Application Nos. and Proposed Exemptions; D-11569, Sherburne Tele Systems, Inc.; and D-11597, John D. Simmons Individual Retirement Account; et al. [8/6/2010]
[note-the IRA related application and proposed exemption are omitted from this reprint]

Federal Register: August 6, 2010 (Volume 75, Number 151)]
[Notices]
[Page 47639-47644]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr06au10-129]

DEPARTMENT OF LABOR

Employee Benefits Security Administration


Application Nos. and Proposed Exemptions; D-11569, Sherburne Tele
Systems, Inc.; and D-11597, John D. Simmons Individual Retirement
Account; et al.

AGENCY: Employee Benefits Security Administration, Labor.

ACTION: Notice of proposed exemptions.

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SUMMARY: This document contains notices of pendency before the Department of Labor (the Department) of proposed exemptions from certain of the prohibited transaction restrictions of the Employee Retirement Income Security Act of 1974 (ERISA or the Act) and/or the Internal Revenue Code of 1986 (the Code).

Written Comments and Hearing Requests

All interested persons are invited to submit written comments or requests for a hearing on the pending exemptions, unless otherwise stated in the Notice of Proposed Exemption, within 45 days from the
date of publication of this Federal Register Notice. Comments and requests for a hearing should state: (1) The name, address, and telephone number of the person making the comment or request, and (2) the nature of the person's interest in the exemption and the manner in
which the person would be adversely affected by the exemption. A request for a hearing must also state the issues to be addressed and include a general description of the evidence to be presented at the hearing.

ADDRESSES: All written comments and requests for a hearing (at least three copies) should be sent to the Employee Benefits Security Administration (EBSA), Office of Exemption Determinations, Room N-5700, U.S. Department of Labor, 200 Constitution Avenue, NW., Washington, DC
20210. Attention: Application No. ------, stated in each Notice of Proposed Exemption. Interested persons are also invited to submit comments and/or hearing requests to EBSA via e-mail or FAX. Any such comments or requests should be sent either by e-mail to: ``moffitt.betty@dol.gov'', or by FAX to (202) 219-0204 by the end of the scheduled comment period. The applications for exemption and the
comments received will be available for public inspection in the Public Documents Room of the Employee Benefits Security Administration, U.S. Department of Labor, Room N-1513, 200 Constitution Avenue, NW., Washington, DC 20210.

Warning: If you submit written comments or hearing requests, do not include any personally-identifiable or confidential business information that you do not want to be publicly-disclosed. All comments and hearing requests are posted on the Internet exactly as they are received, and they can be retrieved by most Internet search engines.
The Department will make no deletions, modifications or redactions to the comments or hearing requests received, as they are public records.

Notice to Interested Persons

Notice of the proposed exemptions will be provided to all
interested persons in the manner agreed upon by the applicant and the Department within 15 days of the date of publication in the Federal Register. Such notice shall include a copy of the notice of proposed exemption as published in the Federal Register and shall inform interested persons of their right to comment and to request a hearing (where appropriate).

SUPPLEMENTARY INFORMATION: The proposed exemptions were requested in applications filed pursuant to section 408(a) of the Act and/or section 4975(c)(2) of the Code, and in accordance with procedures set forth in 29 CFR Part 2570, Subpart B (55 FR 32836, 32847, August 10, 1990).
Effective December 31, 1978, section 102 of Reorganization Plan No. 4 of 1978, 5 U.S.C. App. 1 (1996), transferred the authority of the Secretary of the Treasury to issue exemptions of the type requested to the Secretary of Labor. Therefore, these notices of proposed exemption are issued solely by the Department.
The applications contain representations with regard to the
proposed exemptions which are summarized below.

Interested persons are referred to the applications on file with the Department for a complete statement of the facts and representations.

Sherburne Tele Systems, Inc., 2008 Amended and Restated Employee Stock Ownership Plan and Trust (the ``ESOP''), Located in Big Lake,
Minnesota [Application No. D-11569]

Proposed Exemption

The Department is considering granting an exemption under the authority of section 408(a) of the Act and section 4975(c)(2) of the Code, and in accordance with the procedures set forth in 29 CFR Part 2570, Subpart B (55 FR 32836, 32847, August 10, 1990).\1\ If the
exemption is granted, the restrictions of sections 406(a)(1)(A) and (D) and 406(b)(1) and 406(b)(2) of the Act and the sanctions imposed under section 4975 of the Code, by reason of sections 4975(c)(1)(A), (D), and (E) of the Code, shall not apply to the sale by the ESOP of all its shares of common stock (the ``ESOP Shares'') in Sherburne Tele Systems, Inc. (the ``Company'') to the Company, a party in interest with respect to the ESOP, provided that the following
conditions are satisfied:
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\1\ For purposes of this proposed exemption, references to provisions of Title I in the Act, unless otherwise specified, should be read to refer also to the corresponding provisions of the Code.
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(a) The sale is a one-time transaction for cash;
(b) The terms and conditions of the sale are at least as
favorable to the ESOP as those that the ESOP could obtain in an arm's length transaction with an unrelated third party;
(c) The sales price is the greater of (i) $5.01 per share, or
(ii) the fair market value of the ESOP Shares as of the date of the sale, as determined by a qualified, independent appraiser (the appraiser);
(d) The sales proceeds received by the ESOP pursuant to the transaction are valued at a share price that is greater than the share price received by the non-ESOP shareholders;
(e) The benefits received by the members of the board of
directors and officers of the Company pursuant to the board of directors awards program, the Company's phantom stock plan and retention plans, which were paid, coincident with the closing of the asset sale of the Company to Iowa Telecommunications Services, Inc.
were reasonable;
(f) A qualified, independent fiduciary (the ``Independent
Fiduciary'') for the ESOP was and is responsible for (i) reviewing the terms of the sale of the Company's assets; (ii) engaging the appraiser to value the ESOP Shares; (iii) reviewing and, if appropriate, approving the methodology used by the appraiser, to ensure that such methodology is properly applied in determining the fair market value of the ESOP Shares, to be updated as of the date of the sale; (iv) negotiating the terms of the sale of the ESOP Shares to the Company to ensure that the ESOP participants receive
at least the fair market value of the ESOP Shares; (v) determining, and documenting in writing, whether the terms of the sale are fair and reasonable to the ESOP and whether it is prudent to proceed with the proposed transaction; (vi) approving the proposed transaction; and (vii) determining whether the proposed transaction satisfies the
criteria set forth in section 404 and section 408(a) of the Act;
(g) The ESOP pays no fees, commissions, or other expenses in connection with the sale (including the fees paid to the appraiser and the Independent Fiduciary), other than a one-time $500.00 escrow fee (as described in Summary of Facts and Representations 10); and
(h) The proceeds from the sale are promptly forwarded to the ESOP's trust simultaneously with the transfer of the ESOP Shares to the Company.

Summary of Facts and Representations

1. The ESOP was established by Sherburne Tele Systems, Inc. (the ``Company'' or the applicant) on January 1, 1999. As of December 31, 2009, the ESOP had 102 participants. The Company is the named fiduciary of the ESOP. The Company formerly operated as a sub-chapter ``S'' corporation in Big Lake, Minnesota, providing local
and long distance telephone services to residential and business customers. The Company's assets were acquired in 2009, as described in Item 7, below.
According to the applicant, the ESOP had total assets of
approximately $8,204,432.51, as of December 31, 2009; this amount includes $2,966,920.46 invested in money market funds and certificates of deposit, as well as 1,427,115 shares of the Company's stock (the ``ESOP Shares'') with a current value of $5,237,512.05, based upon the annual valuation of the ESOP assets performed by a qualified, independent appraiser.
2. The Company has only one class of stock. As of June 29, 2009, there were 14,436,920 shares of the stock issued and outstanding. Robert Eddy is the President of the Company and a member of the board of directors. Mr. Eddy owned, directly and indirectly, approximately 87% of the outstanding shares of the stock; he owned 6,262,772 shares directly. Mr. Eddy's sister, Jane Eddy Shiota, was the only other shareholder who directly owned more than 10% of the
stock; she owned approximately 35.46% (5,120,123 shares) of the outstanding shares of the stock.\2\ The 1,427,115 shares of stock owned by the ESOP represent a minority interest in the Company of 9.89%.
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\2\ The non-ESOP shareholders besides Mr. Eddy and Ms. Shiota,
some of whom are relatives to Mr. Eddy, are as follows: Rolland K.
Eddy and Donna L. Eddy Trust (1,137,116 shares); Eric R. Morales
(485,750 shares); and Fred I. Shiota, Sr. (4,044 shares).
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3. The background to the ESOP's acquisition of the Company stock is as follows. The applicant represents that, on September 15, 1999, the ESOP acquired 285,423 shares of the stock at $9.81 per share, the fair market value of the stock as of that date, as determined by the ESOP's trustees, based upon a report by a qualified, independent appraiser, Chartwell Business Valuation, LLC (doing business as
Chartwell Capital Solutions) (``Chartwell'').\3\ The total price for the stock purchased on September 15, 1999 was $2,799,999.63, which was financed in the form of an exempt loan (the ``Exempt Loan'').
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\3\ The Department expresses no opinion herein as to whether the ESOP paid ``adequate consideration'' for its initial purchase of the Company stock.
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The Company approved a five-to-one split of its stock, effective November 3, 2005, which increased the shares of stock held by the ESOP from 285,423 shares to 1,427,115 shares. In 2007, the ESOP repaid the Exempt Loan in full, in advance of the amortized payment schedule under the loan agreement, and allocated the remaining ESOP Shares held in the ESOP's suspense account to the ESOP participant
accounts. The ESOP received income distributions from the Company with respect to the ESOP Shares in the following amounts: $19,647.92 (1999); $176,447.15 (2000); $66,638.00 (2001); $14,139.00 (2002); $11,479.00 (2003); $33,917.00 (2004); $54,852.00 (2005); $373,238.00
(2006); $5,651,375.40 (2007); and $841,997.85 (2008). There were no expenses charged to participant accounts in connection with holding the ESOP Shares.
4. The applicant represents that, after reviewing the strategic alternatives, the Company's board of directors decided that a sale of the Company was in the best interests of its shareholders. In October 2007, the Company retained the services of Green Holcomb & Fischer, LLC, an investment banking firm, to find a buyer.
Due to a potential sale of the Company, Barnes & Thornburg LLP, counsel to the Company (specifically, with regard to its ESOP matters), advised the Company to engage First Bankers Trust Services, Inc. (FBTS), a discretionary trustee, to serve as an independent fiduciary (the ``Independent Fiduciary'') for the ESOP in order to avoid any conflict of interest or appearance of impropriety.\4\ As set forth in the July 22, 2008 retainer agreement, FBTS, as the sole discretionary trustee of the ESOP, agreed to ``exercise all duties, responsibilities, and powers of a fiduciary under ERISA in its capacity as a discretionary trustee. *
* *'' As such, FBTS' responsibilities, in addition to other
traditional trustee responsibilities, were (i) to exercise its
exclusive discretion as trustee and make its independent decision concerning any transaction that may arise or occur under the ESOP, and (ii) to control the management and disposition of the assets held by the ESOP trust. FBTS represents that, pursuant to its retainer agreement, FBTS' responsibilities included: (i) Negotiating a fair transaction in which the ESOP participants would receive no
less than fair market value for their Company stock as of the
closing date of the transaction; (ii) reviewing an appraisal of the Company stock, which was prepared by an independent, qualified appraiser, and updated as of the closing date of the transaction; (iii) evaluating the sufficiency of the methodology of such appraisal; and (iv) determining the reasonableness of the conclusions reached in such appraisal.
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\4\ FBTS represents that it is not acting as an ``investment manager'' within the meaning of section 3(38) of the Act because such section specifically excludes trustees.
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5. It is represented that FBTS is a state chartered trust
company that has been specializing in employee benefits as an independent trustee for over twenty years and that, at all times, FBTS has been and continues to be represented by its own counsel, Krieg Devault. Prior to its engagement as the discretionary trustee for the ESOP, FBTS had no relationship with the Company. Moreover, FBTS and its wholly-owned subsidiaries derived less than 1% of its consolidated gross income from the Company and its affiliates for the years ending December 31, 2008 and through May 4, 2010. In
addition, FBTS represents that it has no relationship with Green Holcomb & Fischer, LLC.
6. In regard to its qualifications, FBTS states that the firm
has four offices nationwide and 30 full-time employees devoted to providing trust services for over 600 account relationships. FBTS maintains that its professional staff has in-depth knowledge of Internal Revenue Service and Labor Department regulations and compliance requirements for all types of retirement plans.
Kimberly Serbin, a senior trust officer with FBTS since 2001, is one of FBTS' employees responsible for providing trust services to the ESOP; she has an insurance license, and her past work experience includes manufacturing, investment/financial services, insurance services, and banking. In a letter dated June 18, 2009, Ms. Serbin
asserts that FBTS is well qualified to review appraisals in
connection with the sale of the ESOP Shares. She states: ``In the last three years, FBTS has served as an independent transactional trustee for approximately 15-20 transactions in which the sale of stock by an employee benefit plan has occurred. The circumstances
have usually been in connection with the sale of the plan sponsor (either a stock sale or an asset sale) or in connection with the termination of an employee benefit plan by the plan sponsor.''
7. On or about November 21, 2008, the Company and its
subsidiaries and all non-ESOP shareholders executed an Asset Purchase Agreement (the ``Purchase Agreement''), which provided for the sale of substantially all of the assets of the Company and its subsidiaries to Iowa Telecommunications Services, Inc. (``ITSI'').
The asset sale closed on June 30, 2009, and the final purchase price paid was approximately $82 million due to certain terms and conditions that allowed for adjustment to the purchase price based on changes in the Company's operations. The Purchase Agreement required that the Company ``terminate'' the ESOP immediately prior
to the closing of the asset sale, which occurred on June 30,
2009.\5\ Although the ESOP was ``frozen'' as of the same date, it continues to hold the ESOP Shares in trust.\6\ It is represented that ITSI is not affiliated with any party in interest to the proposed exemption transaction, (i.e., the sale of the ESOP Shares to the Company (the ``ESOP Transaction'')).
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\5\ Counsel for FBTS explained that as a technical matter the ESOP has not yet ``terminated.'' Rather, according to the counsel, a ``partial termination'' of the ESOP occurred, for purposes of the Internal Revenue Code, because the employees of the Company were terminated from employment and, generally were re-hired by ITSI.
Because of the ``partial termination,'' counsel for FBTS represented that participants are 100% vested in their account balances.
\6\ The Department notes that, as the ESOP Transaction has not yet been consummated, the ESOP Shares are ``plan assets'' subject to the requirements of, among other things, Part 4 of Title I in the Act.
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8. Because the ESOP was a minority shareholder of the Company, it did not have the authority to delay the asset sale that occurred on June 30, 2009. Prior to the sale, however, the Independent Fiduciary negotiated a Stock Redemption Agreement (the ``Redemption Agreement'') on May 26, 2009 with the Company and Robert Eddy, in
his individual capacity and in his capacity as majority shareholder representative, providing for a sale of all of the ESOP Shares to the Company. Under the terms of the Redemption Agreement, the consummation of the ESOP Transaction is contingent upon first obtaining a prohibited transaction exemption from the Department.\7\
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\7\ In general, the applicant notes that section 408(e) of the Act provides a statutory exemption for the sale of qualifying employer securities (QES) by an individual account plan to a party in interest. Section 408(d) of the Act, however, excludes from this exemption transactions involving an individual account plan and (i) any person who is an owner-employee with respect to the plan, (ii) a family member of such owner-employee, or (iii) any corporation of which such owner-employee owns 50 percent or more of the combined
voting stock of the corporation. Thus, section 408(d) excludes any transaction between the ESOP and the Company because Mr. Eddy, an owner-employee of the Company, owns 50% or more of the combined voting stock of the Company. The Taxpayer Relief Act of 1997 granted
some relief to subchapter ``S'' corporations that maintain ESOPs. Specifically, section 408(d)(2)(B) of the Act provides an exemption for sales of QES to an ESOP by an owner-employee, a family member of such owner-employee, or related Subchapter ``S'' corporation. It does not, however, exempt a sale by an ESOP to such parties.
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9. Prior to the anticipated sale of the Company's assets, the Company applied for authorization by the Department, pursuant to class Prohibited Transaction Exemption (PTE) 96-62, for the one-time cash sale by the ESOP of 100% of the ESOP Shares to the Company, a party in interest to the ESOP. Because the Company was notified by the Department in June 2009 that it would not qualify for authorization pursuant to PTE 96-62, it has requested an individual
prohibited transaction exemption.
10. As a result, the cash value of the ESOP Shares, attributable to the sale of the Company's assets, is currently held in an escrow account, subject to the final closing of the Redemption Agreement, which is pending until the grant of the requested exemptive relief.\8\ Wells Fargo Bank, National Association is the escrow agent. It is represented that the funds in the escrow account are invested in a money market account. There was a one-time escrow fee of $500.00 paid from the earnings on the escrowed funds and no other
fees.
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\8\ The Department is not expressing an opinion whether the cash equivalent of the value of the ESOP Shares held in the escrow account are ``plan assets'' subject to the requirements of Part 4 of Title I in the Act.
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11. The applicant represents that the terms and conditions of the proposed ESOP Transaction are at least as favorable to the ESOP as those that the ESOP could obtain in an arm's length transaction with an unrelated third party. A fairness opinion, the ESOP Closing Valuation and Opinion, was prepared and issued on July 2, 2009 by Chartwell for the Independent Fiduciary, concerning the proposed
sale of the ESOP Shares to the Company for adequate consideration. FBTS engaged Chartwell to perform this appraisal of the ESOP Shares pursuant to their January 26, 2009 retainer agreement. The Company has confirmed that the financial projections shared with Chartwell are identical with those shared with FBTS, other lenders and ITSI.
As previously noted in Item 3, above, Chartwell is represented to be a qualified, independent appraiser and has performed the ESOP's annual stock valuations to date. It is represented that Chartwell derived less than 1% of its annual gross income from the Company and its affiliates for the years ending December 31, 2007 and December 31, 2008. It is further represented that Chartwell derived less than
3% of its annual gross income from the Company and its affiliates for the year ending December 31, 2009 and will derive no income from the Company and its affiliates for the year ending December 31, 2010.
12. The applicant represents that Chartwell is a nationally
recognized financial services firm located in Minneapolis,
Minnesota, serving privately held companies and their shareholders. The firm focuses on business valuation and transaction consulting and has provided opinions and advisory services to hundreds of organizations in a variety of industries, including over 150 ESOPs throughout the United States. The individuals involved in the July 2, 2009 appraisal of the ESOP Shares were Paul J. Halverson, Managing Director, and Matthew R. Schubring. Mr. Halverson is an
Accredited Senior Appraiser, a Certified Business Appraiser, and a member of the American Society of Appraisers and the Institute of Business Appraisers, who has provided financial advisory services to privately-held companies since 1987; a substantial portion of his work relates to ESOPs and providing independent financial advisory services to ESOP trustees and other corporate fiduciaries. Mr. Schubring is an Accredited Senior Appraiser who has provided valuation services since 1999 and also has extensive valuation experience with ESOPs, buy/sell agreements, and other corporate
matters.
13. It is represented that the methodologies used by Chartwell to evaluate the fairness of the proposed sales price are uniformly accepted and approved for valuing companies of the size and within the industry of the Company and took into consideration all known and relevant facts and circumstances attendant to the proposed ESOP
Transaction. Chartwell represents that it valued the ESOP Shares using the merger and acquisition method of the market approach. Chartwell states, ``In the merger and acquisition method, the sales of entire companies or large blocks of companies are analyzed to determine appropriate valuation multiples for the subject company.
In this case, the sale of the subject company presented the best indication of fair market value under this method. Based upon our knowledge of the diligence of the transaction process undertaken by the Company and the results of these efforts we believe that the value received by the
non-ESOP shareholders represents the best indication of fair market value of the Company. Because this represented the actual fair market value and not theoretical values indicated by the income, guideline public company or asset approaches we chose to rely on the merger and acquisition method.'' As a condition of the proposed exemption, Chartwell will update the appraisal of the ESOP Shares as of the date of the ESOP Transaction.
14. The Independent Fiduciary not only evaluated the Chartwell appraisal of the ESOP Shares, it also negotiated the Redemption Agreement with the Company for the sale of ESOP Shares. It is represented that, over the course of several months, FBTS negotiated vigorously on behalf of the ESOP to receive the sales price of $5.01 per share rather than participating in the liquidating distribution
from the available net asset proceeds, alongside the non-ESOP shareholders. In other words, according to FBTS' counsel, the Redemption Agreement allows the ESOP to avoid being subject to, among other things, potential indemnification liabilities and certain other expenses that FBTS determined should not be borne by the ESOP. Thus, the negotiation resulted in the ESOP receiving a sales price of $5.01 per share rather than the estimated $4.64 per
share that would be received by the non-ESOP shareholders of the Company under the terms of the Purchase Agreement with ITSI.\9\ The $5.01 per share price will be paid in cash upon closing of the ESOP redemption.
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\9\ Of the $4.64 per share value received by non-ESOP
shareholders, $3.65 per share was paid upon closing, $0.75 per share was placed in a separate escrow account to be released 18 months following the closing, and the remaining proceeds (i.e., approximately $0.23 per share) are expected to be distributed after finalizing all transaction costs. The administrative file refers to the $4.64 per share amount even though the sum of the three amounts equals $4.63. The Department assumes that the discrepancy is
attributable to it being an estimated amount.
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By way of further explanation, the total per share proceeds from the asset sale of the Company to ITSI came to $5.68 per share, but this amount was reduced to the putative $4.64 per share after taking into account various payments that the Company intended to make. The
Independent Fiduciary believed that the ESOP participants' benefits should not be reduced by certain post-sale payments that the Company was making, which the ESOP had no control over, including: Certain awards to members of the Company's board of directors and officers (some of whom are also shareholders) for completing the sale of the
Company's assets; S-corporation insurance; and amounts due under the Company's phantom stock plan and retention agreements.\10\
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\10\ For example, FBTS determined that it was not appropriate, in an asset acquisition, for the ESOP to bear the allocable cost of S-corporation insurance, which apparently ITSI required the Company to pay in the event the Internal Revenue Service made a determination that the Company's S-corporation's tax status election was improper and resulted in the assessment of additional taxes.
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Based on the sales price of $5.01 per share, the ESOP will
realize in the aggregate approximately $7,149,846.15 on the sale of the 1,427,115 ESOP Shares, which constitute approximately 71% of the total assets of the ESOP. It is represented that the Independent Fiduciary reviewed the Purchase Agreement, the Redemption Agreement,
and the ESOP Closing Valuation and Opinion and determined that the ESOP Transaction would be in the best interests of the ESOP participants. The Independent Fiduciary, on behalf of the ESOP, reviewed and approved the valuation methodology used by Chartwell, ensured that such methodology was properly applied in determining
the fair market value of the ESOP Shares, and determined that the terms of the sale are fair and reasonable to the ESOP. The Independent Fiduciary also will determine whether it is prudent to go forward with the ESOP Transaction.
15. The applicant represents that the sale of the ESOP Shares for cash pursuant to the terms of the Redemption Agreement is in the best interests of the ESOP and its participants because, in addition to the reasons given by the Independent Fiduciary, above, it will allow participants to diversify their investments. Except for the one-time $500.00 escrow fee, as described in Item 10, above, which
was paid from earnings on the ESOP's share of cash proceeds derived from the asset sale of the Company to ITSI and held pursuant to an Escrow Agreement between Wells Fargo Bank and FBTS, the ESOP will not be responsible for any fees, commissions, or other expenses that may be associated with the sale of the ESOP Shares--including the cost of filing the exemption application, notifying interested persons, and engaging Chartwell and FBTS. The sale proceeds will be
credited to the ESOP's trust simultaneously with the transfer of title of the ESOP Shares to the Company, and each participant's individual account will receive its pro rata share of the sale proceeds.
16. In summary, the applicant represents that the ESOP
Transaction meets the statutory criteria of section 408(a) of the Act because, among other things: (a) The ESOP Transaction will be a one-time transaction for cash; (b) the sales price for the ESOP Shares will be the greater of (i) $5.01 per share, or (ii) the fair market value of the ESOP Shares as of the date of the sale, as determined by Chartwell; (c) FBTS was and is responsible for (i)
reviewing the terms of the sale of the Company's assets; (ii)
engaging Chartwell to value the ESOP Shares; (iii) reviewing and approving the methodology used by Chartwell to ensure that such methodology is properly applied in determining the fair market value of the ESOP Shares, to be updated as of the date of the sale; (iv) negotiating the terms of the ESOP Transaction to ensure that the ESOP participants receive at least the fair market value of the ESOP Shares; and (v) determining whether the terms of the sale are fair
and reasonable to the ESOP and whether it is prudent to go forward with the ESOP Transaction; and (e) the ESOP will pay no fees, commissions, or other expenses in connection with the sale (including the fees paid to the independent appraiser and the Independent Fiduciary), other than a one-time $500.00 escrow fee.


FOR FURTHER INFORMATION CONTACT: Ms. Karin Weng of the Department, telephone (202) 693-8557. (This is not a toll-free number.)

A. LEGAL REQUIREMENTS
1. Definition of an ESOP (Plan and Trust)
a. An employee stock ownership plan (“ESOP”) is a tax-qualified retirement plan which is designed to invest primarily in employer securities (of the employer sponsoring the ESOP) and, therefore, provide participants in the ESOP with a beneficial ownership interest in their company. An ESOP can acquire employer securities by purchasing stock directly from existing shareholders or the employer, or the employer may contribute stock directly to the ESOP. Unlike other tax-qualified retirement plans, an ESOP may also borrow money and enter into other transactions with a related party in transactions that would otherwise be prohibited under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) and the Internal Revenue Code of 1986, as amended (the “Code”). Like other tax-qualified retirement plans, an ESOP is subject to ERISA and the qualification rules under the Code.
b. An ESOP typically incorporates a stock bonus plan (which is a qualified retirement plan under Section 401(a) of the Code); however, an ESOP may also be a combination of a stock bonus plan and a money purchase pension plan. A stock bonus plan is similar to a tax-qualified profit sharing plan except that the benefits in a stock bonus plan are distributable in employer stock.
2. Advantages of an ESOP
a. Tax-qualified retirement plan
(1) Employer contributions are tax deductible (so-called “principal and interest deduction” in C corporation ESOP situations).
(2) Earnings are tax-free.
(3) No tax on employee-participants until they receive distributions of their ESOP accounts.
(4) S corporation ESOPs.
b. Business perpetuation.
c. Provide market for closely-held stock and therefore liquidity for closely-held corporation shareholders.
(1) An ESOP can provide an exit for a shareholder who may not want to sell his or her shares to a third party. For example, a shareholder may not want to sell stock to a competitor, a foreign-owed buyer, a publicly-traded corporation, etc., or may only want to sell a portion of stock owned.
d. Business acquisition.
3. General Requirements of ESOPs
a. Code Section 401(a) Requirements. The Code groups all tax-qualified retirement plans into two categories, defined contribution plans and defined benefit pension plans. An ESOP is a defined contribution plan where a participant’s benefit is based solely on the sum of employer contributions to his account under the ESOP, forfeitures (if any) allocated to the participant’s account, and the participant’s share of income, loss and expenses. In contrast, in a defined benefit pension plan an amount of benefits is paid upon retirement pursuant to a formula in the plan, regardless of contributions to and earnings of the plan. An ESOP must meet all of the qualified plan requirements under Section 401(a) of the Code.
b. Designed to Invest in Employer Securities. An ESOP must be designed to invest primarily in qualifying employer securities as described in Section 4975(e)(8) and Section 409(l) of the Code. “Employer securities” are defined as common stock issued by an employer which are readily tradable on an established securities market. If such common stock does not exist, the term “employer securities” generally means common stock issued by an employer having the voting power and dividend rights equal to or exceeding that class of common stock of the employer having the greatest voting power and the class having the greatest dividend rights. Employer securities also include preferred stock that is convertible into common stock which meets the above requirements (the conversion price must be reasonable). Employer securities issued by a member of a controlled group of corporations are treated as employer securities for all members of the controlled group.
While there is no specific definition of “invest primarily in employer securities,” the general guidelines are that an ESOP must permit the plan trustees to invest or hold the majority of the plan’s assets employer securities.
c. Voting Rights. Voting rights with respect to an ESOP relate to whether a participant has the right to direct the vote of employer stock allocated to his or her ESOP account. These rights differ depending on whether stock is considered to be securities required to be registered under the Securities Exchange Act of 1934 or a class of securities that would be required to be registered except for an exemption (commonly referred to as publicly-traded stock). If the stock does meet that description, then the ESOP must permit each participant to direct the voting of the securities of the employer allocated to his or her ESOP account. If the ESOP does not have registration-type class of securities described above (commonly referred to as closely-held stock), the only voting rights required to be passed through to participants is that the participants must be allowed to direct the vote of stock allocated to the account with respect to any corporate matter involving the voting of shares for or against corporate mergers, consolidations, sale of all or substantially all the employer corporation’s assets, recapitalization, reclassifications, liquidations, dissolutions, or such similar transactions as the Internal Revenue Service (“IRS”) designates through the issuance of regulations.
After October 21, 1986, an ESOP established by an employer without registration-type securities may permit each participant to have one vote on each issue which the participant is entitled to direct the trustee to vote, without regard to the actual number of shares allocated to the participant’s account. In this situation, the trustee may vote the shares held in the ESOP in proportion to the directions given by the participants.
It should be noted that participant vesting is not relevant to the issue of voting employer securities. Whether or not stock has been allocated to a participant’s ESOP account, not whether the participant is vested in his or her ESOP account, determines whether and the extent to which a participant may direct the vote such employer stock.
The extent that employer securities in an ESOP are not allocated (such as shares acquired since the last allocation date, or shares acquired with loan proceeds and not yet released from the ESOP’s loan suspense account, discussed below), the trustee of the ESOP (or other ESOP fiduciary, such as an ESOP committee) generally exercises its discretion in voting such unallocated shares.
d. Put Option. A participant must be given the right to receive a distribution from the ESOP in the form of employer securities, except in limited circumstances. In C corporation ESOPs, the participant must be given the right to demand distributions from the ESOP in the form of employer securities. Absent such demand, ESOP accounts may be distributed in cash.
Unless employer stock is traded on an established securities market, the participants must be given the right to require the employer to repurchase the shares at fair market value. It is important to note that the ESOP itself is not required to purchase the shares. Participants have a put option to force the employer stock distributed to them from the ESOP during two different time periods.
It should be emphasized that distributions of employer securities which are readily tradable on an established security market are not subject to this requirement. In this event, participants receiving a distribution of employer’s stock may simply sell the stock on the established securities market.
e. Right of First Refusal. An employer sponsor of an ESOP which holds non-publicly traded stock, may provide that the employer has a right of first refusal on stock held by the ESOP or distributed from the ESOP to participants. This right may not apply to stock which is publicly traded. The right of first refusal may be in the favor of the employer adopting the ESOP, the ESOP or both. However, the right of first refusal may not be in the favor of any other person.
The selling price and other terms under a right of first refusal must not be less favorable to the seller than fair market value of the stock or purchase price and other terms offered by a buyer making a good faith offer. The right of first refusal must lapse no later than fourteen days after the holder of the stock has written notice to the holder of the right of first refusal that a third party offer has been received.
f. Distribution Requirements. An ESOP contains provisions that allow distributions to a participant of the vested interest in their ESOP account to begin not later than one year after the end of the plan year during which the participant terminates employment because of retirement on or after the plan’s normal retirement age, disability or death. Further, if a participant is terminated (either voluntarily or involuntarily) distributions are to be made not later than one year after the end of the fifth plan year following the plan year during which the termination occurs. A participant may elect to leave their account balances in the ESOP. In addition, unless the participant elects otherwise, the participant’s account balance generally must be distributed in substantially equal periodic payments (not less frequently than annually) as rapidly over a period not exceeding five years. (For large account balances, distributions may be made over a longer period of time.)
The distribution requirements discussed above do not apply to a participant’s account balance which consist of employer securities acquired with the proceeds of an ESOP securities acquisition loan until the end of the plan year in which the entire loan is repaid.
The cash distribution option and Put Option requirements discussed above effectively create a market for employer stock which is not publicly traded. A closely-held company that adopts an ESOP considers the liquidity requirements that these provisions will impose on it at the time a participant either retires or terminates employment with an account in the ESOP, and then plans accordingly.
g. Independent Appraiser. An ESOP that holds employer securities which are not readily tradable on a securities market must have all valuations of those securities made by an “independent appraiser.” The independent appraiser should be a person who does not perform any other services for a party whose interest may be adverse to the ESOP and who would be impartial.
h. Diversification. An ESOP is required to provide “qualified employees” an opportunity to diversify their employer securities credited to their ESOP accounts. Basically qualified employees must be allowed to have a portion of their account invested in assets other than employer securities. “Qualified employees” are those employees who are at least 55 years of age and who have at least 10 years of participation in the ESOP.
The extent of diversification is set forth in the Code which provides that ESOPs must permit qualified participants to diversify their investment of at least 25 percent of their ESOP account during five years of the six year period commencing with or after the plan year in which the participant reaches age 55 (or if later, the plan year in which the participant completes ten years of participation). This period is referred to as the “qualified election period.” In the final sixth year of the qualified election period, the ESOP must allow their participants the opportunity to diversify the investment of at least 50 percent of the balance of the participant’s account, less any portion of the account which was previously diversified.
Participants are entitled to one election per year during the qualified election period.
An ESOP may satisfy the diversification requirement in two ways. The ESOP may distribute, in stock or cash, the portion of participant’s account subject to the diversification requirements to the participant within ninety days of the period in which the diversification election may be made. If the ESOP distributes stock, the put option requirement applies or the stock may be rolled over into an IRA. If the distribution is in cash, the participant may roll the cash over into an IRA. To satisfy the diversification requirements, the ESOP may offer at least three investment options (other than employer stock) to qualified employees.
There is a “de minimus” exception to the diversification requirements. If the fair market value of the employer securities acquired by or contributed to an ESOP and allocated to a participant’s account is $500 or less, the employer securities will be considered de minimus and therefore not subject to the diversification requirements.
i. Requirements that Plan be Designated as an ESOP. The ESOP plan document must specifically provide that a plan is an ESOP.
The plan document must also provide that participants have certain protections with respect to assets acquired with the proceeds of an exempt loan (discussed below). No security acquired with the proceeds of an exempt loan may be subject to a put, call or other option while held by the ESOP. An exception to this rule is for the put options and for the rights of first refusal discussed above.
j. Allocation Requirements. At the end of each plan year, a leveraged ESOP must allocate to participant accounts employer stock representing the participants interest in the employer securities released from an exempt loan suspense account (discussed below). If part of a participant’s ESOP account is forfeited (for example when a participant terminates employment with the sponsoring employer prior to full vesting), stock allocated as of the end of the plan year to the participant’s ESOP account must be forfeited only after all other assets (if any) are forfeited.
k. ESOP Loan Requirements. The prohibited transaction provisions of the Code generally prohibit any tax-qualified retirement plan from receiving a loan from a disqualified person or from receiving a loan which is guaranteed by a disqualified person or collateralized by assets of a disqualified person. An exception to this rule is granted for leveraged ESOPs. In order to qualify for this exemption, the following requirements must generally be met:
(1) the loan proceeds must be used within a reasonable time after their receipt to acquire qualified employer securities or to repay the loan of a prior exempt loan;
(2) the loan must be without recourse against the ESOP, except to the extent of employer securities acquired with loan proceeds, contributions made to the ESOP’s obligations under the loan and earnings attributable to such employer securities and contributions (if ESOP assets are pledged as collateral, the collateral must be released in installments over the loan’s term in accordance with a schedule that meets the requirements of IRS regulations);
(3) the loan must be a term loan, not a demand loan; and
(4) the loan’s terms must be at least as favorable to the ESOP as the terms of a comparable loan resulting from arms-length negotiations between independent parties and it must bear a reasonable rate of interest.
B. TAX BENEFITS
There are distinct tax benefits provided to the parties to transactions involving an ESOP. Specific provisions of the Code benefit an employer that establishes an ESOP, participants of an ESOP, and shareholders selling stock to an ESOP. The benefits include the deductibility (in effect) of principal and interest payments on ESOP loans, the deferred recognition of gain on the sale of stock of a closely held company to an ESOP, and the deductibility of certain dividends on stock held by an ESOP.
1. Leveraged ESOP Buy Outs. There may be a limited market for stock in a closely held corporation. Often owners of a closely held corporation consider establishing a leveraged ESOP to purchase their shares to overcome this obstacle. Although leveraged ESOP buy outs may be complex, proper planning can produce significant tax benefits.
a. A leveraged ESOP essentially is an ESOP that finances the acquisition of the employer stock with borrowed money. With a closely-held corporation, a leveraged ESOP may be used to finance the sale of large shareholder interest. An ESOP buy-out frequently provides the following benefits:
(1) It permits the transfer of the non-ESOP shareholders’ C corporation ownership interest without recognition of taxable income; and
(2) Provides employees with both retirement benefits and added incentive in holding an ownership interest in their employer.
b. A leveraged ESOP buy out often includes the following steps:
(1) The employer establishes an ESOP (a plan and trust).
(2) The majority shareholder(s) enter(s) into an agreement with ESOP to sell his or her/their shares to the ESOP at an agreed upon price (which may not be in excess of fair market value as determined by the ESOP’s independent appraiser).
(3) The ESOP borrows money either (i) from a financial institution (this loan may be guaranteed by the corporation establishing the ESOP and the stock and the employer need to be purchased with the loan proceeds may be pledged as collateral); or (ii) the employer may borrow money from the lender and, in turn, lend the loan proceeds to the ESOP (this is the scenario generally preferred by lenders since the repeal of Code Section 133, the so-called 50 percent exclusion of interest income ESOP loan, over a decade ago). The leveraged ESOP uses the loan proceeds to pay the selling shareholder(s) for the shares it has purchased.
(5) Over time, the employer makes contributions (and/or cash dividend payments) to the leveraged ESOP in the amount needed to repay principal and interest in the loan. The employer receives, in effect, a deduction of principal and interest on the loan since the employer’s contributions to the ESOP are deductible.
(6) The shares purchased by the ESOP are held in an ESOP “loan suspense account” and allocated to participant accounts in the plan as the loan is repaid by the ESOP.
2. Deduction of Employer Contributions. Within limits imposed by Section 404 of the Code, employers may deduct contributions which they make to qualified retirement plans. These limitations also apply to contributions made to an ESOP. The Code provides that an employer may contribute to an ESOP and deduct up to 25 percent of the compensation of all participants for that plan year (reduced by the contributions made by the employer to any other tax-qualified defined contribution plan(s) of the employer).
In addition, employer contributions to a C corporation ESOP that are used to repay interest on a loan used by the ESOP to acquire employer securities are fully deductible.
3. Deduction of Employer Dividend Payments. Corporations are generally not permitted to deduct dividends to shareholders. An exception to this rule are dividends paid on shares held by an ESOP. Dividends paid on shares held by an ESOP may be deducted if they are paid in cash to plan participants, paid to the plan and passed through to participants within ninety days after the end of the plan year or used to repay the loan incurred to purchase employer securities.
4. Allocation of Contributions. Since an ESOP is a tax-qualified defined contribution plan, the plan document must provide a definite formula for allocating employer contributions and forfeitures to individual participant accounts. The allocation formula may not discriminate in favor of highly compensated employees and must disregard annual compensation in excess of $230,000 (for 2008, indexed for inflation). Similar rules apply to the allocation of employer securities released from an ESOP loan suspense account and allocated to accounts of participants.
5. Tax-Deferred Rollover Treatment. The tax-deferred treatment of gain realized in the sale of stock to ESOP is often the critical factor (generally when long-term capital gains rates are in excess of the current 15 percent) in deciding to proceed with a leveraged ESOP buy out. Under Section 1042 of the Code, a shareholder realizing gain from the sale of stock to a C corporation ESOP may elect to defer recognition of the gain if the requirements set forth below are satisfied.
Under Section 1042, if a stockholder sells “qualified securities” to a C corporation ESOP and makes the appropriate election, gain is generally not recognized if all of the following conditions are met:
a. The ESOP must own at least 30 percent of either (a) each class of outstanding stock or (b) the total value of all the corporation’s outstanding stock (excluding nonvoting nonconvertible preferred, immediately after the sale).
b. The sale must otherwise qualify for long term capital gain treatment.
c. The shareholder held the securities for at least three years prior to the sales of the ESOP.
d. Within the 15-month period beginning three months before the sale date, the seller purchases “qualified replacement property” and complies with IRS filing requirements.
6. Making the Code Section 1042 Election. A Section 1042 election is made by a shareholder on a timely filed Form 1040 return (including extensions) filed for the year of sale. The taxpayer must also file a written statement in which the employer whose employees are covered by the ESOP consents to the application of Code Sections 4978 and 4979A.
7. 30 Percent Ownership. The 30 percent threshold (discussed above) may be met by several shareholders as a part of a single transaction under a prearranged agreement among the shareholders. For purposes of the 30 percent rule, the Code applies the Code’s attribution rules with this. This provision is intended to preclude evasion of the 30 percent rule through the use of options, warrants or other devices which would ultimately dilute the ESOP’s proportional equity interest below 30 percent.
8. Gain and Holding. Code Section 1042 provides that any long term capital gain realized in a sale of stock to a C corporation ESOP is recognized only to the extent that the proceeds exceed the cost of the qualified replacement properly purchased with the proceeds of the sale. The deferred gain of the stock sold to an ESOP is preserved through an adjustment to the basis of the qualified replacement property. If more than one item of replacement property is acquired, basis is allocated among the items purchased. The holding period of the employer securities sold to the ESOP will be tacked to the holding period of the qualified replacement property.
a. Premature Disposition of Securities. If within 3 years after acquiring a qualified security under a Code Section 1042 transaction, the ESOP disposes of them, the employer may be liable for a 10 percent excise tax on the amount realized.
b. Prohibited Allocation Rule. A C corporation ESOP acquiring securities in a Code Section 1042 transaction is prohibited from allocating plan assets attributable to the securities to:
(1) An electing seller;
(2) The electing seller’s family; and
(3) Any more than 25 percent shareholder.
Further, a comparable qualified plan for the primary benefit of such persons (or the equivalent cash contributions to the ESOP which are not used to purchase stock or repay ESOP debt) to “make up” for lost ESOP allocations cannot be established. Lineal decedents of the seller are eligible for such allocations if they would not, absent the family relationship, be ineligible for such allocations, provided the total amount of allocated to all such lineal decedents of all sellers is no more than 5 percent of the Code Section 1042 securities attribution to such sellers. There is a 10 year period, beginning after the allocation of all Code Section 1042 securities, beyond which allocations to a selling shareholder (any family members) will not cause the C corporation ESOP to fail to satisfy Code Section 4975(e)(7) or be subject to the excise tax of Code Section 4979A.
C. S CORPORATIONS AND ESOPs
Prior to 1997, ESOPs could not hold stock in S corporations. The Small Business Job Protection Act of 1996 and subsequent legislation amended the Code to allow qualified retirement plans, including ESOPs, to hold stock in S corporations. This opened a tremendous tax planning opportunity for certain corporations. However, not all tax benefits available to ESOPs holding stock in C corporations are available to ESOPs holding S corporation stock.
1. Benefits of S Corporation ESOPs.
a. In General. S corporation status allows a corporation to avoid paying federal income tax at the corporate level (most states tax the income generated by ESOP-owned S corporations). Therefore, all earnings of the S corporation allocated to S corporation shares held by an ESOP go untaxed (i.e., federal, not state, income tax) since the ESOP is a tax-exempt entity (under Code Sections 401(a) and 501(a)). Elimination of the federal income tax liability obviously enhances the cash flow of an S corporation owned by an ESOP.
b. Cash Flow.
(1) If an S corporation has shareholders in addition to the ESOP, the non-ESOP shareholders generally need distributions from the S corporation sufficient to cover payment of the taxes on their share of K-1 income.
If such distributions are made to non-ESOP shareholders, an equivalent distribution must also be made to the ESOP.
i. Even though the ESOP does not pay income taxes, the economic rights relating to the S corporation stock owned by the ESOP must be the same—otherwise the one-class-of-stock rule for S corporations will be violated and the S corporation election automatically terminated.
(2) ESOP can use its K-1 distributions in numerous ways.
i. Purchase of additional employer stock;
ii. Additional payments on ESOP loan(s).
iii. Liquidation of stock in ESOP accounts of participants entitled to distributions.
iv. Other investments in ESOP participants’ accounts.
2. Disadvantages of S Corporation ESOPs
a. No Code Section 1042. Shareholders of an S corporation cannot utilize the Code Section 1042 deferral of gain provisions described above.
b. Anti-Abuse. The Economic Growth and Tax Relief Reconciliation Act of 2001 amended the Code to provide that, in general, for plan years beginning after December 31, 2004, an ESOP established by an S corporation must comply with certain anti-abuse rules relating to “disqualified persons.” Congress intended these rules to limit the establishment of ESOPs by S corporations to those that provide broad-based employee coverage and that benefit rank and file employees. Further discussion of Code Section 409(p) is beyond the scope of this outline; however, failure to comply with the Code Section 409(p) anti-abuse rules can result in significant penalty taxes, and ESOP tax-qualification and S corporation status issues.

By: Robert B. Webb, III
Squire, Sanders & Dempsey L.L.P.

Overview

The use of the "Leveraged ESOP" as a means of providing for a "buyout" of existing corporate shareholders is often extremely advantageous as a result of several factors. The basic transaction generally involves the following fact pattern and steps:

1. Closely held corporation (the "Corp.") has significant blocks (if not all) of stock held by a few (or one) individuals ("Founders") who desire to liquidate a substantial part, if not all, of their holdings. Founders generally have held their stock for an extended period of time, often since formation of the Corp, thus face potentially significant tax upon gain in a sale. Founders generally have a substantial portion of their personal wealth tied up in stock of Corp. and desire to diversify into a broader investment holdings base as part of retirement from the business

2. Corp. establishes an "Employee Stock Ownership Plan" ("ESOP"), which is a qualified ERISA plan, the principal feature of which is that the ESOP's principal investment asset consists of stock of the Corp. Plan assets are, as with other ERISA plans, held by a "trustee" under a trust agreement. The Corp. funds annual contributions to the ESOP and treats these as an employee benefit expense, receiving tax deductions, and, in many cases, with cost reimbursable contracts, obtaining reimbursement of the cost of this employee benefit. Annual contributions (an employee benefit by Corp. to employees) are allocated among employees of the Corp. and used to buy stock of Corp. which is then held by the trust but specifically allocated to individual employee accounts. The ESOP can be a "pension" type ESOP where the Corp. is obligated to make certain annual contributions or a "profit sharing" type ESOP where the Corp.'s contribution obligation is discretionary each year based on Corp. profits.

3. ESOP buys stock of Corp. at fair market value, as determined by bona fide appraisal, to hold as its plan asset; thus the value and return to employees are in large part dependant upon growth in value and dividends from Corp. stock held by ESOP. In a "Leveraged ESOP," the ESOP obtains a loan (the "ESOP Loan") from a lending party (generally a financial institution) and uses the loan proceeds to buy a large block of stock in a single transaction (generally from the Founders, but this purchase can also be on the open market or from the Corp. itself). The shares purchased serve as the sole collateral for the Loan and initially are not allocated to individual participant (employee) accounts. The loan is otherwise nonrecourse to the ESOP or to other Trust assets and individual employee accounts.

4. Over the course of years, as the Corp. makes annual contributions to the ESOP, the contributions fund the amortization of the loan (thus are applied to both principal and interest on the Loan). As the Loan is amortized, unallocated shares held as collateral security for the Loan are released and allocated to ESOP plan accounts of individual participants (employees). ERISA requires that shares be released from the lien securing the loan once allocated to individual participants.

5. When employees retire, they either receive their shares of stock or, more typically in the non public corporation, sell their stock back to the Corp. at appraised fair market value, receiving a payout either in cash or over time. Employees may be permitted to receive and retain their stock in kind, however, this is generally not desirable in the context on private companies because of the lack of liquidity.


Possible Advantages of the Leveraged ESOP

Although each situation is unique and not all of these advantages can be obtained in every case, the Leveraged ESOP often offers the following advantages to the Corp. and to the Founder:

1. Tax Advantages to Founders. Under Section 1042 of the Internal Revenue Code, if Founders reinvest the proceeds in qualified securities (stocks and bonds) of a United States corporation, the proceeds can be reinvested tax free (gain is deferred, not avoided). This tax advantage often results in significantly higher net after tax proceeds to the Founders than a sale to another corporation or a public offering. This advantage is not available if the Corp. is an S corporation (prior to the sale), but if the Corp is a C corporation (i.e. subject to corporate level tax) prior to the sale, it may elect S corporation status once sale is consummated). Stock received pursuant to options or in connection with the performance of services is also not eligible for this tax-free rollover.

2. Cost Advantage to Corp. The Corp. can gain three potential advantages:

(a) possible reimbursement of cost via contract pass throughs.

(b) possible tax savings if the Corp., is eligible for "S Corporation" status as a result of post transaction ownership and then so elects, thereby eliminating corporate level federal and Virginia state income tax (with some possible exceptions) entirely. As an S corporation, income is passed through to the shareholders and escapes income tax entirely to the extent of ESOP ownership. This results because since the ESOP trust is not subject to tax, the Corp. income allocable to the ESOP escapes taxation altogether. Other S corporation shareholders remain subject to taxation.

(c) employee motivational and morale benefits of being an "employee owned company."


Issues

The implementation of a leveraged ESOP transaction involves a number of issues and hurdles, the more significant of which are as follows:

1. Loan Financing - The leveraged ESOP involves a loan, thus a third party financing commitment must be obtained upon terms that are financially acceptable to the Corp. The maximum that the Lender is willing to lend generally defines the maximum price that can be paid to the Founders. Often times to support a larger loan and permit the purchase of more shares at a time when the market valuations are high (i.e. "lock-in" today's value), the Founders will agree to pledge back a part of the securities they reinvest their sales proceeds in as additional collateral for the bank financing. Generally these pledged back securities are bonds valued, for collateral purposes, at 90% of value, and are held in a brokerage account under a collateral account control arrangement until the loan is curtailed substantially (but are generally released prior to payoff in full). Often an interest hedge derivative product is put in place to protect the lender against a decline in value and the Corp. and selling Founder against a "margin call."

2. Appraised Fair Value - Under ERISA, the stock cannot be sold to the ESOP at a price that exceeds appraised fair value, as determined by qualified third party appraisal. Generally, two independent appraisals are obtained to assure that the plan is paying fair value and to protect the Corp. and the Founders against liability.

3. Terms of Sale - The Founders, the ESOP trustee, and the Corp. must agree upon mutually acceptable terms of sale for the stock being purchased. If the sale is all cash, this can be straightforward, but if the Founders are not selling all of their stock or will also be receiving deferred notes (not eligible for 1042 tax free rollover), then other material issues may need to be negotiated.


4. Plan Design - Because the ESOP is an employee benefit plan, decisions must be made with respect to plan design, scope of coverage, participants, and communication of the plan to employees in a positive manner that achieves the desired employee motivational benefit. The plan must, of course, be designed and maintained in compliance with applicable ERISA (Department of Labor and Internal Revenue Service) requirements.

The above summary is intended to provide introductory information and should not be relied upon as legal advice for any actual transaction without further consultation with counsel. For further information, please contact Bob Webb, Attorney-at-Law, Squire, Sanders & Dempsey L.L.P., 8000 Towers Crescent Drive, 14th Floor, Tysons Corner, Virginia. Tel: (703) 720-7855; E-mail: rwebb@ssd.com

Annual Conference
ESOPs: When The Going Gets Tough We Grow Stronger
33rd Annual ESOP Conference
May 12 & 13, 2010
Renaissance Washington Hotel
Washington, DC

Info available at
http://www.esopassociation.org/meetin ... ngs_annual_Conference.asp