Business Succession Planning & Employee Stock Ownership Plans ( ESOP)

1. 60th Tax Institute November 6, 2013 Business Succession Planning & Employee Stock Ownership Plans (ESOP) Joseph E. Marx, CPA Vice President - Consulting Principal Financial Group 100 Corporate Parkway Suite 116 Amherst, NY 14226 (716) 710-4134 marx.joseph@principal.com

2. Agenda Business Transition Options Why use an ESOP? What is an ESOP? How does an ESOP work? Tax and ERISA Considerations Typical ESOP Candidate

3. Sources of pre-retiree assets* ($ trillions) Value of business ownership $4.8 trillion Source: Scaling the pre-retiree market, LIMRA 2010 *Excludes primary residence and other residential assets. Pre-retiree = individuals 55 to 70 who have not retired. For financial professional use only.

4. 79% OF OWNER NET WORTH IS TIED TO BUSINESS VALUE SOURCE: 2007 Survey of Consumer Finances. Excludes value of primary residence.

5. Nearly 9 in 10 business owners do not have an exit strategy …and only 1 in 7 plan to pass business to next generation SOURCE – July 2008 White Horse Advisors Survey of Closely-Held Business Owners: 87% of Baby Boomer Business owners do not have a written, current exit plan; 14% expect to pass their business to family.

6. 68% of employees are concerned about their long-term financial future Employees want and need help Source: The Principal Financial Well Being Index 3Q2011

7. average account balance, defined contribution plans compared to: $195,000** average account balance for ESOP participants $39,947* Source: *The Total View 2011 Retirement Plans Trend Report, Principal Financial Group **2010 Company Survey conducted among ESOP Association members

8. Contemplating the Exit Third Party Family/ Management Selling Shareholders ESOP

9. Third Party Sale Third Party • Owner pays capital gains tax • Buyer pays with after-tax earnings • Owner likely loses control • Corporate identity? • Fate of employees? Selling Shareholders

10. Family/Management Sale Family/ Management • Owner pays capital gains tax • Buyer pays with after-tax earnings • Family/management retains control • Business retains identity • Retain employees Selling Shareholders

11. ESOP Sale ESOP • Owner may pay no capital gains tax • Buyer pays with before-tax earnings • Family retains control • Business retains identity • Retain employees Selling Shareholders

12. What is an ESOP? “Employee Stock Ownership Plan” • Retirement Plan - Qualified Defined Contribution Plan • Internal Revenue Code 4975(e)(7)/ ERISA • Tax deductible contributions for employer • Tax deferred growth for employees • Designed to invest primarily in employer stock • Permitted to borrow • Trustee • Corporate Finance Tool • Tax-advantaged financing for the company • Deductible dividends in some cases • S corporation ESOPs (1998) – tax exempt

13. ESOP History in Brief… • The Employee Retirement Income Security Act of 1974 (ERISA) created a formal legal status for ESOPs • Over 11,000 ESOPs in US, covering over 14 million employees • 3,000 ESOP companies are majority-owned by the ESOP • At least 75% of ESOP companies are (or were) leveraged Source: NCEO, www.NCEO.org, February 2011

14. America’s Largest Majority-Owned ESOPs Source: NCEO, www.NCEO.org, February 2011

15. What is an ESOP? • To Business Owners. . . • It is a tax-efficient exit strategy available for sale to insiders • To Employees. . . • It is a company-funded retirement plan • To Companies. . . • It is an instrument of corporate finance that provides a pre-tax financing plan that can help perpetuate the company as an independent entity

16. Private Co. • Owned by John and Mary Jones, both in their mid-60s • Founded business 30 years ago • Pillars of the community • Limited liquidity - most of their net worth is tied up in the business • Retire in 3 – 5 years • Have child 1 take over business • Give equal value to child 2 outside of business • Implement a comprehensive estate plan •Take care of employees and local charities Facts: Goals:

17. Private Co. • • Sale to ESOP creates liquidity for estate planning and diversification • •Pass the rest of business and estate assets to charity without estate taxes • • Retain control • • Eliminate or reduce corporate taxes • • Employees own part of business and do not pay taxes until retirement The Outcome

18. Why an ESOP? E S O P – Exit at your own pace – Stay in control – Omit taxes – Provide for employees

19. Exiting at Your Own Pace • ESOPs can buy a minority interest • Business owner can exit gradually over a period of years • Diversification (while still remaining active in the business) • Transition plan

20. Staying in Control • Participants are beneficial shareholders • Trust owns shares (trustee controls) • Voting • Financial information • Corporate governance basics

21. C-Corporation ESOP Tax Benefits Omitting Taxes Deferral of gain to seller Principal payments are deductible Dividends are deductible

22. Tax Benefit to Selling Shareholder • Tax deferral; Section 1042 • C corporation • Qualified employer securities • 30% sale / ownership by ESOP • 3 year holding period (tacking) • Stock owned is not a result of stock options or other employee benefit plan • Restrictions on allocations to seller, children, brother/sister, spouse or parents; or >25% shareholder • Purchase Qualified Replacement Property (QRP) within 15 month period

23. ESOP Federal Tax Savings of Sale to an ESOP Taxable Sale ESOP Sale Sale Price $30,000,000 $30,000,000 Basis -5,000,000 -5,000,000 Appreciation $25,000,000 $25,000,000 TAX @ 23.8% $5,950,000 $0 Net Proceeds $24,050,000 $30,000,000 Tax Savings Comparison

24. Qualified Replacement Property – 1042(c)(4) • Stocks, bonds, debentures, or notes issued by domestic operating corporation • Floating Rate Notes (FRN) • Upon sale of any QRP, pro-rata deferred capital gains tax becomes due • Ineligible / Non-QRP • Passive income exceeds 25% of gross revenue in last year prior to purchase • Less than 50% of assets are used in active conduct of business • Mutual funds • Real estate or REITS • Government Securities (T-bills) • Foreign Securities • Limited Partnerships or Limited Liability Companies

25. Tax Deferred Reinvestment Selling Shareholders Company Bank “Traditional” ESOP Transaction Buy Stock ESOP Loan 2 “Inside Loan” Loan 1 “External Loan”

26. C Corporation – Deduction for Principal Company receives tax deduction for providing shareholder liquidity In other words, tax savings pay 40% of debt! ESOP Deductible Contribution Loan Payment Loan Payment Bank Company

27. Allocation of Stock ESOP Trust Participant Accounts Stocks Year 2 4 6 8 10 12 14 16 18 20

28. S-Corporation ESOP Tax Benefits Omitting Taxes • S corporations are pass-through entities • Individual shareholders pay tax on the earnings of the company • The ESOP shareholder is tax exempt

29. S-Corporation – Before the ESOP Omitting Taxes Assume: • $5 million taxable income • 40% tax rate (fed & state) • Requires $2,000,000 tax distribution to cover taxes owed IRS 2 Shareholders pay tax Shareholders $2,000,000 S corp distributions 1 Company $2,000,000 This is for illustrative purposes only.

30. S-Corporation – After the ESOP Omitting Taxes • Assume: • $5 million taxable income • 40% tax rate (fed & state) • ESOP owns 50% • Only $1 million needed • for taxes IRS Taxes paid by non-ESOP shareholders 2a ESOP Non-ESOP Shareholders $1,000,000 NO TAX! 1 1 S corp distribution Company Inside loan payment $1,000,000 2b This is for illustrative purposes only. Tax outlay reduced by the ESOP’s ownership percentage

31. Providing for Employees • Most ESOPs are compensatory • Can be a replacement benefit and more • Value tied to performance

32. ESOP Contribution Limitations… • Deductible limitation • Contributions limited to 25% of covered payroll (404(a)(3)) • Individual compensation limit of $255,000 included as of 2013 (401(a)(17); 404(l)) • Leveraged (404(a)(9)) versus non-leveraged (404(a)(3)) limits • Section 404(a)(9) - C corporations only • Principal – deductible up to 25% of covered compensation • Interest – unlimited deduction • Dividend deduction (404(k)) - C corporations only • Annual addition limitation per participant • Lesser of 100% of pay or $51,000 - (415(c)(1)(A))

33. Other ESOP Rules… • Distributions - 409(o) • Net Unrealized Appreciation - 402(e)(4) • Put Option - 409(h) • Repurchase Liability - 409(h)(1)(B) • The ESOP plan sponsor’s obligation to repurchase shares from plan participants entitled to a distribution • S corporation Anti-Abuse Rules - 409(p)

34. Who is a Typical ESOP Candidate? • A closely held corporation (C or S corporation) • One or more owners nearing retirement • History of profitability • Comfort with the concept of employee ownership • Sufficient payroll • Stable employee population • Strong management team • Available corporate credit • Ability to fund set-up costs

35. Common Objections • “If it sounds too good to be true, it probably is” • Answer:This time it is true. Congress intentionally set up benefits to encourage employers to provide retirement benefits and align shareholder and employee interests. ESOPs are favored by both political parties • “I don’t want to lose control” • Answer:Owner can retain control as trustee and vote all of the shares in the ESOP on most issues • “I don’t want to disclose everything to employees” • Answer:Only disclosure required to employees is standard retirement plan statement – shares and value in participants’ account

36. Summary • With the same dollars, corporations can fund: • A business succession plan and • A cost-effective retirement plan for employees • Employees can develop an ownership interest in the company without any investment of their own funds • Combining an ESOP and the election to be taxed as an S corporation can: • Greatly reduce federal and state taxes or • Eliminate them altogether

37. WE’LL GIVE YOU AN EDGE® Joseph E. Marx, CPA Vice President - Consulting Principal Financial Group 100 Corporate Parkway Suite 116 Amherst, NY 14226 (716) 710-4134 marx.joseph@principal.com While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that The Principal is not rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements. Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group® (The Principal®), Des Moines, IA 50392. 510110101oi