1. ESOP Leveraged Stock Purchases
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Biltmore Tower 500 South Grand Avenue, 19th Floor Los Angeles, California
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2. Employee Stock Ownership Plan (ESOP)
Qualified employee benefit plan designed to invest primarily in employer stock
Employees indirectly own stock in the company where they work
Unique among qualified benefit plans in its ability to borrow money, allowing “leveraged ESOP’s” 2

3. Employee Stock Ownership Plan (ESOP)
Unique among qualified benefit plans in its ability to own stock in an S corporation without paying UBIT, thus avoiding federal income tax at both the corporate and shareholder levels
ESOP companies often experience productivity gains from making employees shareholders, according to research by the NCEO (National Center for Employee Ownership)
A first-stage ESOP buyout can be structured to allow existing shareholders to obtain liquidity yet maintain control of their company. This is done with a “directed trustee.” 3

4. Leveraged ESOP Transactions
Company
Lender
ESOP Trust
Shareholders
Leveraged ESOP Purchase of Existing Stock
Outside Loan
Stock
Cash
Inside Loan
STRUCTURE
The company creates an ESOP and an ESOP Trust.
The company borrows funds from a bank or other lender (“outside loan”) and re-lends the proceeds to the ESOP Trust (“inside loan”).
The ESOP Trust uses the funds to purchase company shares from existing shareholders. The shares are held in a suspense or “contra equity” account. 4

5. Leveraged ESOP Transactions
Repayment of ESOP Financing
Lender
Outside Loan Repayment
Tax Deductible Dividends & Contributions
Company
ESOP
Inside Loan Repayment
The company services the new outside debt by making tax deductible contributions to the ESOP. The ESOP repays the inside loan to the company and the company makes the debt payment 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 is tax-deductible.
As the company makes the ESOP contributions and the principal of the inside loan is thereby repaid, shares are released from the suspense account and allocated to the employee accounts in proportion to their respective compensation. 5

6. Four Primary Tax Incentives
Why Do Companies Use A Leveraged ESOP?
Four Primary Tax Incentives
Deduct both principal and interest on sale financing
Deduct dividends paid on purchased 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 6

7. Deduct Principal, Interest and Dividends
Increased Cash Flow
Principal (and interest) payments on ESOP loans are tax deductible
Dividend payments on ESOP shares can be tax deductible
Thus, Company gets to deduct loan interest, loan principal and dividends from taxes
Provides Company a greater debt capacity
Debt is repaid faster due to improved cash flows 7

8. Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions
Shareholders of a C corporation selling all or a portion of their stock to an ESOP will typically be able to defer capital gains tax indefinitely. This is done under Section 1042 of the IRC and so is called a “1042 rollover”.
The selling shareholders can achieve tax-free liquidity of 90% + of the selling price by buying specially issued “floating rate notes” (FRNs) with the sale proceeds and borrowing against them (“liquidity loan”).
The FRNs are designed so that their face amount is always their fair market value. Banks will typically lend 90% + of FRNs’ face value when they are pledged as collateral. 8

9. Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions (cont’d)
Interest cost on 90% of face amount is about the same (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. 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. 9

10. Deferral of Capital Gains for Selling Shareholders
C - Corp Transactions (cont’d)
Private equity and/or mezzanine debt can be raised to accomplish a 100% buyout or to fill the “gap” not lent by a senior 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 rollovers to the ESOP from employee accounts in other company qualified plans such as 401(k) or profit sharing plans. 10

11. Deferral of Capital Gains for Selling Shareholders
Seller Defers Capital Gains Tax – Rollover – 51% Sale to ESOP
ESOP Transaction
Non-ESOP Transaction
Enterprise Value
$100,000
Less: Existing Debt
(20,000)
Equity Value
80,000
Multiplied by % Acquired
51%
Cash From Sale
40,800
Less: Combined Capital Gains 23%
(9,384)
After-Tax Proceeds
31,416 11

12. Summary of Leveraged ESOP Tax Benefits
LBO
ESOP
ESOP TAX SAVINGS
Proceeds to Shareholder
7.7
10.0
2.3
Cost to Company
(10.0)
(6.0)
4.0
Total ESOP Tax Savings
6.3 12

13. S Election Eliminates All Federal Income Taxes
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 reducing its debt balances a Company can generate additional value for its equity holders
$10,000,000
Year 4
Year 5
$5,000,000
S Election Eliminates All Federal Income Taxes
Pretax Income
Tax 40%
Total Cash Savings to S Election
$2,000,000
Year 1
Year 2
Year 3
(less any state income taxes on S corporation net income) 13

14. 1042 Transaction Deal Points:
Highly Leveraged Transaction
Multiple Financing Sources
Various ESOP and non-ESOP Securities
Private Equity (or Mezzanine Debt) Can Be Used
Profit Sharing Plan Money Can Be Used
“Seller Notes” Can Be Used
Management Incentive Contracts are Encouraged by Bank Lenders and ESOP Trustees 14

15. Residual Shareholder 40%
1042 Leveraged ESOP Transaction – Bank Debt, Mezzanine Debt and Other Plan Assets
Stock Purchase
$10 MM Other Plan Assets
Preferred
Stock
ESOP
60%
$60MM
Sellers
1042
Company
Residual Shareholder 40%
$5MM Mezzanine Debt
$45MM Senior Debt
Outside Loan
Inside Loan
$50 MM
Company borrows $50MM from the various lenders and re-lends the money to ESOP. ESOP uses the $50MM loan proceeds to purchase stock from selling shareholders, and uses the $10MM PSP money to purchase a specially designed preferred stock from the company. (Alternatively, the Selling shareholders can take back a $10MM “Seller Note” in which case the PSP money and the preferred stock will not be used - see next slide). 15

16. Residual Shareholder 40%
1042 Leveraged ESOP Transaction – Bank Debt, Mezzanine Debt and Seller Note
Sellers
$10MM Seller Note
$5MM Mezzanine Debt
Residual Shareholder 40%
Company
$45MM Senior Debt
ESOP
60%
$60MM
1042
Outside Loan
Inside Loan
Stock Purchase
Company borrows $50MM from the various outside lenders, borrows $10MM from the selling shareholders and re-lends the $60MM to ESOP. ESOP uses the $60MM loan proceeds to purchase stock from selling shareholders. 16

17. ESOP Benefits to Employees
The Reason for the Tax Incentives
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
ESOP distributions to employees may be rolled over into an IRA to defer taxes
Company’s cash flow is improved, translating to improved company stability 17

18. When Is An ESOP Indicated?
Significant Employee Census
Good Cash Flow (EBITDA)
Good Management (Including Successors) 18

19. When Is An ESOP Indicated? (cont’d)
Enterprise Value in Excess of $10 Million
Significant Cash Balances
Other Qualified Plan Assets
Motivated Sellers (see next slide) 19

20. When to Consider ESOP’s
Succession Planning / Mature Shareholders
Owners who are close to retirement or have strong loyalty to employees
Diversification of wealth
Desire for tax-free liquidity
Multiple Shareholders
Conflicting objectives
Some or all want liquidity
Specialized Situations
Have limited suitable buyers for sale of company
Spin-Off of subsidiary
Need to “go private”
Sale of company to third party may be undesireable
Existing ESOPs
Partial ESOP companies should consider a 100% S-Corp structure 20

21. QUESTIONS?? Schuck Law Group Law Offices of Edwin G. Schuck, Jr.
Biltmore Tower
500 South Grand Avenue, 19th Floor
Los Angeles, California
(213) Direct
(626) Mobile
(213) Fax 21