abc's of esops
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The ABCs of Employee Stock Ownership Plans
Ohio Employee Ownership CenterSouthwest Ohio ESOP Forum
June 17, 2010
David A. Whaley, Esq. Dinsmore & Shohl LLP
© 2010 Dinsmore & Shohl LLP
What is an ESOP?
A retirement plan A way to build wealth A way for employees to participate in ownership
© 2010 Dinsmore & Shohl LLP
Characteristics of an ESOP
It is a “defined contribution” plan– Employees become “participants”
– A “trustee” holds plan assets
– Each participant has an “account” in the trust
– Assets stay in the trust until they are distributed
– 401(k) plans are also “defined contribution” plans
© 2010 Dinsmore & Shohl LLP
Characteristics of an ESOP
It is different from other defined contribution plans– Must invest primarily in employer stock
– May borrow money to buy stock
– May enter into transactions with related parties
– May delay distributions
– Must pass through certain votes to participants
© 2010 Dinsmore & Shohl LLP
How does an ESOP work? Employer establishes an ESOP trust Trust buys shares of the company
– From the company
– From another shareholder
Where does the trust get the money?– From the employer
– From a bank
– From the selling shareholder
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How Does an ESOP Work?
ESOPCompany
(1) $
Shareholder
Lender
(3) Stock
Suspense Suspense Stock 100%Stock 100%
Allocated Allocated Stock 0%Stock 0%
(2) $
(3) $
Sample Transaction - Initiation
(1) Lender makes a loan to Company.(2) Company lends money to the ESOP.(3) ESOP purchase shares from the shareholder
© 2010 Dinsmore & Shohl LLP
How does an ESOP work?
Employer makes annual contributions to the ESOP Contributions are used to repay a loan Shares are allocated to participants
© 2010 Dinsmore & Shohl LLP
How Does an ESOP Work?
ESOPCompany
(2) $
Lender
Suspense Suspense Stock 95%Stock 95%
Allocated Allocated Stock 5%Stock 5%
(1) Contribution
(3)Stock is released
• The Company makes a contribution which is used for the debt payment from the ESOP
• Company makes debt payment to the lender• Stock is released from suspense and allocated to participants as debt is
repaid
Sample Transaction - 1st year
(1) Debt Payment
© 2010 Dinsmore & Shohl LLP
How does an ESOP work?
What happens when the employee leaves?– Shares may be distributed
– ESOP may distribute cash in some cases
– Employee may sell shares to the company or the ESOP
– Distribution may be delayed until loan repayment
© 2010 Dinsmore & Shohl LLP
Why set up an ESOP?
The law gives some advantages to a selling shareholder Section 1042 allows deferral of gain on the sale Strict requirements
– ESOP must own at least 30% of shares– Must be a C corporation– No allocation to owner or relatives– Seller must buy replacement property
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Advantages to the Selling Shareholder Buy out shares of an existing owner
– Section 1042 allows the deferral of gain
$
$ StockStock
JACKOWNER$3 million$3 millionQUALIFIED
REPLACEMENTPROPERTY
COMPANY
Lender
ESOP30% HOLDER
$
© 2010 Dinsmore & Shohl LLP
The S Corp. Advantage
If the corporation makes an S election, then the profits
of the business become wholly or partially nontaxable
© 2010 Dinsmore & Shohl LLP
The S Corp. Advantage
BANKBANK
IRS
Loan Payment
Distribution
Taxes
4
COMPANY
SHAREHOLDERSBANK
ESOP
IRS
PARTICIPANTSAllocatedShares
Loan Payment
1
1
2
3
BANKBANK
IRS
Loan Payment
Distribution
Taxes
44
COMPANY
SHAREHOLDERSBANK
ESOP
IRS
PARTICIPANTSAllocatedShares
Loan Payment
11
11
22
33
© 2010 Dinsmore & Shohl LLP
Advantages for the Employees An ESOP can reward employees who have produced the employer’s
success
ESOPs can be used to assist with a buyout strategy
Research shows employees of ESOP companies have better benefits and pay
ESOPs are a way for a working person to build wealth
© 2010 Dinsmore & Shohl LLP
Some areas of confusion Do employees “own” the stock?
– Not directly – the shares are legally owned by the ESOP trust
Who votes the shares?
– The trustee
– Employees may direct voting in limited circumstances
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Some areas of confusion
Who runs the company?
– Like other corporations, company is run by
Board of directors
Management
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Corporate Structure and Fiduciary Obligations
Board of DirectorsBoard of Directors
OfficersOfficers
Managers
Shareholders
ESOP Trust
TrusteeEmployees ESOP Admin. Committee
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Laws Governing Retirement Plans
Employee Retirement Income Security Act (ERISA)
Internal Revenue Code
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Government Enforcement
U.S. Department of Labor – Employee Benefits Security Administration (EBSA – formerly Pension and Welfare Benefits Administration)
Internal Revenue Service – TE/GE Division
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Settlor vs. fiduciary functions
What is a “settlor” function?
– Generally relates to formation rather than administration or management of a Plan.
– Generally settlor functions are not subject to ERISA’s fiduciary rules.
– Termination of a Plan is a settlor function.
– Exception: appointment of trustee is a fiduciary function.
© 2010 Dinsmore & Shohl LLP
Who is a fiduciary?
ERISA Section 3(21) – Any person who:
– Has discretionary authority or control over management of the plan or plan assets;
– Provides investment advice for a fee; or
– Has discretionary control or responsibility over plan assets.
© 2010 Dinsmore & Shohl LLP
Who is a fiduciary?
Formal title is irrelevant
Depends on actual control/responsibility
“If it walks like a duck and talks like a duck” analogy
© 2010 Dinsmore & Shohl LLP
Consequences of Fiduciary Status
A fiduciary must comply with the fiduciary provisions of ERISA:
– Prudent person rule
– Exclusive purpose rule
– Prohibited transaction rules (similar, but not identical, provisions in the Code)
© 2010 Dinsmore & Shohl LLP
ERISA Fiduciary Standards
ERISA Prudence requirements
– Prudent person rule
Fiduciary must act with the “care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use”
“[ERISA’s] test of prudence…is one of conduct and not a test of the result of performance of the investment. The focus of the inquiry is how the fiduciary acted in his selection of the investment and not whether his investments succeeded or failed.” Donovan v. Cunningham, 716 F. 2d 1455, 1457 (5th Cir. 1983).
© 2010 Dinsmore & Shohl LLP
ERISA Fiduciary Standards
Exclusive purpose rule
– Fiduciaries must discharge their duties for the exclusive purpose of providing benefits to participants and their beneficiaries
© 2010 Dinsmore & Shohl LLP
ERISA Fiduciary Standards
Plan document rule
– A fiduciary must follow the plan documents to the extent that they are consistent with ERISA
– The overall rule of prudence prevails in that if it is imprudent to follow the plan documents, then the fiduciaries need not follow the plan document.
© 2010 Dinsmore & Shohl LLP
ERISA Fiduciary Standards Overall, the basic requirements are prudent
management, ongoing monitoring and documentation.
Process is the key
© 2010 Dinsmore & Shohl LLP
Important Fiduciary Decisions in an ESOPBuying shares
Selling shares
Voting shares
Determining value
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David A. Whaley, Esq. Dinsmore & Shohl, LLP255 E 5th St., Suite 1900Cincinnati, OH 45202(513) 977-8554 | [email protected]://www.linkedin.com/in/davidwhaley