1. Analysis of Possible ESOP Minority Leveraged Stock Purchase
March 17, 2010
PRIVILEGED AND CONFIDENTIAL
Schuck Law Group Law Offices of Edwin G. Schuck, Jr South Grand Avenue, 19th Floor Los Angeles, California
(213) Direct (626) Mobile (213) Fax

2. Executive Summary
Existing shareholders can take significant cash out now at existing low capital gains rates or with permanent tax deferral and tax-free liquidity - unsold residual is then held and grown to sell with ESOP later at a higher value.
The sale-to-ESOP transaction is highly tax-incentivised compared to alternative structures.
A transaction can be structured to achieve a 100% ESOP-owned S corporation owning a fraction of the business
A sale to a third party three years later will allocate sale proceeds to pay off the original ESOP purchase debt and then only to released ESOP-held stock; the balance will go to the existing shareholders. 1

3. WHY USE A LEVERAGED ESOP TRANSACTION TO SELL A MINIORITY INTEREST:
Selling shareholders can take cash “off the table” now while continuing to grow the company for later sale at a higher value.
Sale gain can be tax-deferred (permanently) or will be taxable at current low federal capital gains rate (before Obama increase).
Later sale (say, three or more years after the leveraged ESOP transaction) can be to a third party strategic or financial buyer or to the ESOP or in a redemption by the company in a second-stage leveraged transaction. 2

4. WHAT IS AN EMPLOYEE STOCK OWNERSHIP PLAN (ESOP)?
An ESOP is a qualified trusteed defined contribution employee retirement plan designed to invest primarily in employer stock.
Employees indirectly own stock in the employer to the extent the stock is allocated to their accounts and vested.
ESOPs are unique among qualified benefit plans in their ability to borrow money, allowing “leveraged ESOP’s” to legally fund the purchase of employer stock from existing stockholders. 3

5. Employee Stock Ownership Plan (ESOP)
ESOPs are unique among tax-qualified benefit plans in their ability to own stock in an S corporation without paying UBIT, thus avoiding all federal income tax at both the corporate and shareholder levels (California taxes an S corporation’s net income at 1-1/2%).
ESOP companies usually experience productivity gains from making employees shareholders, according to research by the NCEO (National Center for Employee Ownership).
An ESOP leveraged buyout can be structured to allow selling shareholders to obtain liquidity yet maintain control of their company, even if the ESOP owns a majority of company stock. This is done with a “directed trustee.” 4

6. Typical Structure of a Leveraged ESOP Transaction
Shareholders
ESOP
Trust
Company
Lender
Leveraged ESOP Purchase of Existing Stock
Outside Loan
Stock
Cash
Inside Loan
STRUCTURAL STEPS:
The company incorporates and creates an ESOP and an ESOP Trust.
The company borrows funds from a bank or other outside lender (“outside loan”) and re-lends the proceeds to the ESOP Trust (“inside loan”).
The ESOP Trust uses the borrowed funds to purchase company shares from the existing shareholders. The purchased shares are held by the ESOP in a suspense or “contra equity” account until released when contributions or dividends are received by the ESOP.
The selling shareholders can elect to defer capital gain on the sale yet still achieve tax-free liquidity. 5

7. Structure of a Leveraged ESOP Transaction
Lender
Company
ESOP
Outside Loan Repayment
Tax Deductible Dividends & Contributions
Inside Loan Repayment
Repayment of ESOP Financing
The company services the new outside debt by making tax deductible contributions to the ESOP. The ESOP uses the company contributions to repay the inside loan to the company and the company then makes debt service payments to the outside lender.
Because the contributions to the ESOP are tax deductible, the new outside debt is, in effect, repaid with before-tax dollars – in other words – the principal repayment to the bank is effectively tax-deductible.
As the company makes annual ESOP contributions and the principal of the inside loan is thereby repaid, the purchased shares are released from the suspense account and allocated to the employee accounts in proportion to their respective compensation.
Dividends paid on C corporation stock owned by the ESOP are also deductible when the dividends are used to repay the inside loan; shares in the amount of the dividends are then released from the suspense account and allocated to employee accounts.
Dividends must be “reasonable”. A 10% dividend if structured correctly can be reasonable.
The dividend deduction is not available for corporate AMT. 6

8. Leveraged ESOP Contribution and Deduction Limits
Annual deductible contributions cannot exceed 25% of aggregate eligible compensation of all eligible employees – an employee’s compensation considered cannot exceed $245,000 in 2010 (subject to annual COLA increases).
If 25 % of such “covered payroll” is not sufficient to zero out C corporation taxable income, some or all of the difference can be made up with a reasonable deductible dividend on the ESOP-held stock.
Also, an additional 25% of “covered payroll” can be a deductible contribution if not used to repay the inside loan.
The “annual addition” to each participant’s account for all qualified plans cannot exceed $49,000 in 2010 (subject to annual COLA increases). 7

9. Incorporate and Make the S Election if Tax Deferral is not Important
If the Company incorporates and makes the S election (or if an existing S corporation holding company is used), the 1042 rollover tax deferral will not be available, but the existing low federal capital gains rate (plus California’s ordinary income rate) will apply to the sale gain.
However, if desired the S election can be made immediately after the 1042 sale (as a C corporation) thus preserving the 1042 rollover deferral.
For a 100% ESOP-owned S corporation, deduction limits for contributions to the ESOP will not be relevant because there will be no federal tax at either the S corporation or ESOP level.
For a less-than-100% ESOP-owned S corporation, distributions to the non-ESOP shareholders of the S corporation to pay quarterly taxes must also be made pro-rata to the ESOP. Such distributions can be used by the ESOP to repay the inside loan. 8

10. Why Do Companies Use a Leveraged ESOP?
A leveraged ESOP transaction is a readily available highly tax-incentivized alternative to an IPO, a strategic or financial sale or a leveraged recapitalization.
Summary of Four Principal Tax Incentives
Deduct both principal and interest on sale debt financing
Deduct dividends (but not for AMT) paid on purchased C corporation stock held by ESOP.
Tax-deferred sale of stock to ESOP that provides 90% + liquidity and ultimately escapes capital gains tax entirely.
The S-election is available to an ESOP-owned company so that, where there is 100% ESOP ownership, no federal income taxes are paid at either the corporate or the shareholder level (there is a 1-1/2% California tax on S corporation taxable income). 9

11. ESOP Company Can Deduct Principal, Interest and Dividends
Increased Cash Flow:
Principal (and interest) payments on ESOP loans are effectively tax deductible as ESOP contributions.
Dividend payments on ESOP-held C corporation shares are tax deductible – must be “reasonable”.
Thus, an ESOP company deducts loan interest, loan principal and dividends paid on C corporation stock (but not for AMT) from taxable income.
Resulting enhanced after-tax cash flow provides company a greater debt capacity.
ESOP-owned S corporations do not pay federal income tax at the corporate level or at the ESOP-shareholder level. Any non-ESOP shareholders pay tax on their pro-rata flow-through income. 10

12. C Corporation Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions
Non-C-corporation shareholders of a C corporation in existence for three years selling all or a portion of their stock to an ESOP will typically be able to defer capital gains tax indefinitely if qualified replacement property (“QRP”) is purchased with the sale proceeds within one year. This is an election under Section 1042 of the IRC and so is called a “1042 rollover”.
A partnership or LLC in existence for three years can incorporate tax-free as a C corporation in order to obtain the 1042 deferral. An S corporation can revoke the S election to obtain the 1042 deferral and re-elect S status five years later if then desired.
The selling shareholders can achieve tax-free liquidity of 90% + of the selling price by buying QRP that is specially issued “floating rate notes” (FRNs) with the sale proceeds and borrowing against them (“liquidity loan”).
The FRNs are issued by AA or AAA-rated public companies and are designed so that their face amount is always near their fair market value. Banks will typically lend up to 90% + of FRNs’ face value when they are pledged as collateral in a margin loan. 11

13. Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions (cont’d)
The interest cost on 90% of face amount is about the same (nominally plus or minus) as interest income on 100% of the face amount of the FRNs. Currently there is a small negative.
Properly structured, the seller’s proceeds in the form of the purchased FRNs may eventually be transferred to the seller’s estate with a tax basis that is “stepped-up” to the original sale price (if the estate tax remains reinstated after 2010). The estate then sells the FRNs at no taxable gain and repays the liquidity loan, effectively eliminating forever the deferred tax associated with the original sale of the stock.
The 1042 rollover election applies only if the ESOP owns at least 30% of the company’s stock immediately after the sale. 12

14. Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions (cont’d)
Private equity and/or mezzanine debt can be raised to fund the buyout or to fill the “gap” that may not be lent by a senior (bank) lender in a first-stage buyout.
Also, the selling shareholders can partially finance the sale of their stock to the ESOP by taking back a subordinated (to the bank senior debt) “seller note.”
Other sources of financing may be tax-free investments in the ESOP from employee accounts in other company qualified plans such as 401(k) or profit sharing plans.
If the 1042 rollover is elected, three years must elapse before the ESOP can re-sell the purchased stock (or a 10% excise tax will be imposed on the company). 13

15. Per $10 of Sale Proceeds in a 1042 Rollover
Summary of Leveraged ESOP Aggregate Tax Savings for C Corporation Shareholders
Per $10 of Sale Proceeds in a 1042 Rollover
Non-ESOP
ESOP
ESOP TAX SAVINGS
After-tax Proceeds to Shareholder 25% combined capital gains rate)
$7.5
$10.0
$2.5
After-tax Cost to Company 40% combined tax rate)
(10.0)
(6.0)
4.0
Total ESOP Tax Savings
Per $10 of Sale Proceeds
$6.5 14

16. Deferral of Capital Gains for Selling Shareholders
EXAMPLE
Seller Defers Capital Gains Tax – Rollover – 31% Sale to ESOP
ESOP Transaction
Non-ESOP Transaction
Enterprise Value
$205,000,000
Less: Existing Debt
(5,000,000)
Equity Value
200,000,00
200,000,000
Multiplied by % Acquired
(Less 20% Minority Discount)
31%
Cash From Sale
50,000,000
Less: Combined Capital Gains 25% (assuming -0- stock basis)
(12,500,000)
After-Tax Proceeds
Invested in QRP
37,500,000 15

17. 1042 Leveraged ESOP Transaction – Bank Debt and Seller Note
Residual- Selling Shareholders 69%
Company
$40MM Senior Debt
ESOP
31%
$50MM
Sellers
$10 MM Seller Note
Outside Loan
Inside Loan
Stock Purchase
The Company borrows up to $40MM from the outside BANK lender, borrows as little as $10MM from the selling shareholders and re-lends the $50MM to THE ESOP. The ESOP uses the $50MM loan proceeds to purchase 31% of the company’s stock from the selling shareholders. 16

18. ESOP-Owned S-Corporations
100% S - Corp Transactions
If the ESOP owns 100% of the common stock, the company can elect S-Corp tax status and avoid paying federal (and most state) income tax completely (California imposes a 1-1/2% income tax at the S corporation level).
Enhanced after-tax cash flows facilitate:
1. Additional debt repayment, resulting in a more rapid “deleveraging” of the company
2. Capital expansion projects
3. Additional growth opportunities, including acquisition.
4. Lower prices for company’s goods or services – more competitive
By rapidly reducing its debt balances with before-tax cash flow, a company can rapidly generate additional value for its equity holders.
$60,000,000
Year 4
Year 5
$30,000,000
S Election Eliminates All Federal and Most State Income Taxes
Pretax Income
Tax combined 40% rate
5-year Tax Savings to S Election
On $150,000,000 of Net Income
$12,000,000
Year 1
Year 2
Year 3 17

19. Company incorporates as a C corporation with two classes of voting common stock, Class A and Class B.
The Class B stock can pay a special dividend independently of the Class A stock.
The Class B stock is sold to the ESOP for its appraised fair market value.
If less than a majority of common stock is sold, the selling price will reflect a “minority discount” (say, 20%); if more than 50% is sold, there will be no such discount.
Company shareholders can sell 31% as a first-stage transaction. If the company is worth $200 million, a sale of 31% with a 20% minority discount would yield about $50 million.
Some or all of the purchase price can be funded with bank debt; the balance can be funded with junior mezzanine and/or seller debt. 18

20. A 10% dividend on about $50 million of stock is about $5 million.
Company Partner’s total payroll is about $3 million; 25% is about $750,000.
A 10% dividend on about $50 million of stock is about $5 million.
Thus, total annual deductions would only amount to about $5.75 million – likely not enough to zero-out C corporation taxable income at EBITDA levels at or above $20 million.
An additional 25% of “covered compensation” deduction is available if not used to pay down the inside loan – but this would add only another $750,000 in deductions.
Thus, this is likely not a tax-attractive structure for Company. 19

21. There is an alternative way to structure the sale so that the C corporation double-tax problem is avoided:
A substantial portion of Company’s business (say, 31%) is separately incorporated by its individual owners and the shares sold 100% (as a C corporation) to an ESOP, after which the S election would be made, resulting in a 100% ESOP-owned S corporation but achieving the 1042 rollover on the sale, if desired.
The ESOP-owned corporation would then be a 31% member of a joint venture LLC with Company as a 69 % member.
The 69% of the LLC ultimately retained by existing members would pay tax on pro-rata flow-through income as at present. 20

22. Alternative 100% ESOP-Owned S Corporation Structure2
Call To
Action
Partners LLC
Existing
Members
Company
ESOP
100%
Sale of 100% to ESOP 1
Distribute and
incorporate 31%
of assets and liabilities
Form ESOP and sell new corporation to ESOP
31%
31% 21

23. Alternative 100% ESOP-Owned S Corporation Structure (cont’d) ESOP
LLC
Existing
Members
Company
ESOP
69%
31%
Corporation
100% 3
New corporation makes S election 4
Create
Joint Venture LLC
entity and drop down
or dedicate all assets
and liabilities 22

24. SUMMARY ESOP Benefits to Employees
ESOPs can be used effectively to increase employee morale.
Employees have an equity stake in the company and therefore share in the growth and increase in company value.
Appreciation in equity and contributions to the ESOP are not currently taxable – taxable only when distributed.
ESOP distributions to employees may be rolled over into an IRA to further defer taxes.
Company’s cash flow is improved, translating to improved company stability.
If a partial ESOP company is later sold (say, three years after the leveraged ESOP transaction), the employees will get a share of the proceeds in respect of stock that has been released from the suspense account by then (the sale proceeds in respect of the unreleased stock revert to the non-ESOP shareholders – after paying all remaining outside debt). 23

25. SUMMARY Leveraged ESOP Transaction Deal Points:
Leveraged Transaction
Possibly Multiple Financing Sources
ESOP Can Own Special Dividend-Paying Stock
Private Equity (or Mezzanine Debt) Can Be Used
Profit Sharing Plan Money Can Be Used
“Seller Notes” Can Be Used
Management Retention Incentive Contracts are Encouraged by Bank Lenders and ESOP Trustees
A 100% ESOP-Owned S Corporation May Present THE IDEAL STRUCTURE 24