The Unique Alternative to the Big Four ® ESOP Features You May Not Have Considered Michigan Chapter of The ESOP Association Annual Conference September 25, 2014 Presented by: Pete Shuler - Crowe Horwath LLP Justin Stemple – Warner Norcross & Judd

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 2 Audit | Tax | Advisory | Risk | Performance Preface  Please fill out a session evaluation form and drop it off at the table outside of the main room  Your feedback on topics and presenters is important and will be used to develop subsequent programs  Take a moment to silence your cell phone

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 3 Audit | Tax | Advisory | Risk | Performance Coordination with 401(k) Plan  Look for *Coordination with 401(k) Plan* noted throughout presentation  Must be the same  HCE definition/assumptions  Limitation Year definition  Top-heavy contribution coordination

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 4 Audit | Tax | Advisory | Risk | Performance “Generous” Entry and Allocation Provisions  Maximum wait to enter:  Service – 12 months (with 1,000 hours), then enter on the following semi-annual entry date  Age – 21  Maximum allocation provisions  Work 1,000 hours during the plan year  Be employed on the last day of the plan year

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 5 Audit | Tax | Advisory | Risk | Performance “Generous” Entry and Allocation Provisions  Why would you want to be more generous?  Can help resolve issues with maximum permissible contribution (25% of eligible payroll) by increasing the eligible payroll  Can help resolve issues with maximum annual allocation each participant can receive by spreading the allocation across more participants  Can get employees focused on the ESOP more quickly – they don’t have to wait up to 18 months to enter and up to three years before they get a statement  What is the downside?  Current employees who had to wait a year to enter may not be happy  Most turnover occurs early in employment and with younger employees  Spreads the allocation a bit (less for each existing participant), but not as much as you may think

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 6 Audit | Tax | Advisory | Risk | Performance Dual Eligibility  Different contributions may have different eligibility rules  Why would you want that?  Can allow new hires to starting contributing to the 401(k) quickly but require longer service to receive ESOP contributions  Different eligibility rules for “fixed” work schedules v. non-fixed/irregular work schedules  Immediate for fixed; 1 year and age 21 for non-fixed  Attempts to address part-time employees without delaying all employees

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 7 Audit | Tax | Advisory | Risk | Performance Exclusions From Eligibility  Certain exclusions have no impact on nondiscrimination testing  Collective bargaining group members  Non-employees  Nonresident aliens without any US earned income  Other nondiscriminatory categories may be excluded  Division  Facility  Subsidiary  Job classification  Students/interns  No hours-based exclusions  Part-time  Temporary  Seasonal  Non-benefitting employees

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 8 Audit | Tax | Advisory | Risk | Performance Service-based Allocation  Two methods of allocation for employer contributions are approved without additional testing  Compensation-based  Per capita  Other methods are generally permissible as long as they don’t discriminate in favor of “highly compensated employees”  Test must be performed annually to ensure that the allocation is “nondiscriminatory”

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 9 Audit | Tax | Advisory | Risk | Performance Service-based Allocation  Example

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 10 Audit | Tax | Advisory | Risk | Performance Service-based Allocation  Why would you want to use a service-based allocation?  If the desire is to reward participants based at least partially on their service, service- based allocation works  Lot of flexibility in designing the formula, as long as the allocation is nondiscriminatory  What is the downside?  Desire may be to reward employees based on current compensation, not service  Could adversely impact recruiting  Nondiscrimination testing must be passed  If highly compensated employees have the most service, test may not pass  Repurchase obligation impact  Could put more shares into the accounts of participants who are closer to diversification and retirement

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 11 Audit | Tax | Advisory | Risk | Performance Compensation-based Allocation  Most common allocation method is pro rata by compensation  Most common compensation definition is gross W-2 (includes pre-tax deferrals)  Withholding wages and Section 415 compensation are also pre-approved  Pre-approved exclusion of taxable fringes: “reimbursements or other expense allowances, cash and noncash fringe benefits, moving expenses, deferred compensation, and welfare benefits” – must be in the plan  Other exclusions permitted if non-discriminatory  Bonuses  Overtime  Commissions  Others?

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 12 Audit | Tax | Advisory | Risk | Performance 401(k) plan-based Allocation  Matching allocation  Safe harbor allocation  Nonelective  Matching  QACA  Eligibility rules/compensation definition  Safe harbor notice(s)  401(k) must provide for safe harbor to be satisfied in the ESOP  *Coordination with 401(k) plan*

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 13 Audit | Tax | Advisory | Risk | Performance Correction/Avoidance Options for Section 415 Excess  Section 415  Limits “annual additions” participants can receive under all company retirement plans to lesser of their 100% of pay or $52,000 (adjusted for inflation annually)  Annual additions are generally employee deferrals and Roth contributions, employer contributions, and reallocated forfeitures  Catch-up contributions (currently $5,500) are not counted for 415 purposes  Correction methods  Return employee deferrals/Roth contributions to the individual  Forfeit associated matching contributions  Reallocate excess amounts to those who have not yet hit the 415 limit  *Coordination with 401(k) Plan*

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 14 Audit | Tax | Advisory | Risk | Performance Correction/Avoidance Options for Section 415 Excess  Return employee contributions/forfeit associated match  For participants at least age 50, deferrals that would have been returned can be recategorized as catch-up contributions, if catch up contributions have not yet been fully utilized. This means they stay in the 401(k) plan.  Participant receives their own contributions back, less any taxes  Positively impacts the average deferral percentage test if the participant is a highly compensated employee  Downside – Employees don’t like to get their deferrals back  Reallocating excess  Generally the avoidance of a failure, not a correct  Because the 415 limit is not hit, due to change in allocation, no deferrals are recharacterized  Any excess is reallocated to those who have not yet hit the limit, so more allocations for lower paid people  Downside – not financially beneficial for those who hit the limit

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 15 Audit | Tax | Advisory | Risk | Performance Forfeitures  Timing  Immediate upon distribution  Five breaks in service  Use of forfeitures  Expenses if cash forfeitures  Reallocate  Reduce next contribution  “Lost” participants   No “Mr. Forfeiture”

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 16 Audit | Tax | Advisory | Risk | Performance Paying ESOP Loan with Contributions v. Dividends  Sources of funds for the loan payment determines how the shares released by the loan payment are allocated  If employer contributions are used to fund the loan payment, the shares released are allocated based on compensation/points  If dividends/income distributions are used to fund the loan payment, at least a portion of the shares released are allocated based on stock account balance  Dividends earned on shares in participant accounts are always allocated on stock account balance  Dividends earned on suspense accounts shares can be allocated in different ways, but generally either on stock account balance or in the same manner as the contribution

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 17 Audit | Tax | Advisory | Risk | Performance Paying ESOP Loan with Contributions v. Dividends  Not always a choice:  Limits on contributions can necessitate the need for dividends/income distributions to fund the loan payment  Example - $2 million loan payment, but only $1.5 million can be contribution. $0.5 million dividend can be used to fund the remainder  404 Limit is 25% of eligible compensation  415 Limit – dividends can be used to avoid a failure  If there are non-ESOP shareholders, and they receive dividends/income distributions, the ESOP must receive these as well  Generally used to repay the loan  Similarly, some preferred stock (C-Corps only) requires a dividend  Generally used to repay the loan

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 18 Audit | Tax | Advisory | Risk | Performance Paying ESOP Loan with Contributions v. Dividends  But if there is a choice:  Use of dividends/income distributions will result in skewing the allocation towards participants with larger balances – longer-term participants  If too much dividend is used, new participants may get little of the share release  Can impact 409(p) testing (generally adversely)  Can impact the repurchase obligation by putting more shares in the accounts of participants who are closer to diversification and retirement  Keep in mind that FMV test must be passed  Additional deduction for C-Corps, not for S-Corps

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 19 Audit | Tax | Advisory | Risk | Performance Pass-through Dividends  Dividends paid directly to participants based on their ESOP shares  C-Corps only  Can be paid directly from the company to the participant or through the ESOP no later than 90 days after plan year end  Can include allocated and suspense account dividends  Not considered a distribution, so:  No notice and consent requirement  No mandatory withholding  Not eligible for rollover  No early withdrawal penalty  Reported on 1099-DIV not 1099R  Benefits  Allows participants to get current income from the ESOP  Can make the ESOP more meaningful, especially to younger participants

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 20 Audit | Tax | Advisory | Risk | Performance Dividend Reinvestment Election  Very similar to pass-through dividends except that participants can elect to:  Receive a pass-through dividend, or  Have their dividend stay in the ESOP and be reinvested in employer stock  Can be based on vested shares only or on total shares, but all dividends on which participant is given an election are immediately 100% vested  May be offered to active participants or to all participants  Reasonable opportunity to make election prior to dividend payment or distribution  Opportunity to change election at least annually and when dividend allocation/payment affected by plan document  Default elections allowed

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 21 Audit | Tax | Advisory | Risk | Performance Prepaying the ESOP Loan  Share release for most ESOPs is calculated as follows: Current year principal and interest (P&I) payments ÷ Current Year P&I + All Scheduled Future P&I * Suspense Account Shares at Beginning of the Year

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 22 Audit | Tax | Advisory | Risk | Performance Prepaying the ESOP Loan  Prepaying the ESOP loan means making more than the scheduled payment in a year or years  Results in shares being released and allocated faster to participants  Why would you want to prepay?  Gets more shares into the accounts of participants in the ESOP at the time of the prepayment  Why wouldn’t you want to prepay?  Since shares are released faster, there are fewer shares for participants down the road  Affects repurchase obligation by loading up accounts

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 23 Audit | Tax | Advisory | Risk | Performance Prepaying the ESOP Loan ABC COMPANY EMPLOYEE STOCK OWNERSHIP PLAN LOAN AMORTIZATION AND SHARE RELEASE SCHEDULE NO PREPAYMENT Principal and Interest Method Fixed Interest Rate: 3.00% Date of Note: 12/31/13 Original Number of ESOP Shares: 100,000 TotalSharesRemaining PaymentDue DatePrincipalInterestPaymentBalanceDenominatorAllocatedShares 12/31/2013 5,000, , /31/ , , , ,731, ,282, , , /31/ , , , ,454, ,863, , , /31/ , , , ,169, ,444, , , /31/ , , , ,875, ,025, , , /31/ , , , ,572, ,607, , , /31/ , , , ,261, ,188, , , /31/ , , , ,940, ,769, , , /31/ , , , ,609, ,350, , , /31/ , , , ,268, ,931, , , /31/ , , , ,918, ,512, , , /31/ , , , ,556, ,094, , , /31/ , , , ,184, ,675, , , /31/ , , , , ,256, , , /31/ , , , , , , , /31/ , , , , Totals 5,000, ,282, ,282, ,

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 24 Audit | Tax | Advisory | Risk | Performance Prepaying the ESOP Loan ABC COMPANY EMPLOYEE STOCK OWNERSHIP PLAN LOAN AMORTIZATION AND SHARE RELEASE SCHEDULE PREPAYMENT Principal and Interest Method Fixed Interest Rate: 3.00% Date of Note: 12/31/13 Original Number of ESOP Shares: 100,000 TotalSharesRemaining PaymentDue DatePrincipalInterestPaymentBalanceDenominatorAllocatedShares 12/31/2013 5,000, , /31/ , , , ,531, ,179, , , /31/ , , , ,248, ,561, , , /31/ , , , ,956, ,142, , , /31/ , , , ,656, ,723, , , /31/ , , , ,347, ,304, , , /31/ , , , ,029, ,885, , , /31/ , , , ,701, ,466, , , /31/ , , , ,363, ,048, , , /31/ , , , ,015, ,629, , , /31/ , , , ,657, ,210, , , /31/ , , , ,288, ,791, , , /31/ , , , , ,372, , , /31/ , , , , , , , /31/ , , , , , , , /31/ , , , , Totals 5,000, ,179, ,179, ,

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 25 Audit | Tax | Advisory | Risk | Performance Account Segregation/Conversion  Conversion of terminated participants’ accounts to cash prior to their distribution payment  Can occur in year of termination or any later year, whether or not the participant is eligible to receive a distribution  Generally done through recycling of shares, although could be done through redemption (with an updated valuation)  Best to convert all shares, not just the participants vested shares  Segregation/conversion feature needs to be in the plan document  Cannot be discretionary, but the decision to put money into the ESOP to convert shares is up to the company each year  Need to have a provisions for partial conversion, if company does not want to put full amount in  Generally pro-rata or based on termination date

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 26 Audit | Tax | Advisory | Risk | Performance Account Segregation/Conversion  Why would you want to convert shares?  Gets shares (and future appreciation of those shares) into the hands of your active participants who can still affect the value of the company  Gets risk of owning the shares out of the hands of terminated participants who no longer have a stake in the company  May not want terminated participants who now work for competitors to see your stock price  In a rising stock price environment, accelerates cash needed for the repurchase obligation but reduces the amount paid to the participant overall  Why wouldn’t you want to convert shares?  Accelerates cash flow needs  Fiduciary obligation to invest the proceeds of the conversion  Can’t just stick it in cash  *Coordination with 401(k) Plan* if proceeds to be transferred to the 401(k)

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 27 Audit | Tax | Advisory | Risk | Performance Account Segregation/Conversion

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 28 Audit | Tax | Advisory | Risk | Performance Rebalancing  IRS Definition: “The mandatory transfer of employer securities into and out of participant ESOP accounts, usually on an annual basis, designed to result in all participant accounts having the same proportion of employer securities.”  Each year, the ESOP accounts are rebalanced so that each participant has the same percentage of his/her account investment in employer stock and other investments  For example, if the ESOP overall has 90% stock and 10% cash, each participant will have 90% stock and 10% cash after the rebalancing is completed

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 29 Audit | Tax | Advisory | Risk | Performance Rebalancing  Does not change any participant’s total account value – changes the composition of that value  May help alleviate “haves” vs. “have nots” issue in the plan  Rebalancing takes stock from the long-term participants (the “Haves”) for the benefit of new participants (the “Have Nots”), but the Have Nots must have cash in order for the rebalancing to help them  Cannot be used to correct 409(p) failures but can help avoid future failures  Provides some diversification for all participants

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 30 Audit | Tax | Advisory | Risk | Performance Rebalancing

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 31 Audit | Tax | Advisory | Risk | Performance Diversification  Statutory Diversification  Enhanced diversification  Longer period  Higher percentage  Mandatory diversification

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 32 Audit | Tax | Advisory | Risk | Performance Investments upon Diversification  Diversification is effected by one of the following three options  Participant is allowed to invest in at least three options in the ESOP (conservative, moderate, and aggressive)  Participant is allowed to have the funds transferred to the 401(k)/profit sharing plan and invested in the investment options available there  Participant is allowed to receive a distribution  Almost no companies establish investment options in the ESOP due to the fiduciary requirements  Transfer to 401(k) Plan *Coordination with 401(k) Plan*  Preserves diversification amounts for retirement  Generally results in fewer participants electing diversification  Distribution  Allows participants to have more control over their own money  Generally results in more participants electing diversification

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 33 Audit | Tax | Advisory | Risk | Performance Beneficiaries  Designation of Beneficiary Form  Default if no named beneficiary?  Estate?  Surviving Spouse?  If no spouse, what next?  Divorce?  Disclaimers?

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 34 Audit | Tax | Advisory | Risk | Performance QDROs  Qualified domestic relations order (“QDRO”)  Alternate Payee  Spouse, former spouse, child, or other dependent  ESOP distributions v. Family Law/QDRO processor  QDRO distribution provisions  When, how much, how paid  QDRO Procedures  Sample QDRO  ESOP  Other qualified retirement plans

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 35 Audit | Tax | Advisory | Risk | Performance In-Service Distributions  When?  Age 59 ½?  Normal Retirement Age?  How much?  May accelerate repurchase obligation  May reduce total amount paid  Mitigates incentive to quit to gain access to ESOP account  Acts as additional diversification tool

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 36 Audit | Tax | Advisory | Risk | Performance Distributions  Form  Lump sum of cash  Installments of cash  Lump sum of stock  Redeemed by the company  Lump sum  Installments – note / adequate security  Recycled by the ESOP  Lump sum  Installments – note / adequate security

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 37 Audit | Tax | Advisory | Risk | Performance Distributions  Timing  Immediate  After plan year end  Up to five year delay  Financed securities delay  Mandatory cashouts  $1,000 direct payment  $1,000-$5,000 IRA rollover  Distribution Policy  Distribution forms

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 38 Audit | Tax | Advisory | Risk | Performance Questions? Thank you!

The Unique Alternative to the Big Four ® © 2013 Crowe Horwath LLP 39 Audit | Tax | Advisory | Risk | Performance Postscript  Please fill out a session evaluation form and drop it off at the table outside of the main room  Your feedback on topics and presenters is important and will be used to develop subsequent TEA programs