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2 What is an ESOP? How can you benefit? Presented by Timothy J. Cleary VP - Consulting The Principal Financial Group ® (952) x318

3 ESOP Opportunities in Estate and Business Succession Planning Sample opportunities What is an ESOP How does an ESOP transaction work Benefit for owners to sell to ESOP Benefit for company – tax savings S corporation benefit Common objections Combining with a GRAT Review and candidate profile

4 ESOP Success – No Successor, Inc. Small distribution company, owner in late-50s Bought business 20 years ago Corporation is primary asset - $7 million No children in business Interested in retiring in 3 – 5 years Want to take care of employees Interested in ESOP Facts: Goals:

5 ESOP Success – No Successor, Inc. Sold 30% to ESOP, deferred tax on sale Gave 10% over 5 years to key employees Sell rest in 5 – 7 years Started including key employees on strategic decisions Solution:

6 ESOP Success – Big Private Co. 30 year old business valued at $185 million Owned by 2 nd generation in late 60’s 2 sons in business, 2 daughters outside Strong management Father and one son value employees Other son wants as much as he can get Ready to retire Management team including sons in control Liquidity for daughters & life-time Charitable giving Facts: Goals:

7 ESOP Success – Big Private Co. Sold 100% of stock to ESOP for $135 million Gave $50 million to sons & management over 15 years Set up estate plan to provide equal value to daughters Solution:

8 ESOP Success – Eggs in 1, Inc. 5 year old marketing firm valued at $8 million Owned by 2 conservative men in early 40’s Worth more than dreamed of Questioning should they sell; don’t want to No buy sell insurance Protection for family Diversification Golden handcuffs/Ownership for key employees Facts: Goals:

9 ESOP Success – Eggs in 1, Inc. Sold 40% to ESOP to get liquidity Diversified investment for family protection Sold 5% to key management Hold the rest of the stock and have fun again Solution:

10 What is an ESOP? Employee Stock Ownership Plan Retirement plan protected by ERISA Similar to profit sharing or 401(k) match Two differences: –Primarily invested in company stock –Can borrow money to buy stock Flexible tax-advantaged tool for many corporate finance transactions!

11 ESOP Success – ABC, Inc. Owned by John and Mary Jones, both in early-60s Founded business 25 years ago Corporation is primary asset Pillar of community Interested in retiring in 3 – 5 years Want Child 1 to take over business Want equal value for Child 2 outside of business Want to take care of employees and local charities Facts: Goals:

12 Contemplating the Exit ESOP Selling Shareholders Third Party Family

13 Third Party Sale Selling Shareholders Third Party Owner pays capital gain tax Buyer pays with after-tax earnings Owner likely loses control Corporate identity? Fate of employees?

14 Family Sale Selling Shareholders Family Owner pays capital gain tax Buyer pays with after-tax earnings Family retains control Business retains identity Retain employees

15 Benefits for you and your clients Liquidity tax free Retain control until retirement Corporate tax savings pay for liquidity Employees own part of business and not pay taxes until retirement Client and key employees protected/insured Have a very happy client Get commissions from several sources Client Benefits: Intermediary Benefits:

16 ESOP Transaction ESOP Bank Tax Deferred Reinvestment Company Buy Stock Loan 1 Loan 2 Selling Shareholders

17 Requirements for Tax Advantage The company is a closely-held C corporation at the time of the sale The seller owned the stock for at least 3 years The seller didn’t acquire the stock through an option or other compensation situation The ESOP owns at least 30% immediately after the sale

18 Sellers’ Advantages Seller has to reinvest in replacement securities Tax on capital gain deferred Tax eliminated if hold reinvestment for lifetime Products available to hold reinvestment for lifetime –Still have use of up to 100% of proceeds Savings maybe in excess of 20% of value!

19 ESOP Transaction ESOP Bank Tax Deferred Reinvestment Company Buy Stock Loan 1 Loan 2 Selling Shareholders

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

21 Allocation of Stock Stock Year 2 Participant Accounts ESOP Trust For financial professional use only.

22 It gets better... S corporation advantage

23 S Corporation – Tax Elimination Company ESOP Tax on shareholder portion only S dividend distributions Loan payment Non-ESOP Shareholders NO TAX!!! Tax savings pay 100% of debt!!!

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

25 Estate Planning... Combine ESOP with GRAT

26 Perfect time for GRAT GRAT – Grantor retained annuity trust Gift asset = retained annuity to grantor No gift tax S distributions for tax on S income count as annuity If annuity insufficient, transfer part of stock back Want to gift when stock value is low, transfer back when stock value is high

27 Use of GRAT with ESOP Sale Company ESOPGRAT for Family 51%49%

28 Perfect time for GRAT Valuation for GRAT immediately after ESOP transaction: –Reduce for ESOP debt –Add back small amount for tax advantage of ESOP –Reduce 49% transferred to GRAT for minority discount

29 Value for GRAT Pre-ESOP company value$100 Less ESOP debt($51) Plus add back for ESOP$15 Post-sale company value$64 49% value$31 Minority discount 30%($9) Discounted 49% value$22

30 Perfect time for GRAT Since transfer value is low, S distributions may equal annuity If not: –Valuation increases as outside debt is repaid –Outside debt repaid over 5-7 years so value likely to be higher at end of GRAT period

31 ESOP Uses in Private Companies Heavy lifting in an exit succession strategy while providing continuity of management and control Partial or complete liquidity for inactive shareholders Create a market for closely held stock Acquisition strategy Combine with a GRAT in family business Reward, retain and attract employees Create tax efficient employee-owned company

32 Who is a Typical ESOP Candidate? Closely-held C or S corporation One or more owners nearing retirement or wanting liquidity History of profitability ($1,000,000 or more) Successor management in place or in wings Available corporate credit Comfortable with sharing value with employees Minimum 50 employees

33 Review... Great opportunity for you and your clients!

34 ESOP Advantages Seller –Friendly buyer for all or part of the stock –Tax on capital gain deferred –Tax eliminated if hold reinvestment for lifetime –Seller retains control –Control fate of company and employees –Better protection from various risks –More complete estate plan

35 ESOP Advantages Employees –Ownership at no cost –No tax until receive distribution from ESOP or IRA Company –Tax savings pay for all or part of the seller’s liquidity –Retain, reward, attract and motivate employees

36 ESOP Transaction Process: Building Value Preliminary Design Comprehensive Design Comprehensive Financial Analysis Seller Investment & Planning Documents Financing Valuation Administration Communication

37 Thank You. When you think ESOP Think The Principal Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group, Des Moines, IA ©2004 Principal Financial Group ®, Des Moines, Iowa All rights reserved. No part of this presentation may be reproduced or used in any form or by any means, electronic or mechanical, including photocopying or recording, or by any information storage and retrieval system, without prior written permission from the Principal Financial Group.