Stage Two ESOP Transactions
Our deep experience in ESOP implementation and design, corporate finance, calculation of repurchase liability, executive compensation planning and compliance in the context of the ESOP, and the valuation of ESOP shares, qualifies us to provide unique services to your existing ESOP plan. A stage two sale of stock to the ESOP is the most complex type of ESOP transaction, yet can be the most effective, and therefore, most beneficial to the company, selling shareholder, and management team taking over the day-to-day operations. Often times when the first loan is paid in full, the selling shareholder may have long since retired, management is trying to decide a clear direction for the company over the next several years, and the consultant that installed the ESOP is unavailable. Also, quite often, stage two ESOP transactions will involve plant expansion, consolidation of fractional ownership, the implementation of stock based incentive plans, the purchase of another company, the re-finance of existing debt, or any combination therein. These multi-purpose transactions have an affect on the ESOP, the plan participants, the existing shareholders, the company, as well as the management team taking over the day-to-day operations of the business. Therefore, an integrated approach to the process which includes a long-term growth strategy for the Company is critical. The transaction can be very beneficial, for it allows newly hired employees to participate in the second transaction in a way that they may not have been able to under the first transaction, giving employees a renewed sense of optimism for the growth of the balance of their retirement account. It provides management with the opportunity to accumulate stock outside the ESOP that can be sold to the ESOP at retirement, and if structured properly, can save the Company several million in income taxes over the following several years. The best way to explain the power of this planning tool, is to illustrate with an example. Let's assume the following facts:
Hypothetical Facts
- Company is a "C" Corporation.
- Company is owned 40% by the ESOP & 60% by one shareholder.
- The selling shareholder has one child in the business.
- The seller has 40% of the his stock in a Family Limited Partnership ("FLP") with he, and his children not in the business, being the partner's of the partnership.
- 20% of the stock is in a qualified Sub-Chapter "S" Trust ("QSST"), see combination transition strategies. The child working as an officer in the business is the sole beneficiary of the trust. The shares in the trust have been gifted to the trust or are paid in full. The trust shares are to pass to the child in business at the seller's death, provided that the child is still working as an officer of the business at the time of seller's death.
- Management has done an excellent job of growing the value of the shares and the owner decides to implement a non-qualified stock based incentive plan at the time of the second sale of stock to the ESOP. Some of the management team will earn and receive cash and others will earn and receive stock through a combination of phantom stock options and stock options.
- This sale of stock to the ESOP will qualify for 1042 treatment and the income generated from the proceeds of the sale will provide the seller and his spouse with more than enough income for life.
- The Company is about to acquire several million of capital goods that will give the company an opportunity to increase sales by 40% over the next several years. This equipment will allow the company to expand into a complementary business line that will reduce the cost of goods sold.
Possible Solution
Based on the above facts and circumstances, here is one possible solution that demonstrates what can be implemented with the right team. Keep in mind that these are hypothetcial facts and therefore, this is a hypothetical solution. ATICG does not endorse, by virtue of this writing, this or any other solution, discussed on this web site and all proposed solutions would be recommended to a business only after consluting with the independent trustee, the ERISA attorney, and the independent valuation professional of an existing ESOP. With that said:
The seller enters into an agreement to sell the 40% of the stock in the FLP to the ESOP for a controlling per share price. The seller makes a IRC 1042 election and pays no tax at the time of the transaction. The shareholders then agree to make a Sub Chapter "S" election, which has the affect of immediately reducing the Company's income tax liability by 80% going forward. The stock based incentive plan is executed on the same day as the stock sale, with management fully understanding their roll in the company and its importance for success going forward. The child in the business will participate in the stock based incentive plan with management. The Company will borrow the money to purchase the stock and finance the capital goods. The cost of the capital goods will be a part of the ESOP transaction, through the issuance of previously un-issued shares for the amount of the equipment loan. This will dilute the shares held in the trust, but keep in mind the capital goods purchase will partially offset the dilution over time, due to the fact that it is estimated that the capital goods will spur growth, which should increase share value. The child in the business is also going to participate in the stock based incentive plan which will help to offset dilution over time (see the four powerful uses).
In this example, ATICG would represent the Company and\or selling shareholders by analyzing the possible structures and making a presentation to the board as to the probable acceptable structures. Upon board approval, ATICG would prepare the financing packages, negotiate with possible lenders, work with the ERISA attorney and trustee to make certain eveything is implemented according to plan. As well as work with the valuator to make sure the shares are purchased for a price that is in compliance with the "adaquate consideration" standard, as outlined in the DOL proposed and temporary regulations, work with the trustee to communicate the results of the transaction to the employees and inform the TPA
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