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  • Writer's pictureRobert M. Fields


Introduction: As you may know, leveraged ESOPs are quite popular with individuals desiring to sell their closely-held businesses or refinance/restructure outstanding debt. This is mainly due to the tax advantages applicable to these transactions, including (i) the company’s ability to deduct contributions to the ESOP that are used to amortize both the interest and principal of the ESOP loan and (ii) in many cases, the ability of the sellers to indefinitely delay the recognition of capital gains on company stock sold to the ESOP.

It is important to note that since an ESOP is a tax-qualified retirement plan, it is subject to virtually all of the rules applicable to similar plans, such as 401(k) plans, including (for example) the minimum participation, vesting and anti-discrimination rules. However, in practice these rules are easy to satisfy when designing an ESOP program.

The following are the steps that must be taken in order to successfully consummate a sale to an ESOP.

I. Engage an Investment Banker or Valuation Firm:

In order for the ESOP transaction to satisfy certain requirements imposed under ERSIA, the sales price cannot exceed the fair market value of the company. This determination must made by an independent appraiser pursuant to certain ERISA mandated procedures. Often an investment banker performs this service, and can also assist in structuring the transaction.

II. Determine the Tax-Deductible Amounts that can be Contributed to the ESOP for Purposes of Amortizing the ESOP Loan:

Generally, each year the company will contribute to the ESOP an amount of cash necessary to amortize the ESOP loans. Although the rules for determining the deductibility of contributions are very generous, they are rather complicated, and there may be situations where the contributions necessary to amortize the loans may exceed the annual deduction limits. In this situation the company will be allowed a deduction “carry forward” to future years until all contributions are fully deductible. Nevertheless, it is desirable to perform the contribution / deduction calculations early in the process for financial planning purposes.

III. Find and Engage an ESOP Trustee:

There are a number of individuals/trust companies that serve as “professional” ESOP Trustees. The advantages of engaging a professional ESOP Trustee are that (i) their experience with ESOP transactions can make the whole process flow easier and (ii) it will significantly reduce the chance that the transaction may be deemed to constitute a prohibited transaction in cases where a person related to the sellers serves as Trustee. When interviewing / engaging potential ESOP Trustees it is important to negotiate the fees and costs the Trustee will charge for engaging in the stock acquisition process and the ongoing fees for its general trustee services.

IV. Find a Lender for the ESOP Loan:

This should be a bank or other lending institution that has ESOP lending experience as it will also make the process flow easier. The company should consider the fees and costs the Lender(s) will charge as part of the lending process.

V. Prepare all Required Documentation (with Trustee and Lender input where necessary):

(a) Create the ESOP Plan and Trust Agreement. The ESOP is a tax qualified retirement plan, similar to a 401(k) plan, which is intended to primarily invest in company securities.

Note: As mentioned above, if certain requirements are satisfied, (i) contributions to an ESOP that are used to amortize the stock acquisition loan(s) are tax deductible by the company and (ii) recognition of capital gains for income tax purposes on company stock sold to the ESOP can be deferred by the sellers for a virtually unlimited amount of time. See Section VII, below, regarding “Code Section 1042 Rollovers.” Code Section 1042 is very complicated and must be reviewed carefully with tax advisor(s) prior to the consummation of the transaction.

(b) Back-to-Back Loan Agreements and Promissory Notes – From Lender to the company, and from the company to the ESOP.

(c) ESOP Stock Pledge Agreement(s) to the Lender(s).

(d) Seller Financing Loan Agreement with the company and Promissory Note.

(e) If desirable, warrants issued by the company to the Sellers (in exchange for a low interest rate on the Seller Financing Loan).

Note: This is usually done when the company purchased by an ESOP converts from a “C” corporation to an “S” corporation post transaction in order to take advantage of certain tax benefits. However, in issuing the warrants, the “synthetic equity” rules of Section 409 of the Code must be complied with. It is also very important to note that (i) the value of the warrants will be taken into account by the IRS and the DOL as part of the purchase price (which must be supported by the value of the company) and (ii) the receipt of the warrants may adversely affect a Seller’s ability to take advantage of the Code Section 1042 Rollover. Thus, great caution must be taken by Sellers and ESOP Trustees before these types of warrants are issued.

(f) Stock Purchase Agreement (and related documentation) between Sellers and Trustee.

(g) If current owners will manage the company after the sale of the company to the ESOP, a Management Agreement between the Sellers and the company and/or Employment Agreements with other executives.

(h) Executive Incentive Plan, if desired.

(i) Board Resolutions approving all of the above and all of the steps necessary to consummate the transaction.

VI. Other Pre- and Post-Closing Steps to be Engaged In:

(a) Finalize legal considerations regarding the transaction:

1. If any compensation paid to certain individuals can be construed as “parachute payments,” confirm that the golden parachute provisions of Code Section 280 do not apply or, if they do, make sure that the shareholder approval exception to the application of Section 280G is complied with.

(b) If the sale of the company’s stock to the ESOP will qualify as a Code Section 1042 transaction (See Section VII, below), and if the Seller(s) desire to utilize the tax benefits available under Code Section 1042, certain “qualified replacement property” must be identified.

(c) The Trustee must perform its “due diligence” on the company to make sure that the transaction is fair from the ESOP’s standpoint. As mentioned in Section III, above, the Trustee may charge for its time and costs for engaging in this exercise. However, any purchaser, whether or not an ESOP, will also take these costs into account when determining the amount it is willing to pay for the company.

(d) The Lender also will want to perform its due diligence prior to making the loan.

(e) If deemed necessary, the fair market value of the company (and, accordingly, the sales price) should be “brought down” from the date of the initial valuation by the independent appraiser to the transaction date. This would help the sellers avoid ERISA prohibited transaction issues if the fair market value of the company decreased from the date of the initial valuation because, as noted above, the sales price can be no greater than the fair market value of the company on the date the transaction is consummated.

(f) Obtain D&O insurance for the company’s post-closing management/directors.

(g) If desired, obtain an opinion letter from the IRS approving the sale as a Code Section 1042 transaction. This may take a significant amount of time and is typically recommended for large transactions.

(h) Close the transaction.

(i) Sellers purchase the Code Section 1042 replacement property within the period beginning three months before, and ending 12 months after, the date of the sale of company stock to the ESOP (see Section VII, below).

(j) File the ESOP and related Trust with the IRS for a formal determination that the ESOP and Trust satisfy the requirements for tax-qualified status. This process can take as long as six months or longer. However, if the ESOP and Trust are filed with the IRS on a timely basis, any drafting changes required by the IRS can be made retroactively to the date the ESOP and Trust were established.

VII. Code Section 1042 Rollovers:

Generally, individuals who, in the aggregate, sell at least 30% of the stock of a privately-held “C” corporation to an ESOP are entitled to a significant tax break under Section 1042 of the Code. They do not have to pay tax on any capital gains at the time of the sale if the proceeds are used to purchase “qualified replacement property” (generally, equity and certain debt securities of operating companies) within a short time before or after the consummation of the transaction. It is important to note that the Code does not require that the actual proceeds from the sale be used to purchase the replacement property. It is only necessary that the sellers use whatever assets they have (or can obtain) to purchase the replacement property within the allowable time period.

In a 100% bank financed transaction this tax provision is easy to satisfy. The sellers would simply take the cash they receive from the sale, invest in the replacement property, and pay capital gains only when the replacement property is sold (with the basis of the replacement property being equal to the sellers’ basis in the company securities sold to the ESOP).

However, in a partially or completely seller-financed transaction this is not so easy. If, as is often the case, a portion of the purchase price paid to the sellers may be in the form of a note from the company, they may not have other liquid assets sufficient to take full advantage of the capital gains rollover. In situations like this, sellers have historically borrowed cash from a bank or other lender to be used to purchase the replacement property. As collateral for the loan, the sellers often pledge the note from the company, the replacement property and/or other assets to the lender. This works fine so long as the collateral maintains its value during the period that the loan is being amortized. In many cases, the replacement property is composed of sophisticated instruments that are intentionally designed to avoid a decline in value.

Nevertheless, even well-designed financial instruments may not retain their value in the face of a significant economic crisis (such as the one we experienced in 2008), and a decrease in the value of the collateral will most assuredly constitute an event of default that would make the outstanding principal become immediately due and payable.

If the loan to the bank or other lender is non-recourse, the borrower would simply forfeit the collateral (to the extent necessary to satisfy the outstanding principal) and walk away. However, loans like these are seldom, if ever, non-recourse, and if the default occurs at a time when the collateral is worth less than the outstanding principal, the borrowers will be personally responsible for the balance of the loan. In this case, not only will the borrowers realize nothing from the sale to the ESOP, they will incur a negative return to the extent they are personally obligated to repay the balance of the loan to the bank.

It is not my intention that this potential adverse outcome should necessarily deter the consummation of the ESOP transaction. However, it is important to address the issue so that the decision to sell to the ESOP is made on a fully informed basis.

VIII. Certain Post-Closing Considerations:

(a) Generally, benefits payable from an ESOP will be in the form of company stock. However, ESOPs established by privately-held companies must provide participants with the right to “put” their vested shares of stock back to the company when a distributable event (such as termination of employment) occurs.

(b) If the sponsoring employer’s corporate charter or by-laws restrict ownership of substantially all outstanding employer securities to employees or to a trust qualified under §401(a), such as the ESOP trust, or if the employer is an S corporation, the ESOP may distribute all benefits in cash without granting participants the right to demand stock, or the plan may distribute employer securities subject to a requirement that the securities be resold to the employer under terms which meet the put option payment requirements.

(c) Participants who are at least 55 years old and who have at least 10 years of participation in the ESOP must have the right to “diversify” the holdings in their accounts.

These provisions may require a company to have a “market” in place for the stock held by an ESOP in order to implement the put option and diversification rights.

IX. Ongoing Trustee Fiduciary Requirements:

As a plan fiduciary the ESOP trustee is responsible for insuring that investments by the ESOP are, and remain, prudent. Thus, if the value of the company stock held by the ESOP significantly decreases, the trustee may be required to liquidate the ESOP’s holdings and terminate the plan.

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