100 % "S" Corporation ESOP

100% "S" Corporation ESOP -The Evolution

From 1974 to 1997 "S" Corporation ESOP did not enjoy very much popularity. Under the old law, each equity holder of an "S" corporation would receive a K-1, including the ESOP Trust, and each would report their share of the "flow through" income on their respective income tax reporting form. Under the old law the trust would have to report and pay tax on its pro-rata share of the income under what is called "Unrelated Business Income Tax" or ("UBIT"). UBIT is a tax imposed on not-for-profit, or non-taxing, entities for income that is considered "outside" the not-for-profit purpose. Prior to 1997, the income reported on the K-1 that was allocated to the trust under an "S" corporation ESOP was subject to UBIT. Under the Taxpayer Relief Act of 1997 (effective January 1, 1998) UBIT is no longer imposed on "S" Corporation ESOPs. That's right! The K-1 income reported by the trust for its pro-rata share of the profit of the business is not subject to federal or state, corporate or personal income tax for that reporting period.

Abusive "S" ESOP Promoters

Shortly after January 1, 1998, certain consultants and "promoters" began creating multi entity "S" corporation ESOP structures which have been deemed by the IRS and the DOL as abusive. The most common abuse was the "S" Corporation ESOP Management Company. This Company would be created, an "S" election made, with 100% of the stock owned by a newly created ESOP. Several key employees would then become executives of this new entity, which would then enter into a management agreement with the "operating company". Management fees would approximate all, or substantially all, of the pre-tax profit of the operating entity; thereby reducing or eliminating most of the corporate income tax liability of the operating entity. Management fees would be considered gross income to the "S" corporation with salaries and wages deducted. The pre-tax income reported on the form K-1 would be reported by the trust and under the new law is free from income tax. This would have the affect of allowing most of the management fee to escape tax and accrue 100% of the retirement benefit to a small number of key executives and family. As a result of this, and other related abuses Congress enacted, as part of the Economic Growth and Tax Relief Reconciliation act of 2001, IRC §409(p). This code section, in affect created what is termed as the 10%/20%/50% Allocation Rules. Here is how it works:

• Any individual who owns 10% or more of the outstanding stock of the company (stock to include actual equity, synthetic equity, and stock in the ESOP, allocated or not allocated) is deemed to be a "disqualified individual".
• Any family members who collectively own 20% or more of the outstanding stock of the company (stock to include actual equity, synthetic equity, and stock in the ESOP, allocated or not allocated) are deemed to be a "disqualified family group".
• If the total of unrelated disqualified individuals, and the related disqualified family groups, collectively own 50% of the number of outstanding shares (or more), on any given day of any given year, then the plan is deemed to be in a "non-allocation" year.

Under this process there will be a 50% excise tax imposed on any allocation, of any equity, to any disqualified person or family group based on the value of the amount allocated to the account to any above listed person, and for an ESOP's first non-allocation year, an additional penalty of 50% of THE TOTAL VALUE OF ALL THE DEEMED OWNED SHARES of all disqualified persons and all disqualified family groups. The effects of not properly planning to make sure a non-allocation year takes place can be substantially catastrophic to an "S" ESOP. Therefore, only through proper planning can a 100% "S" ESOP work. A deep understanding of ESOPs, as well as the related income tax law is required. The problem with IRC §409(p), from the perspective of the Internal Revenue Service is that the effective date for entities set up prior to March 13, 2001 was to be effective after December 31, 2004. To that end, the IRS felt abuses would continue, so Revenue Ruling 2003-6 was issued. In that ruling the IRS concludes that if an "S" ESOP appears to be set up prior to March 14, 2001 for the purpose of being able to take advantage of the delayed effective date of December 31, 2004, it will not honor the delayed effective date and non-allocation years and excise taxes can and will be imposed. Lastly, in 2004 the service issued Rev Rule 2004-4 treating the previously discussed "S" ESOP structures as a Listed Transaction. Designating certain "S" Corporation ESOP transactions as listed transactions gives the IRS broad power for enforcement, with specific reporting requirements for anyone who may have set up one of these types of ESOPs. What is important to understand here is that if properly structured, an "S" Corporation ESOP or more specifically, 100% "S" Corporation ESOPs that are properly set up can be a significant tool for growing the value of your company. If structured as part of "Combination Planning" motivating all three groups of employees generates substantial results.

Proper Tax Planning with "C" Corp. and "S" Corp. ESOPs

Here is just one example as to how to use these various tools to obtain tremendous results. Starting with the following assumptions:

• Hypothetical Company is in the Specialty Metal Fabrication Business
• Business has developed several "niche" markets over the years and is known as a leader in these markets
• Business has an approximate equity fair market value of $10MM.
• Business does not currently have a management incentive plan or deferred compensation plan.
• Business owner has no children in the business, but has a well qualified management team capable of taking over the day-to-day management of the company within the next three years.
• Sole shareholder is confident that he can grow the business through acquisitions.
• Company is currently an "S" Corporation, but the seller wants to take advantage of IRC §1042 and defer the Capital Gain Tax.
• Business owner wants to take advantage of the corporate tax savings associated with "S" Corporation ESOPs.
• Business owner wants to see the legacy of his business continue beyond his lifetime.
• Business owner wants management to run and own the business after he retires.
• Real property leased by the business is owned by an "S" Corporation, with the stockholder and his family owning the stock.
• Owner has four grown children and nine minor grandchildren.
• Owner has a moderate "charitable intent"
• Owner wants to continue in the business for at least five more years, but does not want to be forced out at any time.
• Owner has worked with his personal financial planner and is comfortable that he and his wife can achieve all of their financial lifetime goals with $8MM or more of liquid assets.

The following represents just one possible solution to this hypothetical business owners set of facts and circumstances. Keeping in mind that facts and circumstances can change over time and that ATICG is not representing or warranting that these strategies will work for any individual without proper planning and review by your estate tax attorney and your personal CPA.

Initial Design and Implementation

Phase One Company:

• Owner converts from an "S" Corporation to a "C" Corporation on the day before selling stock to the ESOP.
• Owner is elected as Chairman of the Board and CEO for a 10 year term prior to the sale of stock to the ESOP.
• Owner will properly renegotiate a long-term lease for the property prior to the sale of stock to the ESOP.
• Owner transfers 20% of his stock to a Charitable Remainder Trust ("CRT"), 20% to a Defective Grantor Trust or a "Dynasty" Trust (depending on what state he lives in) and keeps 60% in his name personally. He names himself the trustee of the CRT and one of his grown children is named as trustee to the Grantor or Dynasty Trust.
• The ESOP is implemented by purchasing 40% of the then outstanding stock for $4MM. Seller will sell the stock that remained in his name, with the balance of the stock placed into a "revocable" trust, aka a "living" trust.
• A properly structured ESOP will include an independent trustee who is an ESOP expert, who will hire independent ERISA counsel and an independent financial advisor to the transaction.
• Management agreements and employment agreements are designed and signed the day of the ESOP as well. Compensation for the management team, to included bonuses for performance in excess of industry, and\or for meeting or exceeding projected profitability (SBV)
• Repurchase obligation of ESOP shares is met through properly designed universal life insurance contracts on the key management team members taking over the business. These policies will be part of a Death Benefit Only ("DBO") plan that will compensate management's estate for loyalty to the company.

Phase One Personal

Now that this first step has been accomplished on the business side, personal planning can begin:

• A IRC §1042 election is made by purchasing $4MM of "Floating Rate Notes" ("FRN") using $400M of the proceeds and investing the remaining $3.6MM in a diversified portfolio of marketable securities based on the seller's determined risk tolerance.
• Seller will receive an approximate $300,000 charitable deduction for the stock contributed to the CRT.
• Seller will receive dividend and interest income from the investments of $4MM net of the "negative spread" on the FRN (interest earned vs. margin interest paid).
• Seller will continue to receive a salary from the Company as CEO (although it might be slightly reduced if needed to help the company cash flow the third party debt on the ESOP).
• Seller will have to make beneficiary determinations for the CRT and the Grantor trust.
• Seller will consider re-capitalizing the "S" corporation that owns the commercial real estate to voting and non-voting stock, and selling a portion of the non-voting stock to the grantor or dynasty trust in exchange for a note. (non-voting stock is valued on a non-controlling\minority basis so DLOC and DLOM valuation discounts will apply).
• Rent collected can be distributed to the shareholders, including the trust(s), which is then used to make the note payments to seller.
• Seller begins to embark on the Operating Company's first acquisition of another company or product line.

Conclusion - What has been accomplished?

As we can see, much has been accomplished under phase one of the integrated plan.  As importantly, the foundation for completing the process has been created with everyone understanding the intent of the seller, the direction of the Company and the roll of each family member going forward.

Accomplishments for the Seller include:

• Has diversified 40% of his holding of the private company stock without giving up control.
• He paid no taxes on the $4MM of proceeds, and in fact received a $300M income tax deduction for his contribution to the CRT.
• Has locked in his income from the rent and begun to get that appreciating asset out of his estate, while securing the business' interest in the property through the long-term lease.
• He has begun the retirement process and has re-characterized much of his income from wages to wages, interest, dividends and capital gain income, all at lower tax rates than wages alone.
• He has made his intentions known to his family, the management team, and his employees and has acted on them during his lifetime.

As for the Company and the Management Team:

• The Company has begun the buy-out process with a $4MM income tax deduction.
• Now has a retirement plan in place that preserves cash for working capital vs. a 401(k) plan that is a cash drain on the Company.
• Management positions have been secured through employment agreements, cash based incentive compensation, phantom stock options, or other non-qualified compensation plans.
• Management will participate in the ESOP.
• Improved employee moral.
• The Company has begun a process whereby the Seller, the Management Team, and the Employees will begin to become revenue and profit growth oriented understanding how that affects them and their retirement.
• The Company has taken a step toward becoming non-taxed entity witch will give the company a competitive advantage over its competition.

As for the Employees:

• They are aware of the owners intent.
• They do not have to worry about the future of the company if something happens to the seller unexpectedly.
• They have a 100% employer contributed retirement plan in place that will grow in value based on their efforts.

Stage Two Design and Implementation

At the appropriate time, when the first loan has been substantially repaid, the owner will engage in a "stage two" ESOP transaction. Since ERISA requires an annual valuation of ESOP shares, the owner will be able to monitor management performance via changes in the value of the ESOP shares. Assuming the same facts, except assume that the Company now has a $14MM equity value, the following steps are completed:

Phase Two (Corporate)

• Company secures a new loan through a third party, through seller financing or combination therein.
• Trustee of the Dynasty Trust and the Trustee of the ESOP agree to allow the Company to make a Sub Chapter "S" election one day after the "stage two" transaction provided it has been five years since the conversion to a "C" Corporation.

Phase Two (Personal)

• CRT sells its 20% to the ESOP for $2.8MM and invests the proceeds in a diversified portfolio of stocks and bonds.
• Shareholder sells his remaining personal holdings of 20% to the ESOP for $2.8MM.
• Seller elects IRC §1042 treatment and defers the capital gain tax on $2.8MM of proceeds.
• Seller invests proceeds in a diversified portfolio of stocks and bonds.
• Seller considers adjusting his salary and benefits going forward based on his determined future roll as CEO and Chairman of the Board. He can even consider resigning as CEO but remain on as Chairman of the Board.

Conclusion - What has been accomplished?

Now that we have completed this phase of planning, let's see what has been accomplished:

For the Company

• Employees now enjoy all the benefits of an 80% ESOP.
• The entire $5.6MM is tax deductible in determining the pre-tax profit of the Company.
• 80% of the pre-tax profit, after deducting for the $5.6MM based on the debt service on the loan, will not be subject to corporate or personal income tax, federal or state going forward.
• The Company does not have to pay taxes on the remaining 20% of pre-tax income that reverts to the trust (distributions by the Company are not required).
• The Company can now begin to aggressively grow revenue and profit by any number of techniques available under the ESOP structure now that the Company is not subject to income tax. Remember distributions are no longer necessary to pay the tax on pre-tax corporate income.

For the Seller

• Seller will receive an income for life from the CRT based on $2.8MM of proceeds (CRT is now funded with liquid assets that can be distributed).
• Seller deferred tax liability sold directly to the ESOP.
• Seller now enjoys income from the $4MM sold to the ESOP from the first transaction plus growth over the last five years, the $2.8MM from the second transaction, and will receive an income from the $2.8MM sold to the ESOP by the CRT.
• Seller can continue to take a salary from the business until the total value of the portfolio reaches $8MM.
• Seller continues to receive note payments from the sale of non-voting "S" stock to the trust as outlined in stage one above.
• All stock and future appreciation from both the operating company and real estate holding company is out of his estate.
• Seller has executed his intentions during his lifetime, therefore, there can be no fighting among his heirs about his intentions after his death.
• Seller and the children in the business do not have to worry about a charity eventually owning stock in the company.
• Through proper planning "estate equalization" takes place without non-working family members becoming shareholders of the Company.
• Since Dynasty Trust is "intentionally defective" they pay tax on 20% of the profit, further reducing the estate.
• Child or children in the business are accruing time towards vesting of stock options and will eventually own the 20% in the trust, plus another 16% to 20% from the non-qualfied compensation plan, depending on determined fairness by the trustee and his financial advisor.
• Children in the business will not have to worry about hostile family shareholders not in the business.
• Children in the business do not have to share future appreciation with non-working shareholders.
• Children not in the business will be more than adequately represented in the parents estate.

Conclusion

As we can see, and as stated previously, corporate transition strategies for the owners of privately held businesses present complexities that require a team approach to problem solving. These professionals must have particular expertise in one or more of the above discussed areas of planning who understand your motives, can work together to accomplish what you desire, and are willing to not force their biases on you. That is why the feasibly and design phase must be completed by a firm that is extremely "entity planning" savvy, has a deep understanding of corporate and personal income tax law, and has extensive estate tax planning experience for owners of privately held businesses. None of your personal plans can be addressed unless you know how your are going to transition the equity in your business. Likewise, you can not determine how you are going to transfer the equity in your privately held business unless you know the value of your company based on multiple definitions of value such as: market value, fair market value, investment value, or synergistic value.  At ATICG we act as the architect during the design phase, giving you the "blueprint" based on your facts and circumstances, we have the expertise to objectively determine the value of your business based on multiple definitions of value, allowing us to help you complete the blueprint based on family values, economic values, and your personal charitable desires. Once a blueprint has been completed to your satisfaction, we move to the "implementation" phase acting like a general contractor working in conjunction with all the professionals necessary to get the task completed.