Interview on ESOPs With A Third-Party Administrator

Interview with Carla Klingler, Vice President, Swerdlin & Company

Kevin: We’re meeting today with Carla Klingler, Client Relations specialist of Swerdlin & Company, a third-party administrator based in Atlanta.  Carla is a recognized industry expert on retirement plans.  Today, she will be sharing with us the basics of an Employee Stock Ownership Plan, also known as an ESOP.

Welcome, Carla, and thank you for joining us.

Carla: Thanks for inviting me.

Kevin: Can you tell us a bit about your firm and your background?

Carla: We are a 3rd party administration firm (known in the retirement industry as a TPA) and ERISA Consulting firm.  We provide consulting, recordkeeping, and compliance services for all types of retirement plans and we specialize in business transitions using Employee Stock Ownership Plans (ESOPs).

Kevin: There is a good deal of literature about ESOPs from various organizations.  They seem complicated but also appear to offer a good number of benefits to both owners and employees.  What is an ESOP?

Carla: An ESOP is an employee benefit plan which owns the stock of the company for the benefit of the employees.  It is often seen as a great motivating tool for employees to work hard, be more productive, and share in the wealth of a growing company.  For companies, it can become a method of lowering tax burdens.  For owners, it provides a means to sell their interest often at a great tax advantage and on their own timeframe.

Kevin: What are some specific advantages of an ESOP?

Carla: An ESOP is the only business transition tool that allows an owner to sell their interest in their company gradually over time or all at once (as in a traditional sale to a third party).

For an owner, it can be a great way of ensuring a smooth transition to the next generation of managers, whether that be the next generation of family members or a trusted management team.

It also can provide significant tax savings to the owner and the company as well as being a unique employee motivator and value driver.

Kevin: Can you tell us more about the benefit?

Carla: The Employee Ownership Foundation recently tracks economic performance of esop companies.  Over the last 23 years, 76% of survey respondents said their esop improved the overall productivity of the employee owners. 70% reported revenues increased and 64% stated profits rose.  93% agreed creating an esop was “a good business decision that has helped the company”.

Kevin: How can it help companies with their taxes?

Carla: Contributions to esops are tax deductible.  There are limits as there are with most plans.  If an esop is leveraged, the deductibility is even higher.

Kevin: How can an ESOP be leveraged?

Carla: The esop or its corporate sponsor borrows money from a bank or other qualified lender. The company usually gives the lender a guarantee that it will make contributions so the trust can pay back the loan.  A company which repays an esop loan gets to deduct principal as well as interest from taxes.  Dividends paid on esop stock passed through to employees or used to repay the esop loan are also tax deductible if the sponsor is a C corporation.

Kevin: What other ways can an ESOP save a company taxes?

Carla: A huge advantage to having an esop in an s-corporation (where profits are passed through to the shareholders via a K-1) is that the ownership % owned by the esop trust is tax free.  The esop trust is a tax-exempt entity; therefore, no tax is due on the esop’s share of the sponsor’s income.  In a 100% esop owned s-corporation, there are no corporate taxes due.

Taxes are paid when esop participants receive a distribution from the retirement plan with the same tax advantages and rollover opportunities to the employee that are available on distributions from all other types of qualified retirement plans like 401(k)s.

Kevin: What can an ESOP do for an owner?

Carla: Owners of closely held C corporations can sell their stock to the esop and defer federal income taxes on the gain from the stock sale.  The esop must own at least 30% of the company’s stock immediately after the sale and the seller must reinvest the proceeds in securities of domestic operating companies within either three months before the sale or twelve months after the sale.  There are some other restrictions.  In a nutshell, the seller can cash out fully or partially tax free.  Not until the securities he or she bought with the sale proceeds are sold are any federal taxes payable.

Kevin: Thanks, Carla for your time.  If readers have any questions, how can they contact you?

Carla: You can reach me at or call (678) 775-5506.

The ESOP Trustee – Selecting the Right Candidate is Important

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Employee Stock Ownership Plan (ESOP) trustee selection can have important regulatory implications, particularly with the Department of Labor (DOL). While it is not unusual for a business owner to want to serve as trustee for the ESOP, an external trustee is almost always a better course, particularly when the trustee is also the selling shareholder.

Anyone providing ESOP trustee services should be sufficiently independent to ensure that they cannot be influenced by the company’s management and owners. They should follow the prime directive of trusteeship, namely, to focus solely on the benefit of the ESOP and its participants.

With increasing frequency, we hear of the DOL recommending in its review findings that an external trustee is suggested.  Court cases such as Perez v. Bruister, support this.

The sole owner of Bruister & Associates was one of three trustees in a staged sale of all of his stock to an ESOP.  The other two trustees were an employee and the outside CPA, respectively.  The Fifth U. S. Court of Appeals, in its decision, stated that while Bruister abstained from voting on the transactions, he influenced the valuation with actions ranging from firing the ESOP counsel, firing the initial appraiser and influencing the second appraiser by adjusting assumptions and financial information.  The Court further stated all the trustees violated their fiduciary duty by failing to act solely for the benefit of ESOP participants.  Clearly, an owner should not be a trustee in a transaction in which his/her ownership interest is involved.

We recommend that ESOP trustee selection be limited to external parties with no conflict of interest.

Changes in the Wind for Estate Taxation

Section 2704 Proposed Changes: Much Ado About Nothing? A Different Kind and Level of Estate Taxation? A Golden Opportunity? All the Above?

Estate TaxesThe December 1 IRS hearings on proposed changes to the Section 2704 Regulations demonstrated the significant opposition from taxpayers, advocacy groups and other interested parties. Thousands of comments, almost all against the proposals, were submitted. A record crowd attended the five-hour hearing. No supporter (or just one depending on the reporting source) came forward.

The controversy includes limits to valuation discounts many see in the proposed regulations. Experts disagree on the extent and intent of these limits.

After the hearing, some believed the IRS would rework their proposals. Others thought it may be moot.

As part of his sweeping tax plan, President-elect Trump calls for the elimination of estate taxes. Most presume this would include gift taxes. When/if this broad-reaching tax plan is passed depends on how many Senate Democrats Mr. Trump can persuade to join him to reach the 60 votes required. And where in his list of tax changes do estate taxes fall? Many times, we have seen proposed tax changes negotiated away.

Trump spoke of implementing a capital gains tax at death. Most agree stepped-up asset values would remain. The Tax Foundation thinks otherwise. They read into Trump’s proposal that estates over $10 million would effectively lose their stepped-up basis. They further believe the capital gains tax would be deferred until the inheritor disposed of the asset. (Interestingly, the Tax Foundation projects a repeal of estate taxes would lower federal government revenues by $240 billion between 2016 and 2025 and would have a positive 0.9% effect on GDP over the same period).

A capital-gains-at-death tax could mean an effective tax of 20%. It’s uncertain if the federal exemption would continue. In 2017, that exemption rises to $5.49 million ($10.98 million for a married couple).

Estate planning professionals are understandably unsure how to proceed. Many unknowns are in play.

One strategy is certain: with no change, a new tax or a tax repeal, moving assets out of an estate remains beneficial.

  • If no change occurs, the benefits seen today remain.
  • If a new tax is enacted, the benefits diminish but will still exist.
  • If the tax is repealed, this becomes a golden time to move assets, potentially federal tax free.

The biggest uncertainty: What happens when Democrats regain control?

Estate of Giustina V Commissioner

This recent estate tax case is rife with valuation issues.  And it is one of the few that the issues are clearly defined and resolved.

The United States Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) remanded the case to the Tax Court to reconsider its decision on the valuation of the Estate’s interest in the Giustina Land and Timber Company Limited Partnership (the “Partnership”).

On January 1, 1990, the Partnership was formed to operate a sustained yield timber harvesting company.  (A sustained-yield timber harvesting company looks to harvest timber and replace it with new plantings at a rate that will allow it to continue into the foreseeable future).  The partnership agreement stated the Partnership would continue in business until December 31, 2040, 50 years after it was formed.

The partnership agreement placed all control of the partnership into the hands of the two general partners.  This control included the ability to sell off the land and harvested products.  The agreement stated a general partner could only be approved or replaced by limited partners owning at least two-thirds of the limited partnership (“LP”) interest. (Note the two GP’s were family members operating through corporate structures.  The decedent was not a GP.  All limited partners were either family members or trusts for the benefit of family members).  To dissolve the partnership, the backing of the same two-thirds ownership of LP interests would be required.

Natale Giustina passed away on August 13, 2005 holding a 41.128% LP interest.  The Estate’s valuation expert and the IRS’ valuation expert opined widely divergent values, primarily from the IRS expert’s reliance on a net asset method and from very different results from the guideline company method.

The Tax Court primarily agreed with the IRS.  The Court ultimately derived a value based on the net asset method and the cash flow method.  The Estate appealed.

The net asset method, in my view, is associated with liquidation, not with a going concern.  Under a net asset method, the value derives from the analyst’s belief of what the assets sell would for and liabilities be settled for in an orderly sale.  At the date of death, this Partnership had been in successful operation for almost 15 years.  Predecessor companies existed, dating back to the early 20th century.  The GPs had never expressed any intent to cease operations or sell off major assets.  This Partnership definitely qualifies as a going concern.  The Ninth Circuit apparently agrees.

In its initial decision, the Tax Court weighted the net asset method 25%.  It presumed there was a one-in-four chance a limited partner could either replace the two general partners or force a partnership dissolution.  As the Ninth Circuit pointed out, not only would this require the backing of limited partners holding two-thirds of the total LP interests, it would mean a new limited partner would turn against the GPs who just admitted him or her to the partnership.  (Alternatively, a transfer could occur to an existing limited partner without GP approval).  In such a cohesive family partnership, turning other family members against the GPs appears more hopeful than possible.  And, as I stated above, the GPs never expressed any intent to sell assets.  The fact the entity and its predecessors had been in operation for decades was significant evidence the Partnership was a going concern.

On remand, the Tax Court weighted the cash flow method 100%.

The Tax Court took issue with a component of the company-specific premium the Estate’s expert included.  All income-generating assets were timberland in Oregon, significant revenue and geographic dependencies.  The Estate expert added a 3.5% risk factor.  The Tax Court halved it under the presumption a buyer could force diversification.  The Ninth Circuit stated the Tax Court did not provide support for cutting this premium in half.  The Tax Court rescinded it.

The Estate expert applied a 35% lack of marketability discount.  The IRS expert applied a 25% discount. The Tax Court, in its initial decision, applied a 25% discount, but only to the cash flow result.  The Ninth Circuit did not question the Tax Court’s use of a 25% discount.  It pointed to the Estate expert’s statement that these discounts can range from 25% to 35%.  This supports the standard that all factors used needs to be thoroughly supported.  Support for discounting is among the most difficult parts of a valuation.  It’s one of the many reasons why a valuation is an opinion.

Normalizing Adjustments and Valuations

Valuations frequently assume a third party will purchase a business and primarily run it unchanged.  This does not mean a buyer will continue to pay expenses or a level of expense not considered typical.  Non-operating assets are typically excluded from a valuation, too.  Normalizing adjustments take the atypical expenses or portion of expense (or income) out of the mix.

Non-operating and one-time items include but are not limited to gains and losses from the sale of assets, income and expenses related to investments and legal settlements.  Expenses related to layoffs are an example of operating but non-recurring expenses generally removed.  If an income source or expense is not related to ongoing operations, it is subject to adjustment.

Discretionary adjustments look to income sources or expenses over which an owner has a choice.  Compensation paid to owners and officers as well as rent paid to related parties are frequent candidates for a discretionary adjustment.  Rent paid to a related party is often based on the cash flow requirements of that related party.  For a property with no mortgage, for instance, below market rent may be paid.  This is an example of how adjustments can work as a reduction of expense or an addition to expense.

Various authoritative sources report officer/owner compensation based on industry type, size and location.  These sources can form the basis for this adjustment.  Real estate appraisals are frequently used as the source for an adjustment to market rent.

Controversy exists over whether to include “discretionary” adjustments when valuing a minority interest.  Opponents say no, correctly stating a minority owner has no control over these discretionary expenses.  Proponents argue these adjustments should always be considered.  Shareholders of publicly-traded companies will invest elsewhere if they deem company management is overpaying executives, for example, resulting in a lower return on their investment.  A growing lack of investor interest leads to a decline in share price.

Proponents point to the derivation of yields used when calculating value based on cash flow.  These yields are often based on data from public equity markets.  As investors price shares and the related returns based on how well management is running the company, a perceived overpaying of expenses will lead to lower share prices and returns.


Stock Options and the Smaller Business

Stock options and stock ownership plans are a popular and effective method of incentivizing employees, often at a low cost to both the employer and the employee. Several types exist, including non-qualified stock options, incentive stock options, employee stock ownership plans, phantom stock, stock appreciation rights and more. In this second of a series of articles, we will look at Phantom Stock Options and Stock Appreciation Rights.

Phantom Stock Options and Stock Appreciation Rights

Under traditional stock option plans, an employee can become an owner of the company. Often, a business owner does not wish to pass along ownership. But s/he does want to incentivize key employees. Phantom stock options (“mirror stock” or “shadow stock”) and stock appreciation rights (SARs) both provide these features.

As with other stock plans, a set of milestones can be established. The “shares” are “issued” when the milestone is reached.

Phantom stock plans are tied to long-term company performance. There are advantages to both the employer and employee traditional stock plans don’t offer. Employees do not need to invest any money. Nor are they subject to corporate governance issues that may arise. They cannot be asked to personally guarantee company obligations. Most importantly, if they wish to sell shares under a traditional plan, their options may be limited. Typical smaller businesses are not traded and often do not hold any defined means for redeeming shares. This issue is not relevant for a phantom plan.

For an employer, the shares are “phantom”, the employee is NOT an owner. These employees hold no authoritative input in the management of the business. Yet, the employee can be incentivized through additional value added to the business, much like an owner. Administratively, these plans are much less complex than traditional stock option plans.

For the employer and the employee, the exercise of the option becomes an immediate taxable event. The employee reports it as ordinary income; the employer as a deduction.

With a SAR, many of the same advantages exist as with phantom stock. The key differences are in the exercise of the option and the amount of the award. A SAR can be exercised at the employee’s discretion once the vesting schedule is met. A phantom plan calls for exercise at the time the vesting schedule is met. A SAR awards the employee the amount equal to the difference between the FMV of the underlying stock at the exercise date and the grant date. The recipient of phantom options receives the full value of the share.

An attorney and a tax advisor should design the plan with your guidance to avoid any legal or tax consequences.

At JBV, we have valued many stock option plans, from ESOPs to phantom stock and SAR plans to ISOs and more. We are here to assist you.

What Is Fair Market Value? The IRS v The Taxpayer

James and Julie Kress (the “Taxpayers”) filed a lawsuit in United States District Court for the Eastern District of Wisconsin [Case 1:15-cv-01067-WCG] on September 2, 2015. They sought a refund of federal gift taxes and interest they claim were erroneously assessed by the IRS on gifts made in 2007, 2008, and 2009.

The Facts

The Taxpayers are shareholders of an S corporation. The shares are owned by members of the Taxpayers’ family and certain employees and directors. The company’s bylaws and shareholders’ agreement restrict transfer of shares by family members to other family members or to trusts, as defined in the bylaws. An annual valuation opines the value of minority blocks of the shares.

The bylaws and shareholders’ agreement also stipulate transfers of stock by non-family shareholders are subject to a right of first refusal by the company. The bylaws and stockholder agreements specify these transfers must be at 120% of the company’s book value at the time of transfer.

In the years stated above, minority shares were gifted to members of the Taxpayers’ family at Fair Market Value as determined by an independent valuation. These valuations took into account the restrictions on transfers of shares held by family members.

The IRS challenged these amounts. It determined the gifts should have been valued at 120% of book value, the value which the company’s shareholders agreement and by-laws provide for transfers by non-family members.

The Issue

Fair Market Value is defined as the value a property would receive if it were sold in the open market. Among other factors, it assumes the buyer and seller are reasonably knowledgeable about the property in question, they are acting in their own best interest and neither party is under any undue influence.

In this Case, we see two sets of values. One is the values determined by the independent valuations, the other is 120% of book value. The Taxpayers assert the transfer price calculation for non-family members is to simplify transfers. (Shares transferred by non-family members typically had different, and much higher, bases than those transferred between family members).

The Taxpayers claim the restrictions on family transfers are a “bona fide business arrangement.” The restrictions, they claim, were not designed to attain discounted values.

So who is right?

The Taxpayers believe an independent valuation of their company should address the stock restrictions unique to family-owned shares. Because of these restrictions, the value of the shares is heavily discounted. The family contends the restrictions are intended to centralize ownership of the company in the family, not to lower the fair market value of transferred shares.

The IRS has been and is continuing to scrutinize transfers of stock among family members, especially those with high discounts. A perceived goal of the IRS is to prevent businesses from reducing the value of their shares through the imposition of severe restrictions limiting transferability of shares by family members. The IRS claims its valuation at 120% of book value better reflects what an external party would expect to pay for shares. It should be noted employees and directors are not third parties.

This case remains pending.

DOL Proposes New Definition for Fiduciary

Since 1975 and prior to April 2015, the definition of fiduciary as put forth by the Department of Labor included a five-part test. Only if all five parts listed below were met would an adviser be considered a fiduciary. Advice was given:

  • as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property;
    on a regular basis;
  • pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary;
  • that will serve as a primary basis for investment decisions with respect to plan assets; and
  • that will be individualized based on the particular needs of the plan or IRA.

In the April 2015 proposed rule, the definition of fiduciary is expanded. If a person meets this definition below, s/he is considered a fiduciary:

  • provides investment or investment management recommendations or appraisals to an employee benefit plan, a plan fiduciary, participant or beneficiary, or an IRA owner or fiduciary, including advice regarding rollovers and distributions from ERISA plans and IRAs;
  • for a fee or other direct or indirect compensation; and
  • either (a) acknowledges the fiduciary nature of the advice, or (b) acts pursuant to an agreement, arrangement, or understanding with the advice recipient that the advice is individualized to, or specifically directed to, the recipient for consideration in making investment or management decisions regarding plan assets.

Exceptions, or carve-outs, are provided:

  • statements or recommendations made to a “large plan investor with financial expertise” by a counterparty acting in an arm’s length transaction;
  • offers or recommendations to plan fiduciaries of ERISA plans to enter into a swap or security-based swap that is regulated under the Securities Exchange Act or the Commodity Exchange Act;
  • statements or recommendations provided to a plan fiduciary of an ERISA plan by an employee of the plan sponsor if the employee receives no fee beyond his or her normal compensation;
  • marketing or making available a platform of investment alternatives to be selected by a plan fiduciary for an ERISA participant-directed individual account plan;
  • the identification of investment alternatives that meet objective criteria specified by a plan fiduciary of an ERISA plan or the provision of objective financial data to such fiduciary;
  • the provision of an appraisal, fairness opinion or a statement of value to an ESOP regarding employer securities, to a collective investment vehicle holding plan assets, or to a plan for meeting reporting and disclosure requirements; and
  • information and materials that constitute “investment education” or “retirement education.”

A comment period expired in June with an expected final hearing date in late July 2015.

The DOL specifically carves out valuation analysts from the role of a fiduciary. At Jennings Business Valuation, we always consider it our mission of providing a defensible valuation that is fair to all to include all participants in the ESOP, as well as its Trustees and the company that sponsors it.

IRS May Try to Restrict Discounts

At the American Bar Association (ABA) Section of Taxation meeting on May 8th, 2015, Catherine Hughes, of the Office of Tax Policy in the U.S. Treasury Department, announced that proposed regulations under section 2704(b)(4) could be released before the fall. She indicated that the tax community could look to the Obama Administration’s prior budget proposals on valuation discounts for clues about what the proposed regulations might provide.

Section 2704(b)(4) states:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.

Many believe the IRS does not have the authority to ignore minority and marketability discounts without Congressional action.

The IRS has unsuccessfully tried the Congressional route before.

A proposal was included in President Obama’s budget proposals in each of fiscal years 2010 to 2013. These proposals called for the elimination of discounts in family-controlled entities. None made it to the final approved budget.

Within the last ten years, the Certain Estate Tax Relief Act of 2009 appears to be the sole introduced bill on the topic. (Note my search was unscientific and may exclude other recent actions.)

HR 436: “Certain Estate Tax Relief Act of 2009”

This bill proposed the elimination of the ability to apply discounts for lack of marketability for transfers of “nonbusiness assets” of an entity. “Non-business assets” are those that are “not used in the active conduct of one or more trades or businesses.” For example, the new law would disallow a lack of marketability discount for the transfer of an interest in an entity that relates to the entity’s holdings of marketable securities.

Exceptions would have applied to two particular types of assets. First, an exception would have been made for real property owned by an entity is which the transferor materially participates, which would be measured in a manner similarly to passive activity limitations for income tax purposes. Second, an exception would have existed for “reasonably required” working capital of a trade or business.

Additionally, the Bill disallowed any minority discount for transfers of interests in a family controlled entity. This would have attributed ownership of the transferor to their spouses, parents, children, grandchildren, etc., thus eliminating the minority interest discount.

Status – Died in Congress

Does this mean the current attempt will fail? Who knows! However, panic mode is not called for.

DOL v PBI Banks, Inc. and The Miller’s Health Systems, Inc. Employee Stock Ownership Plan

No case is clear cut, but lessons often can be learned.  In the recently filed action, the Department of Labor v PBI Bank, Inc. and The Miller’s Health Systems, Inc. Employee Stock Ownership Plan (United States District Court for the Northern District of Indiana, Civil Action: 3:13CV1400), some, but not all, of the issues surrounded the valuation report.

In this initial ESOP transaction, multiple drafts of a valuation report were produced.  The ultimate valuation, according to the Department of Labor’s filing, failed to consider several items.

  • No marketability discount was applied.  Though drafts of the report included a discount of 5%, the final version had none.
  • The stock purchase agreement included an earn-out agreement which provided the selling shareholders an amount equal to 40% of future earnings over a specified threshold for about eight years.  The valuation, according to the Department of Labor, failed to address this issue.
  • A stock option plan set aside 20% of Company shares for the selling shareholders, at a strike price of $4.08 per share.  The valuation for the initial transaction provided a total value of $42,379,000 for the 1,000,000 outstanding shares, according to the Department of Labor.  At the valuation date, these options apparently were “in the money” but according to the Department of Labor, the dilutive effect was not considered in the final report

Note that all of the above statements are based on our interpretation of the Department of Labor’s filing, not on a final Court decision.

Other issues outside the valuation report trumped those mentioned above.

The ‘lesson learned’ here is to ensure the valuation analyst knows the intricacies of an ESOP, particularly with the initial valuation.  At our firm, we review all important company resolutions and agreements, those directly associated with the ESOP and those created contemporaneously with the ESOP transaction.  We look at the financing arrangements.  We discuss all of items these with the Plan Administrator, the Trustee and company management.

We don’t opine unless we’re satisfied the final opinion is reasonable, fair to all parties, and, most importantly, can be supported. A DOL auditor recently remarked to a client our work product was among the most thoroughly documented he had reviewed.