Exit Planning Exchange

By Charles A. Wry, Jr.

The after-tax consequences of buying or selling a business can vary dramatically depending on how the transaction is structured.  Often, what’s good for one party is bad for the other.  The structure of the transaction, therefore, can be driven by the relative bargaining positions of the parties and, in any event, should be taken into account in determining the price.  The consequences of the transaction to employees and other service providers should be considered as well.

I.          Taxable Transaction.

As described below, the owners of a business can sell the business “tax-free” if the business is organized as a corporation and the price to the owners is paid in the form of stock of an acquiring corporation. Otherwise, the sale of the business generally will be taxable to the owners.  If the transaction will be taxable, the tax consequences will depend primarily on (i) the form of organization of the business being purchased (the “Target”) and (ii) whether the buyer (the “Acquiror”) purchases (x) the equity interests in the Target from the Target’s owners or (y) the assets of the Target from the Target.

a.         Target is a Corporation.

1.         Stock Purchase.

If the Target is a corporation, the shareholders of the Target will generally prefer to structure the transaction as a purchase and sale of their stock in the Target.  That way, the gain on the transaction is taxed only once (at the shareholder level) and at capital gain rates.  The Acquiror, on the other hand, may not want to purchase stock because, except as described below under “Stock Purchase Treated as Asset Purchase,” a stock purchase has no effect on the tax bases of the Target’s assets.  Instead, the Acquiror takes a basis in the stock purchased equal to the amount it pays for the stock (and the taxable income inherent in Target’s assets remains inherent in the assets).  Stock is not amortizable.

The Target shareholders may also prefer a stock sale from a non-tax standpoint because the Acquiror assumes the economic burden of any Target liabilities except to the extent that the Target shareholders agree to remain responsible.

A stock purchase may be effected by a direct purchase of the Target’s stock or by a “reverse subsidiary merger.”ⁱ In a reverse subsidiary merger, the Acquiror forms a transitory subsidiary, capitalizes the transitory subsidiary with the cash or other assets to be used as the purchase price (including any borrowed money if the purchase will be leveraged), and then merges the transitory subsidiary into the Target.  When the dust settles, the Target shareholders have the cash or other assets used as the purchase price, and the Target is a subsidiary of the Acquiror.

If the Target stock is “qualified small business stock,” individual Target shareholders who have held their shares for more than five years may be able to exclude portions of their gains.ⁱⁱ

If the Target is an S corporation and owns “collectibles,” a portion of the gain may be taxable at a higher capital gain rate than would otherwise apply.

A stock sale may also be desirable if the Target has assets (such as non-assignable contract rights) that would be difficult to transfer.

2.         Asset Purchase.

If the Target is a corporation, the Acquiror generally prefers (at least for tax purposes) to structure the transaction as a purchase and sale of the Target’s assets so that the Acquiror may “write up” the tax bases of the assets.  By writing up the bases of the purchased assets, the Acquiror can report greater depreciation and amortization deductions with respect to, and smaller amounts of gain (or greater amounts of loss subject to any applicable limitations) upon re-sales of, the purchased assets.  The Target shareholders, on the other hand, may not want to structure the transaction as an asset sale because (i) if the Target is a C corporation  (or an S corporation with assets acquired while it, or any corporation it acquired in a tax-free transaction, was a C corporation), the gain on the sale may be taxable to both the Target and the Target shareholders, and (ii) if the Target is an S corporation, some or all of the gain may be reportable by the shareholders as ordinary income (depending on the Target’s assets and the allocation of the purchase price).

The Acquiror may also prefer an asset purchase from a non-tax standpoint so that the economic burden of the Target’s liabilities remains with the Target’s shareholders.

An asset purchase may be effected by a direct purchase of the Target’s assets or by a merger of the Target into the Acquiror or a subsidiary of the Acquiror.

In an asset purchase, the Target is treated as selling, and the Acquiror is treated as buying, the various Target assets separately for allocable portions of the aggregate purchase price.  The aggregate purchase price is allocated among the various Target assets in accordance with certain tax rules (essentially, by class and fair market value).  Particularly if the Target is an S corporation, the Target’s shareholders will prefer to allocate the purchase price so as to maximize the amount of long-term capital gain to be reported by them on the sale.  The Acquiror, on the other hand, will likely want to allocate as much purchase price as possible to assets that are likely to turn over in the short term or that have short depreciation or amortization schedules.

3.         Stock Purchase Treated as Asset Purchase.

If the Acquiror is a corporation, the Target is an S corporation or a subsidiary of another corporation, and the Acquiror purchases at least 80% of the outstanding stock of the Target, the Acquiror and the Target shareholders may join in making a special tax election to treat a purchase and sale of the stock of the Target as a purchase and sale of the Target’s assets.

Although making such an election allows the Target to step up its bases in its assets, the election may be disadvantageous to the Target’s shareholders for the reasons noted above (possible taxabililty of the Target if the Target is a C corporation or an S corporation with assets acquired while it, or any corporation it acquired in a tax-free transaction, was a C corporation; possibility of ordinary income for the Target’s shareholders if the Target is an S corporation).  In addition, if the Acquiror is not purchasing all of the outstanding stock in the Target, the Target is nonetheless treated as having sold all of its assets.

b.         Target is a Tax Partnership.

1.         Purchase of Interests.

If the Target is a limited liability company (“LLC”) or other form of entity classified as a partnership for tax purposes and the Target’s owners sell their equity interests in the Target to the Acquiror, the Target’s owners are required to report the ordinary income they would have had to report if the Target had sold any “unrealized receivables” (which include, among other things, depreciable property to the extent of any inherent depreciation recapture) or “inventory” (which includes, in addition to traditional inventory, property income from the sale of which would be ordinary) it may have at fair market value.ⁱⁱⁱ Any remaining gain or loss a selling owner of the Target may have on the sale is generally capital gain or loss.  The Acquiror, on the other hand, is treated as having purchased the Target’s assets if the Acquiror purchases all of the outstanding interests in the Target.  Alternatively, if the Acquiror does not purchase all of the outstanding interests in the Target but the Target has a special tax election in effect, the Acquiror will be able to write up its share of the basis of each of the Target’s assets.

2.         Asset Purchase.

As described above, in an asset purchase, the Target is treated as selling, and the Acquiror is treated as buying, the various Target assets separately for allocable portions of the aggregate purchase price.  Thus, because the Target’s owners report their shares of the Target’s income or loss directly, the mix to the Target’s owners of capital gain and ordinary income will depend on the Target’s assets and the allocation of the purchase price.  Like S corporation shareholders in an asset sale, the Target’s owners will prefer to allocate the purchase price so as to maximize the amount of long-term capital gain to be reported by them on the sale.  The Acquiror, on the other hand, will likely want to allocate as much purchase price as possible to assets that are likely to turn over in the short term or that have short depreciation or amortization schedules.

II.         Tax-Free Transaction.

If the Acquiror and the Target are corporations, the transaction may be “tax-free” entirely or in part to the Target shareholders if it qualifies as a “reorganization.”  In that case, the Target shareholders generally report their gains only to the extent of any of their purchase price that is not paid in the form of stock of the Acquiror (or the Acquiror’s parent corporation).  Any gain they avoid reporting remains inherent in the Acquiror stock they receive in the transaction.  The Acquiror writes up the tax bases of the Target’s assets only to the extent of any gain reported by the Target.^iv

There are a limited number of ways for a transaction to qualify as a reorganization.  A detailed discussion of those ways is beyond the scope of this article.  Each way, however, requires (among other things) that a minimum percentage of the price paid for the Target be paid in the form of qualifying stock of the Acquiror (or its parent).  The minimum percentage ranges from 50% (or even lower under judicial authorities) for a straight (i.e., not a reverse subsidiary) merger (an “A” reorganization) to 100% for a simple stock-for-stock swap (a “B” reorganization).

If the Target stock is “qualified small business stock,” the stock of the Acquiror (or its parent) received by a Target shareholder in the reorganization is also treated as qualified small business stock (if it otherwise would not have been) received by the Target shareholder on the date he acquired his Target stock.  The amount of gain that may be treated as gain from the sale of qualified small business stock upon the subsequent sale of the stock of the Acquiror (or its parent) by the Target shareholder, however, is limited to the amount of gain built into the Target stock as of the time of the exchange of the Target stock for the Acquiror stock.

III.       Deferred or Contingent Payments; Holdbacks and Escrows.

It is not uncommon for a portion of the purchase price to be paid over time or as certain performance goals are met (the deferred payment obligation may be evidenced by a note or by the purchase and sale agreement.) In addition, a portion of the purchase price may be held back or placed into escrow to secure obligations of the Target or its shareholders to indemnify the Acquiror for breaches of representations, warranties and covenants.

a.         Original Issue Discount.

If a deferred portion of the purchase price does not bear an adequate interest rate, part of the deferred portion may be re-characterized as interest.  In addition, interest that is not payable at least annually as it economically accrues may have to be reported as it accrues on the basis of a constant yield to maturity rather than as it is actually paid (so that the Target or its shareholders may have to report interest income for a year in which they receive no payments).

In the case of a contingent deferred payment, the portion of the payment that is interest is generally the amount by which the payment exceeds the present value of the payment discounted back to the closing date at a “test rate” applicable to the sale (with the present value of the payment being principal).  Contingent interest is generally reported as it becomes fixed (subject to some special rules that apply when the contingent interest is payable more than six months after becoming fixed).

b.         Installment Method.

Generally, a taxpayer’s gain on a deferred payment sale is reported under the installment method unless the taxpayer elects not to use the method.  Under the installment method, the taxpayer computes the percentage which his overall profit on the transaction represents of the overall amount he will receive in the transaction (other than from the purchaser’s assuming or taking subject to certain “qualifying indebtedness”).  He then multiplies each “payment” he receives by that percentage to determine the portion of the payment that is gain.  Payments of interest (including amounts re-characterized as interest) are disregarded in applying the installment sale rules.

The contingent payment provisions of the installment sale rules make some unfriendly assumptions (including that the full amount of any capped contingent payments will be received).  Accordingly, they may distort the reporting of the gain on the sale.

Care must be taken to ensure that escrow and other security arrangements do not result in deemed “payments” to the Target or its shareholders.

Recapture and gains from sales of inventory and publicly traded stock are not eligible for reporting under the installment method.  Care must be taken in structuring deferred payment sales of interests in LLCs and other entities classified as partnerships for tax purposes that hold assets to which the installment method would not apply.

A taxpayer who holds more than $5 million in installment obligations may be subject to an interest charge on the deferred tax liability with respect to the balance in excess of that amount.

Deferred payment sales of stock or assets of S corporations may raise certain special issues or present certain special opportunities related to installment method reporting.  For instance, in an asset sale by an S corporation for cash and an installment obligation of the purchaser, it may be more advantageous to have cash that would otherwise be paid at the closing of the sale instead be paid on the installment obligation shortly after the S corporation has sold its assets and liquidated.

c.         “Tax-free” Reorganization.

If the transaction is intended to qualify as a “tax-free” reorganization, care must be taken to ensure that the arrangement does not jeopardize that qualification.

IV.       Outstanding Options and Restricted Stock.

Often, employees and other service providers of the Target have Target options or shares of restricted Target stock.  The consequences of their participation in the purchase and sale transaction can vary significantly depending on the circumstances.^v

a.         ISOs.

The tax consequences of the transaction to a holder of an incentive stock option (“ISO”) of Target will depend on what the holder receives for the option.

The holder of a Target ISO is generally not taxable on his exchange of the ISO for a new option of the Acquiror unless (i) the value of the stock underlying the new option exceeds the exercise price of the new option (that is, the new option is “in the money”) when he receives the new option and (ii) the new option fails to qualify for treatment as an ISO.^vi

For the new option to qualify as an ISO, (i) with certain exceptions, the terms of the new option must not be more favorable to the option holder than those of the old option, (ii) the spread (the amount by which the value of the underlying stock exceeds the exercise price) on the new option as of the time immediately after the exchange must not be greater than the spread on the old option as of the time immediately before the exchange, and (iii) the value of the shares subject to the new option as of the time immediately after the exchange must not be greater than the value of the shares subject to the old option as of the time immediately before the exchange.

If the holder receives cash or stock for the option, he reports the amount of cash and the value of any stock he receives (less any amount he pays to exercise the option) as ordinary income (unless he receives the stock in a “tax-free” reorganization in exchange for stock of the Target acquired by exercising the option).^vii If any new stock received by the holder is restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.

If the holder exercises the option for stock of the Target and then exchanges the Target stock for stock of the Acquiror in a “tax-free” reorganization, the holder has only a potential alternative minimum tax liability based on the spread at the time of exercise if he holds the stock of the Acquiror for at least a year after exercising the option (and for at least two years after being granted the option).

b.         NQSOs.

Like the consequences to a holder of a Target ISO, the tax consequences of the transaction to a holder of a non-qualified stock option (“NQSO”) of Target depend on what the holder receives for the option.^viii

The holder is generally not taxable on his exchange of the Target NQSO for a new Acquiror option unless (i) the Acquiror option is in the money upon its grant to the holder and (ii) the Acquiror option fails to satisfy the substitution test that would be applicable in determining its qualification as an ISO if the Target NQSO were an ISO.^ix

If the holder receives cash or stock for the option, he reports the amount of cash and the value of any stock he receives (less any amount he pays to exercise the option) as ordinary income.^x If any new stock received by the holder is restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.

c.         Restricted Stock.

The consequences of the transaction to a holder of restricted Target stock will likely depend on whether or not the holder made a timely Section 83(b) election with respect to the Target stock.

If the holder did not make a timely Section 83(b) election with respect to the restricted Target stock, he reports ordinary income on the transaction equal to (i) the amount of cash and the value of any stock he receives for the restricted Target stock less (ii) the amount he paid for the restricted Target stock.  If any new stock received by the holder is itself restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.

If the holder made a timely Section 83(b) election with respect to the restricted Target stock, he generally reports capital gain equal to (i) the amount of cash and the value of any stock he receives for the restricted stock less (ii) the amount he paid for the restricted Target stock plus the amount of any income he reported upon his receipt of the restricted Target stock.  If, however, the transaction is a “tax-free” reorganization, the holder reports gain on the transaction only to the extent of any purchase price he receives other than in the form of stock of the Acquiror (or the Acquiror’s parent corporation).

d.         Golden Parachute Issues.

Special rules apply to payments (referred to as “parachute payments”) in the nature of compensation by a corporation to a “disqualified individual” that (i) are contingent on a change of control of the corporation and (ii) have an aggregate present value equal to at least three times the disqualified individual’s “base amount.”  A “disqualified individual” is an individual who performs personal services for the corporation and who is either an officer or shareholder of the corporation or is among the highest paid 1% or, if less, 250 employees of the corporation.  An individual’s “base amount” is his average annualized compensation from the corporation during the five year period before the year of the change of control.  Under the rules, an “excess parachute payment” (the amount by which any parachute payment exceeds an allocable portion of the disqualified individual’s base amount) is non-deductible by the corporation and is subject to a 20% excise tax in the hands of the disqualified individual.

The acceleration of the vesting of Target options or restricted stock can give rise to parachute issues.  Often, however, the amount that must be taken into account as a payment contingent on the change of control of the Target is limited to the time value of the acceleration (plus an amount reflecting the lapse of the obligation to continue performing services).

If the Target is a private company, the applicability of the parachute rules can be avoided by subjecting what would otherwise be parachute payments to approval by the Target’s shareholders.  Unfortunately, for the approval to achieve its purpose, the right of the disqualified individual to receive the payment must be made contingent on the approval.

V.        Covenants Not to Compete; Consulting and Employment Arrangements.

Key personnel of the Target may be asked not to compete, either individually or on behalf of another entity.  Alternatively, they may be asked to remain employed or available for consulting.

a.         Consequences to the Acquiror.

The Acquiror amortizes the amount payable for any non-compete agreement over fifteen years.  Any employment or consulting payments are deductible by the Acquiror under its regular method of accounting so long as the payments are bona fide and reasonable in relation to the services the Acquiror receives for them.  The Acquiror is generally required to amortize any employment or consulting payments that are not bona fide and reasonable over fifteen years.

In Massachusetts, reasonable non-compete agreements are generally thought to be enforceable so long as legitimately necessary to protect the interest of the payor.  Reasonableness is usually measured in terms of geography and duration.

b.         Consequences to the Recipient.

Non-compete, employment and consulting payments are ordinary income in the hands of their recipients.^xi

“From a standpoint, the reverse subsidiary merger generally allows for the purchase of all of the Target’s stock without the approval of all of the Target’s shareholders.  Generally, though, dissenting shareholders have “appraisal” rights entitling them to receive a judicially determined fair price.

ⁱⁱ The maximum excludible portion has historically been 50%.  The recently enacted American Recovery and Reinvestment Tax Act of 2009, however, increased the maximum excludible portion to 75% for “qualified small business stock” acquired after February 17, 2009 and before January 1, 2011.  Currently, the portion not excluded is taxed federally at a rate of 28%.

ⁱⁱⁱEntities classified as partnerships for tax purposes include LLCs, limited partnerships, limited liability partnerships and general partnerships (so long, in each case, as they have more than one owner and that have not elected to be classified as corporations).

^iv Because any gain is usually reported by the Target’s shareholders rather than by the Target, the Acquiror generally gets no basis increase in the Target’s assets.

^v To keep things simple, unless otherwise noted, we’ll assume that holders of options will receive only new options, cash and/or stock, and that holders of restricted stock will receive only cash and/or stock, of the Acquiror in the transaction.

^vinThe potential taxability of the receipt of an in-the-money option is the result of the enactment of Section 409A of the Internal Revenue Code by the American Jobs Creation Act of 2004.  Among other things (and with an exception for ISOs), Section 409A subjects a service provider who is granted an option at an exercise price below the then fair market value of the underlying stock to tax and a 20% penalty as the option vests.

^viiSection 409A of the Internal Revenue Code should be considered in structuring deferred option cancellation payment arrangements.

^viii It is assumed that Target NQSOs were not already subject to Section 409A of the Internal Revenue Code.

^ix Again, the potential taxability is the result of the enactment of Section 409A of the Internal Revenue Code.

^x Again, Section 409A of the Internal Revenue Code should be considered in structuring deferred option cancellation payment arrangements.

^xi Care must be taken to avoid Section 409A of the Internal Revenue Code in structuring deferred payment arrangements.

For more information, please contact Charles Wry at cwry@ mbbp.com.

By Rob Edwards

I. OVERVIEW OF LEGAL REQUIREMENTS

A. An Employee Stock Ownership Plan (“ESOP”) is usually structured as a tax-qualified “stock

bonus” plan. Properly designed, an ESOP can offer significant financial benefits to the

sponsoring corporation while also providing employees with a valuable stock ownership benefit

at no cost to them.

1. An ESOP must cover a nondiscriminatory classification of employees who have attained

age 21 and completed a year of service (2 years if the plan provides for 100% vesting).

Employees may not otherwise be excluded solely by reason of age or service. Effective in

2007, an ESOP must provide for either graduated vesting of participant accounts, with full

vesting required after 6 years of service, or cliff vesting of participant accounts, with full

and immediate vesting after 3 years of service. Nonvested benefits are subject to

forfeiture if the employee quits or is fired before normal retirement age.

2. Employer contributions to an ESOP can be made in the form of employer stock (valued at

fair market value) or cash. ESOP contributions are tax-deductible within prescribed limits

and may be made under a formula or in the employer’s discretion.

3. Assets held in an ESOP may include employer stock and other investments. ESOP plan

assets must be held in a trust. The ESOP trustee may be an individual or individuals

affiliated with the employer.

4. The ESOP must provide for allocating contributions among participants and for

distributing benefits upon a participant’s retirement, death, disability, or separation from

service.

5. Assets held in the ESOP must be valued at least annually.

6. Benefits may be distributed in the form of employer stock or cash. The participant must

have the right to receive a distribution of stock, unless the employer is an S corporation, or

a bank prohibited from repurchasing its own shares, or the employer’s charter or by-laws

restrict ownership of substantially all employer stock to current employees or to a trust

under a qualified plan. Generally, an ESOP participant must be permitted to elect to begin

receiving ESOP benefits not later than one year after the participant’s death or retirement,

or six (6) years after the participant separates from service for any other reason.

7. If ESOP benefits are distributed in employer stock that is not readily tradable on an

established market, the participant must have a limited right (the “put option”) to require

the employer to repurchase the stock at fair market value. The future cost of repurchasing

employer stock distributed from the ESOP under the put option is referred to as the

employer’s “repurchase liability”. Distributed shares may be subject to a right of first

refusal in favor of the employer and the ESOP.

8. Voting rights with respect to employer stock of a company that is registered under the

Securities Exchange Act of 1934 must be “passed through” on all shares that are allocated

to participants’ accounts. For employer stock that is not publicly traded, pass-through

voting is required for shares allocated to participants only on mergers, recapitalizations,

liquidations, dissolutions or similar major transactions. Unallocated shares, and allocated

shares voted on matters for which pass-through voting is not required may be voted by the

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ESOP fiduciary, on a pass through basis, or as provided in the plan document. An ESOP

established by a nonpublicly traded company may also provide for per capita voting (1

person 1 vote). If per capita voting applies, the percentage of votes cast will govern the

voting of all employer stock (both allocated and unallocated shares) held in the ESOP.

9. If the employer is a member of a controlled group of corporations, the ESOP may be

established by one member with respect to the stock of another controlled group member.

10. Since 1998, ESOPs have been permitted to invest in S corporation stock without adverse

tax consequences.

11. State law often restricts the ownership of shares in a corporation which is authorized to

carry on certain professional practices (e.g., architecture, engineering, accounting,

medicine, etc.) to individuals who hold professional licenses. While ESOPs are prohibited

under the laws of most states from owning stock in such a corporation, the corporation

may be able to establish an ESOP if it qualifies to do business under the general business

corporation act of the state in which it is incorporated, if a “grandfathered” charter is

available, or if incorporation under the laws of another state is possible.

12. An ESOP may be part of a 401(k) plan or arrangement (a KSOP). KSOPs are common in

publicly-held companies. Some nonpublic companies have also adopted KSOPs to fund

matching contributions to their 401(k) plans in the form of employer stock, and to help

create a market for their stock. KSOPs which allow participants to elect to invest their own

salary reduction contributions in employer securities must comply with federal and state

securities laws.

13. An ESOP must comply with all Internal Revenue Service and Department of Labor rules

and requirements applicable generally to qualified employee benefit plans.

B. Special qualification requirements apply to “leveraged” ESOPs. A leveraged ESOP is designed to

use borrowed funds (an “exempt loan”) to purchase employer stock, with the loan repaid from

future employer contributions to the ESOP, plus dividends on the shares purchased with the

exempt loan proceeds. An exempt loan almost always involves a guarantee or extension of credit

(this may take the form of an installment purchase obligation) between the ESOP and a

“disqualified person” (usually the sponsoring employer and/or its shareholders) that would be

prohibited in any other kind of employee benefit plan.

1. A leveraged ESOP must be designed to invest primarily in “qualifying employer

securities”. This generally means either voting common stock with full dividend rights, or

preferred stock that is readily convertible into voting common.

2. A leveraged ESOP must provide for the release of financed shares that are held in the

ESOP’s suspense account as the exempt loan is repaid. The release of employer stock

under the ESOP must be made under one of two alternative methods. One method allows

the release of employer stock in proportion to the repayment of principal and interest on

the exempt loan. The other method allows for employer stock to be released in proportion

to the amount of principal only repaid on the exempt loan.

3. Employer stock of a company that is not publicly traded held in a leveraged ESOP must be

valued annually by an independent appraiser.

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4. A participant age 55 or older with 10 or more years of participation in a leveraged ESOP

must be offered the option to “diversify” his or her ESOP account. The option is

exercisable annually over a period of 5 years, and allows a qualified participant to direct

the investment of 25% of the employer stock that has ever been allocated to the

participant’s ESOP account (including any stock diversified under prior elections) into

investments other than employer stock. If the leveraged ESOP does not offer at least three

investment options inside the ESOP, the participant must be allowed to cash out the

diversified amount or to have the diversified portion of the account transferred to another

qualified plan which offers three or more investment options. In the sixth and final year of

the option period, the participant must receive a similar one-time option covering 50% of

the account. Cashout distributions are eligible to be rolled over into an IRA. KSOP

arrangements which allow investment in publicly traded stock are subject to more rapid

diversification requirements.

5. Leveraged ESOPs benefit from certain favorable rules:

(i) Effective for plan years beginning in 2002, the general limit on deductible

contributions to individual account plans was increased from 15% of covered

compensation to 25% of covered compensation. However, an employer taxable as a C

corporation may deduct all contributions to a leveraged ESOP which are used to pay

interest on an exempt loan, plus loan principal payments up to 25% of covered

compensation. S corporation deductible contributions are limited to 25% of covered

compensation

(ii) Dividends paid on employer stock held in a leveraged ESOP are tax deductible if they

are distributed currently to participants in cash, used to repay an exempt loan the proceeds

of which were used to acquire the employer securities with respect to which the dividend

is paid, or at the election of the participant, invested in the plan in employer stock.

Distributed dividends are also exempt from the 10% penalty tax on early distributions to

employees under age 59 1/2. Distributions with respect to employer stock of an S

corporation are not deductible, and are subject to the 10% penalty tax if the recipient is

under age 59 1/2.

(iii) Dividends on C corporation stock and S corporation distributions may also be used to

repay an exempt loan, provided that employer stock equal in value to the dividends (or

distributions) paid on allocated shares is allocated to the participants’ accounts.

(iv) A leveraged C corporation ESOP is permitted to allocate forfeitures and interest on an

exempt loan under a special provision of Section 415 of the Internal Revenue Code, if not

more than one-third of employer contributions for the year are allocated to highlycompensated

employees. If this special rule applies, the only amount taken into account

for Section 415 purposes is the principal reduction on the exempt loan. Interest on the

exempt loan, deductible dividends and forfeitures of employer stock acquired with an

exempt loan are not included in calculating the maximum permissible allocation. A stock

bonus or profit-sharing plan, in contrast, must include all allocations of principal, interest

and forfeitures in computing the Section 415 limitations.

(v) An ESOP participant who receives a lump sum distribution of employer stock will

only be taxed on the ESOP’s cost basis for the stock. The “net unrealized appreciation”

(the difference between its fair market value at the date of distribution and its cost to the

ESOP) is not taxable until the stock is sold. This favorable tax treatment extends to

distributions from stock bonus and profit-sharing plans.

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6. To guard against the possibility of self-dealing, leveraged ESOP transactions are subject to

special regulatory scrutiny to ensure that the transaction is primarily for the benefit of

ESOP participants and their beneficiaries. Purchases and sales of employer stock held in a

leveraged ESOP are subject to fiduciary rules enforced by the Department of Labor,

including the requirement that the ESOP cannot pay more than “adequate consideration”

for employer stock.

7. For newly formed ESOPs, and existing ESOPs after 2004, severe tax penalties are

imposed on S corporation ESOP sponsors for any year in which “disqualified persons”

collectively own or are deemed to own 50% or more of the corporation. A “disqualified

person” is a person who (i) individually owns 10% or more of the S corporation’s

“deemed-owned” shares, or (ii) collectively with other family members owns 20% or more

of its deemed-owned shares. Deemed-owned shares are the individual’s allocated ESOP

shares, a proportionate share of any unallocated ESOP shares, and any “synthetic equity”

owned by disqualified persons. Synthetic equity is broadly defined to include the right to

acquire stock of the corporation or to share in the corporation’s value or growth through

equity-based compensation. These rules are complex, but will generally preclude small S

corporations with ten or fewer employees from adopting an ESOP. Corporations with up

to 50 (or more) participating employees will also need to carefully monitor their ESOP

program to ensure compliance.

II. ADVANTAGES OF LEVERAGED ESOP FINANCING

 

A. Section 1042 Rollover for Selling Shareholder. If a leveraged ESOP owns at least 30% of the

company after purchasing employer stock, a selling shareholder who has held (for at least 3 years)

employer stock that was not acquired in a distribution from a qualified plan or in an employmentrelated

transfer, may qualify for nonrecognition of gain under Section 1042 of the Internal

Revenue Code if the seller reinvests in “qualified replacement property”. Qualified replacement

property includes stocks, bonds, notes and other evidence of indebtedness issued by active U.S.

operating companies. In order to qualify for the rollover, the qualified replacement property must

be purchased within a 15-month period beginning 3 months before the sale, and the employer must

consent to the nonrecognition treatment and agree to pay a 10% excise tax in case of certain

premature dispositions of the acquired securities within 3 years after the sale. In addition, the

seller, the seller’s family members and 25% or more shareholders are prohibited (or restricted in

certain cases involving a selling shareholder’s lineal descendants) from receiving allocations of

acquired shares. Sales of S corporation stock are not eligible for the tax free rollover.

B. Tax Benefits for ESOP Sponsor. Because the ESOP sponsor can deduct its entire ESOP

contribution, principal as well as interest paid on the ESOP loan becomes, in effect, tax-deductible.

This affords ESOP financing an immediate advantage over a conventional loan, although the

liquidity necessary to fund the employer’s future repurchase liability (see I.A. 7.) needs to be

considered. In addition, the increased contribution and allocation limits, and deductible dividends

available to leveraged C corporation ESOPs (See I.B.5) add even more flexibility to leveraged

ESOP financing.

5

III. PRINCIPAL REASONS FOR A COMPANY TO ADOPT AN ESOP

 

A. Business Succession. A leveraged ESOP creates an immediate market for the sale of a founder’s

stock. The founder benefits by deferring income tax on the sale proceeds, and the employees

benefit by acquiring a significant interest in the employer without any cost to them.

B. Financing Vehicle. A leveraged ESOP can be used as a vehicle to obtain financing for the

employer, with a full tax deduction allowed for ESOP contributions used to repay principal as

well as interest.

C. Employee Productivity. An ESOP can serve as a means of enhancing employee productivity by

providing substantially all employees with an economic stake in the financial success of their

employer. A sound ESOP communications program is essential to help ensure that this benefit is

realized.

IV. ILLUSTRATION OF ESOP BENEFITS

 

A. Leveraged ESOP. Assume that DEF Engineering, a C corporation, is valued at $2,000,000 and

that D, the principal owner, wants to sell a 70% interest in the company to an ESOP for

$1,400,000. The ESOP will borrow the funds and repay the loan in level annual installments over

7 years at 9%. The following table illustrates the potential ESOP tax savings in this transaction

compared with a stock redemption:

COMPANY

REDEMPTION ESOP

1. TOTAL INTEREST AND PRINCIPAL PAYMENT $2,013,018 $2,013,018

2. TAX DEDUCTIBLE PORTION $613,018 $2,013,018

3. TAX BENEFIT AT 34% $208,426 $684,426

4. NET AFTER-TAX COST (1 – 3) $1,804,592 $1,328,592

As illustrated above, the potential federal tax savings to the Company in this example is $476,000, which

represents the difference between the after-tax cost of a stock redemption loan versus an ESOP loan.

B. Additional Rollover Benefits. If D makes a qualifying Section 1042 rollover, the total tax

benefits in the transaction are significantly increased. If D had only a nominal tax basis in his

stock of DEF, his federal tax savings could be as much as $280,000. The total federal tax

benefits for the employer and the selling shareholder in the $1,400,000 transaction illustrated

could amount to as much as $756,000, or 54% of the sale proceeds. Additional tax savings for

both the employer and the selling shareholder may be available under state law.

C. Nonleveraged ESOP Financing Alternative. As an alternative to the leveraged ESOP illustrated

in IV. A. above, it is possible to obtain many of the ESOP’s financing advantages with a

nonleveraged ESOP or even a profit-sharing plan in conjunction with a loan to the company.

This technique involves a redemption of stock by the company which then makes tax-deductible

contributions of employer stock to a qualified plan each year in an amount equal to the principal

6

value paid down on the loan during the year. Because the fair market value of contributed stock

is tax-deductible, the company has, in effect, obtained a deduction for the principal repaid on its

loan. This alternative method has some advantages and some limitations in comparison with

leveraged ESOP financing:

1. Advantages.

(i) Avoids prohibited transactions problems.

(ii) Allows use of a profit-sharing or traditional stock bonus plan.

(iii) If the value of stock increases over the loan period, the number of contributed

shares is reduced. This results in less dilution of shareholders’ equity, and spreads

dilution over a greater period.

(iv) Greater flexibility.

2. Limitations

(i) A selling shareholder cannot obtain a tax-free rollover.

(ii) Financing may be more difficult to obtain for a stock redemption than for an

ESOP.

(iii) Higher deduction limits apply to a leveraged ESOP, so larger deductible

contributions are permitted.

(iv) A leveraged ESOP may have a greater effect on employee productivity.

 

Rob Edwards is a partner with Steiker, Fischer, Edwards & Greenapple, P.C.

The Foundry Corporate Office Center

235 Promenade Street, Ste. 497,

Providence, RI 02908

tel. – 401/632-0480

 

By Michael Oleksak

In the early days of my consulting practice, I met with the owner of a small manufacturing business. The owner had just learned he had inoperable cancer and confided that he would be dead in about six months. He did not have a succession plan but hoped his daughter, who was then 22 years old, would take over the business.  The owner wasn’t sure because he had not discussed this plan with his daughter yet.  Ultimately, the business owner turned to his accountant, who was also a close family friend, to oversee the transfer of the company to his daughter while the accountant stayed on as advisor. Because it was cancer, the owner had time to draw up a will and organize his estate.

His succession plan for the company, however, started with hoping his daughter would take over its management. His exit strategy had been determined by his health.

Prepare for Sudden Changes in Management or Ownership

Imagine you were this business owner’s commercial banker. Your small-business borrower drops this situation in your lap. Your first reaction is disbelief: This middle-aged man looks healthy. Then you become sad because you know and like this person.  But when you hear the owner’s succession plan is to hope he can leave the company to his young daughter, you wonder: “What experience does this just-out-of college daughter have?  Have I even met her?” This leads to more questions.

• How will employees react?
• How will customers react?
• How will you as a lender react?
• What is the future of this company?
• Will it stay financially healthy enough to repay the loan?

No question, the lender’s risk just went up. Should the interest rate rise as well? Is there a change of ownership clause in the loan agreement?  The owner’s terminal illness is not his fault. It is, however, his responsibility to prepare for eventualities like his own untimely death. His family, employees and company rely on his leadership and foresight to anticipate future issues.

By the same token, it is the commercial lender’s duty to ask tough questions to protect the bank’s position. Even if there is a change of ownership clause, you as the lender are in the same boat as your borrower. You want the company to succeed so the loan will be repaid or taken over at some point by another lender. No other lender will want to step in now unless the conditions can be improved with a defined succession plan along with increased collateral or financial support.

Understand the Owner/Manager’s Exit Strategy

Commercial lenders should address this risk by understanding the exit strategy of every owner/manager in their loan portfolios (if these owners even have an exit strategy).  The exit strategy will have a big influence on the strength of your credit as well as on the viability of your relationship with the company.

The exit strategy can lead to a conversation about whether the owner has a will and a succession plan. If the owner has not made a will, this could mean that ownership of the company’s shares is undecided or that the shares could land in the hands of under-prepared family members in case of the owner’s sudden death.

Case in point: Miami Dolphins owner Joe Robbie, a successful real estate attorney, did no estate planning before his death. His heirs had to sell the Dolphins franchise and Joe Robbie Stadium at fire-sale prices to pay estate taxes. The family fractured over the crisis, and Robbie’s legacy is not his successful real estate development career but the poor planning that harmed his family.

As a lender, you need to ask about an owner’s succession plan and whether the firm has the management depth and clear operational assignments to survive a surprising end to the owner’s life or incapacitation. A lender who asks these questions can prompt a business owner to develop a strategy and address shortcomings, thereby alleviating the lender’s concerns about unforeseen occurrences.

What are the possible outcomes for an owner-managed business besides the dire circumstances just addressed? Let’s look at two, both with different implications for the commercial lender: internal transfer and external transfer.

Internal Transfer

An internal ownership transfer could be (1) a sale to the management team, known as a management buyout; (2) a sale to employees via a tax-advantaged employee stock ownership plan (ESOP); or (3) a gifting of shares, usually to the next generation of the family, also with significant tax benefits. If the internal transfers are for less than 50 percent of the ownership shares of the company, the owner may stay in control of decisions and finances by controlling the voting stock.

Influence on relationship with lender. With an internal transfer, the lender should already be familiar with management if there is a change. With a management buyout, the lender should know the individuals taking over and must make a decision about whether the new team can lead the company despite the increased debt to finance the transaction. If not, the bank will ask to be paid out of the loan.

With an ESOP, the transaction will often be for less than the control of the company, a way for the owner to share with loyal employees by giving them an equity stake. A lender’s decision making should be the same, however, given greater debt on the books to finance the purchase. Gifting of company shares may be done in stages, so the current owner or management team may still be in control.

In all of these scenarios, what role will the current commercial lender play? No outside financing source will know the debt-service capability of the company better than the current lender, making it likely that the current lender will be the first invited to stay on to provide loans and services, including financing an internal transaction or ongoing operations.

All these scenarios could be subject to a change of ownership clause in the loan agreement, allowing the lender to opt out if not satisfied with the new ownership structure.

External Transfer

An external transfer would be a sale, either to a strategic buyer (such as a competitor) or to a financial buyer (such as a private equity investor). Because the external transfer will likely be for at least a majority of the shares, the owner will likely be out of the picture in a few years.

Influence on relationship with lender

With external transfers, it is likely that the private equity group or strategic buyer will have its own stable of lenders. By keeping the lines of communication open with the company and the prospective financing team, as well as expressing interest in taking at least a piece of the financing, however, the current lender may well have a role in the new loan or be kept on to provide some services.

Exit Strategy: Not Always Obvious

Commercial lenders are not often thought of as trusted advisors to a company’s business owners. Trusted advisors are generally the company’s CPA, attorney, and, sometimes, the owner’s investment advisor. The fault is not with the banker. Decades ago, the relationship was closer. However, successful lawsuits for lender liability cases have influenced lenders’ behavior. As such, lenders never want their actions to be interpreted by judges as having exerted undue influence over a borrower’s business decisions. Lender liability can result in big financial penalties against the lender.

For this reason, commercial lenders are often out of the loop when it comes to a critical factor influencing the strength and viability of their borrowers: the owner’s exit strategy. Much conversation between a bank and the owner-manager of a business focuses on the owner’s managerial role. It can be hard to get an owner to talk about ownership issues because these often require a discussion of personal and family issues. However, the owner’s exit strategy can have a huge influence on the health of the company and on the bank’s relationship with the company.

A good commercial banker provides numerous services to the owner-managed business, generating considerable fees for the lending institution. Apart from the fees and interest from the loan, the relationship probably also provides income for the bank from cash management services, trade services, account fees and balances.

Sometimes, when the lender is successful in engaging the owner in discussions of exit strategy, the loan and services may be lost anyway. Recently, a 12-store retail chain in the Northeast was sold to a large national retailer. Over the previous year, the lender had actively reviewed all the options facing the owner and the second-generation owners of the family business. In the end, the acquiror will pay out the family members for their shares, and the acquiror’s bank at the corporate level will take over the financing and services. Even with this outcome, the former lender had a good understanding of risk throughout the life of the loan and was able to anticipate some form of upcoming change.

Sources of Strategic Information

The lending officer typically meets regularly with the borrower’s chief financial officer, treasurer, vice president of finance, or controller to discuss the quarter’s results and trends. The lender can use these meetings to ask about ownership issues, including whether the owner has a will, who the beneficiary is regarding the company’s ownership, if there is a succession plan and whether or not there is an exit strategy. If the lending officer is aware of upcoming changes in ownership, the lender can protect the bank’s position as the preferred commercial lender.

The lender can help focus the owner-manager on the future by asking probing and thought-provoking questions about the owner’s will, succession plan and exit strategy. If the owner is reluctant to discuss these issues, the lender should take this as a signal that such plans may not exist.

If there is a board of directors, or board of advisors, the lender should ask these questions:

• Where will the business be in five years?

• Does the owner want to own the business in five years?

• Does the owner want to be managing the business in five years?

• Does the owner have a will?

• Who is currently the beneficiary regarding ownership of the company?

• Is there a succession plan if the owner gets hit by a bus on the way to work?

• Does the owner simply envision the spouse or other relative taking over if something happens?

Owners Want Their Businesses to Live On

Given the personal nature of these questions and their implied reminder of the owner’s mortality, these can be difficult topics to discuss openly. But the commercial lender is a key stakeholder in a business, and asking such questions protects the bank’s interest and capital.

Ultimately, most owners would like their businesses to carry on and thrive even after they are no longer active participants in it.

Creating and sharing details of a will, succession plan and exit strategy with their lender can help build toward a longer, successful existence for the business.

 

Michael Oleksak was a lender for 17 years at Bank of Boston. He is a principal at Trek Consulting LLC, Woburn, Massachusetts and co-founder of the Exit Planning Exchange. He works with small and medium-sized businesses to increase value and prepare for exit. Contact him at oleksak@ trekconsulting.com.  www.trekconsulting.com

© Copyright 2010 Michael Oleksak. All rights reserved.