inc. - Amazon Web...
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Today’s Agenda
Introduction
Basic ESOP Transactions
Advanced ESOP Transactions
Tax Considerations
Financing Considerations
Incentive Plans for Key Employees
Q&A
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What is an ESOP?
• Similar to a Profit Sharing Plan:• Tax deductible contributions for employer
• Retirement savings for employees
• Also an M&A opportunity • ESOP invests in sponsor’s stock
• ESOP participates in earnings and growth of the
sponsor
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Why Use an ESOP?
• Liquidity for shareholders
• Diversify owner’s asset allocation
• Real business succession strategy
• Increase company cash flow
• Enhance employee productivity
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The Company Incorporated (TCI)
Owners: John 75%
Pat 25%
Sales $ 10,000,000
Payroll $ 1,000,000
Pre–tax Profit $ 600,000
Net Worth (Book Value) $ 2,000,000
Fair Market Value $ 3,000,000
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Case I – Gradual ESOP
John wants to cash out on a
gradual basis, starting with a 5% sale
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10
20
30
40
50
60
70
80
90
100
1 2 3 4 5 6 7 8 9 10 11
Year
ES
OP
Ow
ne
rsh
ip %
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Case II – Prefund
ESOP accumulates $400,000 for future purchase of stock.
TCI takes annual deductions for contributions
TCI ESOP
ESOPTCI
$ 250,000
$ 150,000
Year 1
Year 2
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• John wants to cash out more quickly
• TCI’s bank is willing to extend financing
• Potential for tax deferral on John’s sale
Case III – Leveraged C Corp ESOP
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Case III – Leveraged C Corp ESOP
• The ESOP uses that contribution to repay interest and principal on the company loan.
• TCI makes a deductible cash contribution to the ESOP.– Up to $250,000 (1/4 of payroll) plus interest.
• TCI repays the bank loan.
ESOP
TCI
Bank
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Case IV – Combine Cases II &III
AnnualDebt
ServiceRequiredbank loan
Prefunding– – –
annual
Company’sFair
MarketValueYear
1 $ 3,000,000 $ 900,000 $ 250,000 $ 250,000 $ 900,000 $ 243,000
2 N/A N/A 150,000 400,000 N/A N/A
3 $ 3,333,333 $ 1,000,000 N/A $ 400,000 $ 600,000 $ 162,000
30% of FMVTax–deferredsales proceeds
To seller
Prefunding– – –
cumulative
Results:1. John receives additional $ 100,000 in tax–deferred rollover funds.2. The required loan is reduced by 33% ($600,000 rather than $900,000) and
the Company’s first-year principal + interest debt service is reduced by $81,000 pretax.
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Case V – Combine Cases I and III
Year
% Sale --
Annual
% Sale --
Cumulative
Taxable or
Tax Deferred S or C
1 3 % 3 % Capital-gains S or C
2 4 % 7 % Capital-gains S or C
3 5 % 12 % Capital-gains S or C
4 18 % 30 % Tax Deferred C
Capital-gains sales followed by a tax-free rolloversale
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Case VI – Two–Stage ESOP Buyout
1 $3,000 $1,500 (50%) $1,500 $450
2 3,200 1,200 420
3 3,500 900 390
4 3,800 $1,900 (50%) 2,500 550
5 4,100 2,200 530
6 4,400 1,900 490
7 4,800 1,600 460
8 5,200 1,300 430
9 5,600 1,000 400
10 6,000 700 370
DebtService
LoanBalance
SaleProceeds
MarketValueYear
($ thousands)
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Tax-free Rollovers
Tax–FreeESOP
Gross Purchase Price
Net to Seller
Less Tax
$ 225,000 = 33% More CapitalSeller’s Extra Cash
TaxableSale at 25%*
$ 900,000
$ 900,000
$
900,000–0–
$
675,000
($ 225,000)
* 20% Federal Tax, plus 5% State tax
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ESOP must acquire 30% or more of the stock of a
privately–held C corporation
Seller must have a holding period of at least 3 years
Seller must reinvest the proceeds within 12 months
Funds must be reinvested in “Qualified Replacement
Property”
Tax deferral continues as long as seller holds QRP
Basis in QRP carries over from basis in stock sold
Seller may not receive ESOP allocation of sold shares
Tax-Free Rollover
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Stocks, Bonds or Notes issued by U.S.
Corporations, Public or Private
Can invest in Brother/Sister of the ESOP
Company, but not a Subsidiary
Option to create diversified portfolio
Qualified Replacement Property
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Unlocking the QRP Lockup
$ 900,000
From Saleof StockTo ESOP
NetUnrestricted
ProceedsTo Seller
$ 720,000Margin
LoanProceeds
$ 900,000QRPBond
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Benefits of S Corp ESOPs
ESOP’s share of S corp. earnings is exempt from unrelated business income tax (UBIT).
Taxation is delayed until distributions are made to ESOP beneficiaries.
Thus, a 100% ESOP-owned S corp. does not pay Federal income taxes.
However, an S corp. ESOP must meet “broadly based” test.
Selling Shareholders participate in ESOP allocation
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S Corp. ESOPs
Tom, age 50, owns 100% of “S, Inc.”, an S corp.
Tom’s compensation is $210,000/year
S, Inc. employs 20 other employees with total compensation of $840,000/year
Annual pretax earnings are $800,000
The fair market value of S, Inc. is $4MM
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Leveraged S Corp. ESOP (Seller Financed)
ESOP
NOTE PAYMENTS
TOM
STEP 2
* Stock is allocated to participants as a note payments are made
ESOP*TOM
S, INC.CONTRIBUTIONS
DISTRIBUTIONS
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Leveraged S Corp. ESOP (Seller Financed)
Seller Note Options
• Conventional Seller Note• 10 to 15 year term with prepayment provisions
• 6% to 8% interest rate
• Fully Priced Seller Note• 10 to 15 year term with prepayment provisions
• IRR of 13%, based on comparable mezzanine loan rates
• 6% to 8% current-pay interest
• Warrants for 10% - 20% ownership to make up the difference
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Leveraged S Corp. ESOP
END RESULTS:
• S, Inc. no longer pays income tax, as its sole shareholder is tax-exempt
• Tom receives $ 4MM and, on the gain, paysonly capital gains tax (not ordinary income tax)
• Tom is allocated 20% of ESOP stock (which he will be able to cash out when he leaves Company)
• Since Company avoids making distributions to fund S corp. shareholders’ income tax, additional Company funds are available to repay debt and increase Company value
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Advanced ESOP Transaction Overview
Section 1042 Transaction and Floating Rate Notes
Combination Redemption / ESOP buyout
Stock warrants
Case Study: 100% Leveraged 1042 ESOP Transaction
Asset Purchase by ESOP-Owned Company
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Section 1042 Transaction and Floating Rate Notes
Company
Seller
ESOP
2 $
1
$
QRP=
FRN
3
10%$
90%$
4
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Redemption and ESOP Purchase Combo
• More flexibility with purchase price
• More flexibility on seller note terms of collateral
• Helps manage company’s repurchase obligation
• Seller note has higher interest rate (mezzanine debt)
• Disadvantage: 1042 probably not available
• Disadvantage: state solvency laws
Company
Note
ESOP
Seller
5%95%
Cash
Cash
$
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Stock Warrants
Gives the holder a right to purchase company stock at a specified price at a future date
Almost identical to an option
Used in Seller-financed transactions
Issued in lieu of a higher interest rate on the seller note
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Stock Warrants
Example: 15% total IRR with 8% cash pay = 7% of note balance (per year compounded) would represent a predetermined number of warrants (a certain ownership %) in the Company to enable sellers to acquire shares in the future at a pre-determined price
Sellers often have right to put warrants to Company for cash once all transaction debt has been repaid
Company may request a “call” feature
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Case Study: 100% ESOP Transaction
ABC Corp Lenders
(Bank & Mezz Firm)
ESOP Shareholders
1042 Deferral
Step 1 – Outside Financing: (1) $12MM
bank term loan, (2) $13MM bridge loan
from bank, (3) $10MM Mezzanine Debt
Step 5 – Repay Bridge Loan ($13MM)
Step 3 – ESOP pays $35MM)
cash for 100% of ABC Stock
Step 2 – $35MM
Loan to ESOP
(“Inside Loan”)
Net Cash before 1042 Deferral:
$22MM and Approx. $18.5MM
after 1042 deferral
Step 6 – Invest in Qualified
Replacement Securities
(approx. $3.5MM)
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Case Study: 100% ESOP Transaction
• Receive a total of $35MM for the sale of ABC Corp stock:
• $22MM cash (from $12MM senior debt loans and $10MM mezzanine financing)
• $13MM subordinated seller notes
• Sellers may elect to defer (possibly permanently) capital gains taxes on entire sale by investing in qualified replacement securities (e.g. Floating Rate Notes or “FRNs”)
• If 1042 Deferral is elected, Capital gains tax savings up to $7MM (assumes $35.0MM price, stock basis of $0 and 20% federal long-term capital gains tax rates)
SELLERS
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Asset purchase by ESOP-owned Company
• Objective• Due to pending liabilities, Company wants to
purchase assets rather than stock, or• Seller wants to sell assets in exchange for cash, a
seller note, and an earn-out provision
• Application• Can be used either by an S or C corp• Cannot be used in a 1042 transaction
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Asset purchase by ESOP-owned Company
Steps in the transaction1. Management forms a Newco with
paid-in capital of $10,0002. Newco establishes an ESOP3. ESOP purchases all of the
outstanding stock of Newco in exchange for a promissory note in the amount of $10,000 payable over a term of 10 or 15 years.
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Steps in the transaction (ctd.)4. Newco borrows say, $10 million from
a bank, secured by the assets to be purchased
5. Newco purchases the assets from company X in exchange for $10 million of cash, a promissory note of, say, $5 million, and an earn-out of up to $5 million if earnings over the next 5 years exceeds projections
Asset purchase by ESOP-owned Firm
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C corp remains as C corp• Taxable sale
• Pay current federal capital gains tax• Seller participates in ESOP
• Tax-free rollover sale • No current tax on sale of stock• If QRP sold later, capital gains tax may be higher• If QRP never sold, estate gets a step-up in basis• Seller, seller’s family, and 25% shareholders (and
their families) are excluded from ESOP participation
C corporation tax strategies
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C corporation tax strategies
C corp makes an S election• Advantages
• ESOP tax shield • S corp distributions can be used to pay debt
• Disadvantages• Must adopt calendar year• Built-in-gains tax• One class of stock• Switch from LIFO to FIFO & LIFO recapture• Loss of NOL carryovers• Anti-abuse provisions-§409(p)
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• If ESOP acquires less than 100%• Advantage of remaining a C corp
• Continued availability of §1042
• Advantage of switching to S status• ESOP tax shield• S corp distributions can be used to pay bank debt and/or
seller note
• If ESOP acquires 100%• No advantage in remaining a C corp
C Corp Second Stage Transactions
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S corporation tax strategies
S corp remains an S corp• Advantages
• Seller taxes are low if stock basis was high• Sellers and their family members participate in
allocations• S corp distributions can be used to repay ESOP loan• ESOP tax shield on S corp distributions enables faster
pay down of ESOP loan
• Disadvantages• 1042 election not available to sellers
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S corporation tax strategies
S corp election ended before year end• Advantages
• Sellers can elect 1042
• Disadvantages• Short period accounting & tax returns• Sellers and family members cannot participate in
ESOP• Corporation will be subject to income taxation &
liable for income tax on AR• 5 year wait to switch back to S corp• ESOP will not have access to S corp distributions to
help repay loan amount• Corporation must use accrual method of
accounting
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• Borrow if:• Want to lock in capital gains rate• Want to lock in current value• Seller plans to elect 1042 and need to purchase QRP
• Do not borrow if:• Company is in a cyclical industry• Borrowing will use up company’s line of credit• Borrowing will otherwise jeopardize company’s financial
security• Personal guarantees are a concern
Financing Considerations
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Alternatives to borrowing – Seller Notes• Seller can lock in current valuation• Seller can be more flexible than a bank• Seller can still lock in capital gains rate, provided that
seller elects out of installment sale treatment• Seller can still qualify for 1042 treatment by buying
Floating Rate Notes (“FRNs”)
Financing Considerations
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• To lend or not to lend?• Advantages:
• Seller can earn interest at the same rate that a bank would charge
• Seller may charge a mezzanine rate of interest in certain cases
• Seller may receive warrants in certain cases• May or may not be worth more than deferred
interest• But warrants may qualify for capital gains
treatment
Financing Considerations
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• If there is a prior bank loan, seller note will be subordinate to bank loan
• C corp dividends and S corp distributions on both allocated shares and unallocated shares can be used to repay an ESOP loan
• But dividends and distributions paid on a prior block of stock cannot be used to make loan payments on a loan used to acquire a second block of stock
Second Stage Transactions
Financing Considerations
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Incentive Plans for Key Employees
• Key employees receive a relatively small percentage of the ESOP shares
• Banks and some large suppliers may require that key employees have skin in the game
• Available tools• Deferred Compensation • Phantom Stock Plans• Stock Appreciation Rights (SARs)• Stock Options• Stock Purchase Plans• Management Stock Bonus Plans
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Menke’s Total ESOP Servicing
RECORD
KEEPING
SERVICES
EMPLOYEE
COMMUNICATIONS
FINANCING
SERVICES
VALUATION
SERVICES
DESIGN &INSTALLATION
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Complete Feasibility
Questionnaire
Analyze ESOP Feasibility
Propose Alternative ESOP
Structures
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Confidential
ESOP
Questionnaire
255 California Street, 10th FloorSan Francisco, CA 94111
Phone: 415-362-5200Fax: 415-398-2260
For a free ESOP analysis, mail or fax this information to:
Over 2,500 ESOPs ESTABLISHED SINCE 1974
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To determine if ESOP is feasible
call or email Michael Pasahow or Chuck Bachman
(415) 362-5200
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go to: www.menke.com