The ESOP Plan Advisors

The ESOP Plan Advisors 1

ESOP strategies to diversify your business and preserve your legacy

We have been asked many tax considerations in their Our goal is simple: to help you times why we specialize in companies while helping to grow more than wealth. An ESOPs. The answer is simple— resolve matters of wealth ESOP can be an effective tool we believe in small and middle transfer and business to help you achieve this goal. market businesses. It is so succession. satisfying to watch a person grow an excellent idea, product Listed U.S. company count is down 46% from peak or solution into something Domestic companies listed on U.S. exchanges, thousands they can be proud of and turn Source: https://ca.finance. into a legacy. yahoo.com/news/jp- startup-public-companies- fewer-000000709.html Business owners often use Listed U.S. company count employee ownership is down 46% from peak. plans (ESOPs) to address (Image: JP Morgan liquidity, diversification and Asset Management)

Investment and insurance products offered through RBC Wealth Management are not insured by the FDIC or any other federal government agency, are not deposits or other obligations of, or guaranteed by, a or any bank affiliate, and are subject to investment risks, including possible loss of the principal amount invested. 2 RBC Wealth Management

What is an ESOP?

An employee stock ownership plan (ESOP) is a qualified plan that provides tax advantages to both the employer and employees. Similar to a traditional profit sharing plan, an ESOP offers many additional advantages.

Benefits for the employer Benefits for the employee ESOPs provide a unique way for A unique aspect of ESOPs is that business owners to diversify their risk benefits are paid to participating on a tax-advantaged basis. They allow employees in the form of company business owners to cash out some or stock. A trust fiduciary sets up all of their equity in the company while individual accounts within the trust keeping operational control. Closely for each participating employee. The held business owners can use an ESOP employer then contributes either cash as an excellent estate-planning tool that or shares of company stock to the trust generates liquidity for their shares and on behalf of participating employees. creates succession options for those If employers make cash contributions, involved in the business. the trust uses that money to purchase shares of company stock either from Designed to invest mainly in the stock shareholders or from the company itself. of the employer, an ESOP can be a stock bonus plan or a combination An ESOP is an excellent way to reward stock bonus plan and money purchase employees with retirement benefits at plan. The Internal Revenue no cost to them while inspiring them to Code (IRC) gives tax incentives to participate in the growth and success employers who sell their company stock of the company. Because ESOPs have to the ESOP. Companies can benefit many tax advantages, employees do not from tax savings in many ways using this pay tax on the stock allocation to their unique corporate financing strategy. accounts until distributions are taken, usually after retirement. The ESOP Plan Advisors 3

Who qualifies for an ESOP?

A growing trend The potential ESOP candidate ESOPs have existed for many years. While each situation is different, here The concept was first developed in the are some characteristics of a possible 1950s and legislation implementing tax ESOP candidate: advantages for ESOPs was passed in • The company must currently be a 1974. From numbering only a handful C corp, or a Sub S, or be willing in the 1970s, today there are more than to convert. 11,000 ESOP plans*. • The company must have sufficient The National Center for Employee collateral or cash flow to support Ownership (NCEO) estimates funded . that ESOPs have 13.7 million plan • A successor management team participants and control over $900 should be in place or developed billion in plan assets*. ESOP legislation over time. continues to provide incentives and advantages to both companies and • The company should have been employees, adding to the attractiveness in business for several years and of this liquidity *. be experiencing steady and controlled growth. Because of the broad appeal of these • The company should have had plans, ESOP candidates can vary widely. strong earnings and cash flow over Most ESOPs (approximately 97 percent) the previous two years and be able are established for privately held to reasonably predict future revenue companies.* Any company—whether a and cash flows (probably more manufacturing, distribution or service important than having hard assets to business—that can borrow enough support the loan). money to fund the ESOP is a viable • The selling shareholders should want candidate. However, high-end service to participate in the future growth of businesses with educated workforces— the company after the sale. such as architecture, engineering or consulting firms—tend to be better represented in ESOPs today.

*National Center for Employee Ownership (NCEO). 4 RBC Wealth Management

Why business owners choose ESOPs

Three key reasons why business owners Exit strategies choose ESOPs as their financing strategy Baby boomers are retiring rapidly these of choice are: 1) tax advantages; 2) exit days and over the next four decades, strategies; and 3) to build company value. approximately 30 to 40 percent of businesses in the U.S. will be changing Tax advantages ownership as a result*. ESOPs offer Currently, the tax code gives sellers the important benefits to help company potential to defer capital gains tax while owners make this transition. These giving the company tax deductions of benefits make ESOPs an excellent the transaction price over time, which alternative to other exit strategies. They can enhance cash flow and improve can facilitate family business succession metrics. ESOPs are tax exempt planning and estate planning through and pay no tax on their pro-rata share of the transfer of different types of assets company earnings. In addition, only 30 to family members with different levels percent of the business needs to be sold of involvement. And because ESOPs can to the ESOP to obtain these tax benefits be structured as a series of transactions, and the owner can continue to actively they can be either an intermediate or participate in and receive compensation long-term exit strategy. from the business. Building company value Finally, the tax benefits of an ESOP produce financial rewards not just for ESOPs give sellers the ability to profit the company but also for the owner from building value in the company and the employees. As the employer over many years and to gain liquidity sponsoring an ESOP for your employees, to diversify wealth or buy other assets. your contributions to the plan, whether ESOPs can also be strong motivators in the form of company stock or cash that in services industries by adding to the is used to purchase company stock, are benefits of employees owning stock generally tax deductible on your federal and aligning shareholder interests income return for the year in which you with those who drive shareholder make those contributions. However, to value—employees. ESOPs can also help be eligible for this employer tax benefit, circumvent a poor buyer’s market, help your plan must remain a “qualified” plan. in the transition of franchisee ownership, be structured to take advantage of foreign tax treaty provisions, use other qualified plan investments, facilitate a going-private transaction, and more.

*National Center for Employee Ownership (NCEO). The ESOP Plan Advisors 5

How ESOPs work

The following steps illustrate the way most companies establish an ESOP: Loan “Mirror” Loan Repayment to ESOP 1. A company borrows money to finance the purchase of stock from current Bank/Lender Company shareholders. Commercial 2. The company then lends these funds Loan to the ESOP. 3. A trust is created to buy stock of the Principal & Interest Contributions company on behalf of the ESOP plan. Loan Repayment 4. The company makes annual cash contributions from its operating profits to the trust (which are tax Cash deductible). Diversifying ESOP Trust 5. The trust uses the cash to pay down Shareholder(s) the ESOP loan while a trust fiduciary Shares releases and allocates shares of the company’s stock to the accounts of plan participants (employees) Company Shares according to a pre-established formula. 6. After time, employees are vested based on years of service for the shares in their account. 7. When employees retire or leave the Employees company, they receive a distribution of their vested benefits in the form of cash or company stock. If in stock, the employee can choose to either hold the stock or sell it back to the company at fair market value. If the stock is not publicly traded, the employee must have the right to sell the stock to the company at fair market value. 6 RBC Wealth Management

IRC §1042

IRC §1042 and qualified are called by the issuer, or sold. Thus, a to 90 percent or more of their market replacement property business owner might be able to defer, value. As a result, business owners or possibly eliminate, capital gains on can monetize them by borrowing a A 1042 ESOP Exchange allows a the sale of their business. substantial portion of their market value shareholder to exchange his or her and then reinvesting the borrowed interest in a private company for a Wealth management and ESOPs funds in a diversified portfolio of , portfolio of qualified replacement bonds and other assets. property without paying any capital gains Business owners can generate income taxes on the transaction. Capital gains from their qualified replacement property by investing in high- The investment portfolio can then be tax is deferred as long as the qualified actively managed without triggering tax replacement property is held. Through stocks or long-term fixed-income securities. While this approach does on the deferred capital gains resulting the use of IRC §1042, the Qualified from the ESOP sale. Business owners Replacement Property (QRP) is assigned not allow them to access the securities directly without triggering tax will have to pay interest on their margin the basis of the original investment. loan, but the rate will be relatively low If certain requirements are met, consequences, it does generate current income. and the interest paid may be partially investments that qualify for QRP include: or fully offset by the interest earned on • Common stock Business owners can invest in floating- floating-rate ESOP notes. • Preferred stock rate notes, which are sometimes referred to as ESOP Notes because Reinvesting the proceeds from an ESOP • Convertible bonds they were designed specifically for is complex and requires the assistance • Corporate fixed rate notes ESOP sales. These are securities issued of a professional who is well versed • Corporate floating rate notes (FRNs) by major corporations, which have in ESOPs and qualified replacement that allow active investment portfolios maturities of 30 to 40 years or more properties. Business owners do not want and offer a variable interest rate based to find themselves liable for taxes they If a U.S. corporation uses 50 percent or on a short-term market index. The thought they had deferred or unable to more of its assets in an active trade or rate is typically monthly or quarterly, withdraw assets for fear of triggering tax business and does not receive greater depending on the security. consequences. than 25 percent of its gross receipts from passive income, the securities can Highly rated floating-rate notes are be used as QRP. These strategies let the often the first choice for investors in business owner sell their business and qualified replacement property because defer the tax until the securities mature, they are typically marginable for up The ESOP Plan Advisors 7

Example of how an ESOP works

The tax basis in the business owner’s 1. The wnero owned the stock for at company is $200k. The owner is least three years and did not receive it considering either an outright sale or an as part of a compensatory transaction ESOP, both of which have been valued 2. Post-transaction, the ESOP will own at $10 million, meaning the business at least 30 percent of the company appreciated $9.8 million. Under the sale 3. The company is organized as a scenario, the business owner will pay C corporation at the time of the ESOP the 23.8 percent long-term capital gains tax on the appreciated value, or $2.33 4. Qualified Replacement Properties million, reducing net proceeds to $7.5 (QRPs) must be purchased within the million. Under the ESOP, the business 15-month period ending 12 months owner can defer the capital gains after the sale to the ESOP tax and receive the full net proceeds Other requirements apply, including the of $10 million under the following filing of certain documentation with the circumstances: IRS, so you should always consult your tax and legal advisors.

Sale not using Sale using IRC 1042 IRC 1042 Sale Price $10,000,000 $10,000,000 Less Federal Capital Gain (23.8%) $2,330,000 $0 Less State Capital Gain (Avg. 6%) $600,000 $0 After Tax Dollars $7,020,000 $10,000,000 Difference $2,980,000 8 RBC Wealth Management

Other advantages of ESOPs

In addition to the financial benefits for Having an ownership interest may sellers, an ESOP can also ease concerns boost company morale and give your an owner may have around a strategic employees an incentive to perform sale or a sale to a private equity (PE) better, resulting in greater overall firm. In these types of sales, it’s always productivity. From your perspective as a possibility that the new owner or the employer, increased productivity company will leverage the business and may improve your business’s bottom break apart its operational components line over the long term. In addition, purely for profit, disrupting the business employees who feel well rewarded are and potentially threatening the job more likely to stay with your company, security of its workforce. An ESOP can allowing you to retain quality workers be a great option for owners focused on and reduce your employee turnover rate. preserving the business and supporting the employees after ownership transition. An ESOP is relatively cost effective With most types of employer- An ESOP may boost employee sponsored retirement plans, employer morale and productivity contributions to the plan are made in Along with its tax benefits, an ESOP the form of cash. This is not the case, may offer additional benefits for both however, with an ESOP in which the you and your employees, making employer may contribute shares of it an attractive form of stock-based company stock to the plan. An ESOP employee compensation. One of the that is funded in this manner is often main advantages of an ESOP is that it seen as more cost effective than other provides participating employees a stake types of plans, because there is minimal or ownership interest in your company. cash outlay required on the employer’s This is primarily because plan benefits part. This is something to consider if you are in the form of your company’s would rather use your business’s cash employer stock, and shares of stock flow for purposes other than funding represent a “piece” of the company. employees’ retirement accounts. The ESOP Plan Advisors 9

ESOPs may not be for everyone

Although ESOPs can help business In addition, the company may be owners achieve liquidity and required to repurchase vested shares diversification, offer many tax of departing employees. The funding advantages, and inspire employees of this repurchase must be managed through stock ownership, they can carefully. Also, the equity value of present some drawbacks as well. existing owners is diluted any time a company assumes debt to finance First, ESOPs may not be used in a transaction without reducing the partnership structures or in most number of shares outstanding. professional corporations. Although ESOPs can be used in S corporations as Careful consideration of some of well as C corporations, restrictions and these issues should be weighed lower contribution limits can apply. against an ESOP’s potential tax and other advantages. Second, a conflict of interest under ERISA could result (if not handled properly). An ESOP is both a corporate finance and retirement savings strategy—especially in smaller companies where an ESOP’s fiduciaries might also serve as officers or directors. Situations like this might require the help of independent legal, investment and financial professionals. 10 RBC Wealth Management

About our team

M. Ben Hamilton, AWM Sally Walker Senior Vice President – Branch Service Manager Private Client Group Senior Registered Senior Consulting Group Client Associate (702) 893-8751 (702) 893-8782 [email protected] [email protected]

Kerry L. Withrow, CEPA, AWM Marina Randolph Senior Vice President – Client Associate Private Client Group (702) 893-8707 Senior Consulting Group [email protected] (702) 893-8749 [email protected]

Ryan D’Souza Christine Gehring, CFP®, ® ® Associate Financial Advisor CIMA , CPWA (702) 893-8781 Wealth Planning Consultant [email protected] (415) 445-8431 [email protected]

Terri Criswell Senior Registered Michael Pritts, CFA, Client Associate FINRA Licenses (702) 893-8781 Wealth Management [email protected] Consultant (415) 445-8416 [email protected] Notes

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Notes

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M. Ben Hamilton, AWM Senior Vice President – Private Client Group Senior Consulting Group

Kerry L. Withrow, CEPA, AWM Senior Vice President – Private Client Group Senior Consulting Group

Ryan D’Souza Associate Financial Advisor

Terri Criswell Senior Registered Client Associate

Sally Walker Branch Service Manager Senior Registered Client Associate

Marina Randolph Client Associate

Christine Gehring, CFP®, CIMA®, CPWA® Wealth Planning Consultant

Michael Pritts, CFA, FINRA Licenses Wealth Management Consultant

RBC Wealth Management does not provide tax or legal advice. We will work with your independent tax/legal advisor to help create a plan tailored to your specific needs. RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC. © 2019 All rights reserved. 18-LV-283 (02/19)