Table of Contents

Introduction ix
Chapter 1: Employee Stock Ownership Plan History and Background


Overview of Employee Ownership and Employee Stock Ownership Plans 1


Underlying Philosophy of ESOPs 1


Legislative History  2


Employee Retirement Income Security Act of 1974  3


Revenue Act of 1978  3


The Chrysler Loan Guarantee Act of 1979  3


The Economic Recovery Tax Act of 1981  3


Deficit Reduction Act of 1984  4


Tax Reform Act of 1986  4


Small Business Job Protection Act of 1996  4


Taxpayer Relief Act of 1997 4


The Economic Growth and Tax Relief Reconciliation Act of 2001 5


Jobs and Growth Tax Relief Reconciliation Act of 2003  5


Impact on ESOPs  5


ESOPs Today 6


Summary  7


Chapter 2: Significant Events and Organizations


Regulations and Government Agencies  9


Employee Retirement Income Security Act of 1974  9


IRS  11


Securities and Exchange Commission  13


DOL  14


General ERISA Fiduciary Considerations  16


Proposed DOL Regulations Specifi c to ESOP Valuations 19


Major Exceptions to ERISA for the Benefi t of ESOPs  20


ESOP and ERISA Litigation  21


Summary  22


Industry Organizations and Standards  22


The AICPA  22


The ESOP Association  26


National Center for Employee Ownership (NCEO)  28


Ohio Employee Ownership Center  30


Appendix 2A—IRS Form 5309, Application for Determination of Employee Stock Ownership Plan  31


Chapter 3: Employee Stock Ownership Plan Transaction Mechanics


Traditional Uses of an ESOP  35


Provide Liquidity and Diversifi cation for Shareholders  36


Provide a Means of Capital Formation  36


Finance Corporate Acquisitions  36


An Incentive to Increase Employee Productivity and Retain Personnel  36


Provide a Succession Plan  37


Provide Liquidity in Divorce Situations  37


Provide Negotiating Leverage for Any Proposed Transaction  37


Summary  38


Alternatives to an ESOP  38


Sell or Transition the Business to Family Members  38


Sell to Management or Key Employees  38


Sell or Merge With a Third Party—Financial Buyer  38


Sell or Merge With a Third Party—Strategic


or Investment Buyer  39


Sell Stock Through an Initial Public Offering  39


Liquidate the Business  39


Summary  39


Basic Features of ESOPs 40


Operating Considerations of an ESOP  40


Contributions to an ESOP Are Tax Deductible Within Statutory Limits  44


Contributions to an ESOP Based on Dividends (C Corporation)  50


Contributions to an ESOP Based on Distributions (S Corporation)  52


IRC Section 1042 Tax-Free Rollover (C Corporation)  54


Nontaxable Income Related to ESOP Stock (S Corporation)  58


Assets in ESOP Remain Untaxed Until Retirement  59


Appendix 3A—Sample Documents Relating to the Internal Revenue Code Section 1042 Election  61


Sample Statement of Election  62


Sample Statement of Consent for ABC, Inc  63


Sample Statement of Purchase  64


Chapter 4: Employee Stock Ownership Plan Transactions and C Corporations


Sample Facts—ABC, Inc (C Corporation)  65


Abbreviated Financial Statements  66


FMV of Common Stock for the Purposes of an ESOP  67


Common Entities in Transactions  68


Example—Stock Contributed to ESOP (Capital Formation ESOP)  69


Example—Leveraged ESOP With IRC Section 1042 Rollover  70


IRC Section 1042 Restrictions  71


Example—Prefunded ESOP With IRC Section 1042 Rollover  72


IRC Section 1042 Restrictions  74


Example—Leveraged ESOP With IRC Section 1042 Rollover and Control  75


Example—Leveraged ESOP With IRC Section 1042 Rollover, Multiple Classes of Stock, and Control  78


Summary  83


Chapter 5: Employee Stock Ownership Plan Transactions and S Corporations


Sample Facts—ABC, Inc (S Corporation)  85


Abbreviated Financial Statements  86


FMV of Common Stock for the Purposes of an ESOP  87


Common Entities in Transactions  88


Example—Stock Contributed to ESOP (Capital Formation ESOP)  89


Example—Leveraged ESOP (Paying Capital Gains)  90


Example—Prefunded ESOP With No Bank Debt  92


Example—Convert to C Corporation—Leveraged ESOP With IRC Section 1042 Rollover and Control  94


IRC Section 1042 Restrictions  98


Example—Leveraged Sale of 100 Percent to the ESOP in a Single Transaction  100


Summary 103


Chapter 6: Advanced Employee Stock Ownership Plan Applications


Mergers and Acquisitions—Buying a Target Company With Pretax Dollars 106


Purchase of Stock  106


Purchase of Assets  107


Mergers and Acquisitions—Extending the Internal Revenue Code Section 1042 Rollover to a Target Company  107


Extending the IRC Section 1042 Rollover to an Investment in Another Closely Held Company 108


Multiple Investor ESOPs 108


Charitable Giving and ESOPs 109


Contributions of Closely Held Stock to Charities  109


Charitable Remainder Income Trusts and ESOPs  110


Summary  110


Chapter 7: Valuation Issues and Considerations


Issues Regarding ESOP-Based Valuations 112


Identify the Client  112


Standard of Value 113


IRS  113


DOL  115


Valuation Independence and SOX 119


Impact of SOX  119


AICPA Newsletter: CPA Expert, Summer 2003  119


Valuation Perspective on the Repurchase Obligation and the Put Option 120


Valuation Report Date and Events 121


Opinion of Value at a Point in Time  123


Approaches to Establishing Value 123


Initial Valuation: C Versus S Corporation Considerations 123


Income Approach  125


Market Approach  127


Asset Approach  128


Lack of Marketability Adjustment (Discount)  129


Ownership Characteristics 129


Minority and Control Positions 129


Multistage Transactions  130


Dilution Considerations and Outstanding Shares  131


Dilution With the ESOP Contribution of Newly Issued Stock  132


Leveraged ESOPs—Initial Valuation and Annual Updates 133


Annual ESOP Update Issues 134


Fluctuations in Value Between Years  134


Valuation Methodology—Issue of Consistency  135


Increasing Value With Time  136


Multi-Investor ESOPs and Allocation Considerations 136


Multiple Classes of Stock in C Corporation ESOP Transactions  137


Practical Valuation Considerations 139


Chapter 8: Administration and Transaction Considerations


Initial Considerations and ESOP Feasibility Study 141


Team of Advisors  142


Team of Advisers Summary—Have a Transaction “Quarterback”  145


Feasibility Study  146


Informal Planning Process  146


Written ESOP Feasibility Study  146


Feasibility Summary  147


Strategic ESOP Design Considerations 148


Contribution and Addition Limits to Qualified Plans Expanded  148


Maintaining Both an ESOP and a 401(k) Plan  148


Creation of a Preferred Stock or Super Common Stock for the ESOP in a C Corporation  149


Compatibility With the S Corporation Election  150


Senior Management Compensation and Incentives  150


Special S Corporation Considerations  152


ESOP Trustee and Transaction Considerations  152


Benefits of an Independent Fiduciary  154


ESOP Fairness Opinion  155


Fairness From Only a Financial Viewpoint  155


Common Components of the Fairness Opinion  155


Rights of ESOP Participants  156


Right to Demand Employer Securities  156


ESOP Participant Voting Rights  156


Written Materials  158


Dispute Settlement  158


Diversification Requirements  158


Stock Repurchase Obligation  159


Practical Insights  159


Repurchase Studies  160


Funding the Repurchase Obligation  161


Election: Redeeming the ESOP Stock Back to the ESOP  162


Election: Redeeming the ESOP Stock to the Company Treasury  163


ESOP Termination  163


Plan Termination With Outstanding ESOP Debt  164


Disadvantages of ESOPs  165


Complex Regulatory Environment  165


Fiduciary Responsibilities  166


Initial Cost and Ongoing Expenses  166


Repurchase Obligation  167


Employees Fail to Understand and Appreciate the ESOP  167


Summary  168


Chapter 9: Financial Considerations


Financing Overview for ESOPs 169


ESOP Loan Exemption  170


Financing an ESOP—Internal Sources  171


Financially Successful Employer (Plan Sponsor)  171


Prefunding the ESOP  171


Stock Contributions to the ESOP  172


Inside Loan From the Company to the ESOP  173


Financing an ESOP—Seller Financing  173


S Corporation Application  173


C Corporation Application  174


Leveraged QRP Solution  174


Floating Rate Note  175


Financing an ESOP—Third-Party Financing (Bank Debt) 176


Historical Note—Repeal of ESOP Loan Interest Exclusion  176


Overview of General Banking Concerns  176


Common Loan Mechanics  177


C Corporation ESOPs  178


S Corporation ESOPs 178


Summary  179


Chapter 10: Litigation and Significant Cases


The Employee Retirement Income Security Act of 1974 and ESOPs  181


The Importance of Court Cases  182


The IRS  182


The DOL  183


Significant Court Cases  183


Court Case: Donovan v Cunningham  184


Court Case: Hines v Schlimgen  185


Court Case: Las Vegas Dodge, Inc v US  186


Court Case: Gary L Eyler v Commissioner  187


Court Case: William R Davis v Torvick, Inc  190


Court Case: Delta Star v Patton  191


Chapter 11: Practical Considerations and Employee Stock Ownership Plan Resources


Qualifying ESOP Candidates  195


Qualities of Successful ESOP Candidates  196


Characteristics of Less Successful ESOP Candidates  196


Practical Insights Summary  198


Overview of ESOP-Related Resources  198


The EA Publications  198


NCEO Publications  199


The Ohio Employee Ownership Center  199


Other ESOP Resources  200

About the Author

Scott D. Miller, CPA, ABV, CVA, is president and founder of Enterprise Services, Inc. which provides financial consulting services to private business, specializing in transition planning and business valuations. Scott understands closely held and family-owned businesses, serving as officer and principal in several businesses. He has helped hundreds of business owners through transition planning, valuations, and other strategic financial issues. A nationally recognized authority on business transitions and valuations. Scott publishes in professional journals and authors seminars for the American Institute of CPAs and the National Association of Certified Valuation Analysts.