1. ESOP Corporate Resources, Inc. Hilary J. Schneider, CLU, ChFC
ESOP Discussions
The C-Model ESOP
The C To S Model ESOP
Prepared by:
ESOP Corporate Resources, Inc.
Hilary J. Schneider, CLU, ChFC
Chairman/CEO
2436 W. Coast Highway, Suite 201
Newport Beach, CA
Phone: (949)
FAX: (949)

2. The Disclaimer
This presentation is designed to be educational in nature and is not intended to provide tax or legal advice. ESOP Corporate Resources, Inc. does not provide tax or legal advice. Consult with your tax advisor and/or legal counsel for suitability to your specific situation.
All materials protected by Copyright© 2003 by ESOP Corporate Resources, Inc. None of the following may be reproduced in any form without the express written consent of ESOP Corporate Resources, Inc.

3. What if you had a tool that could provide distinct advantages to:
Business Owners
Corporations
Employees
… A tool that is stronger than any other single financial planning vehicle?

4. What if you had a tool that could:
Create a tax free corporation
Free up pre-tax dollars for acquisition of corporate assets
Provide strong competitive advantage over rival businesses
Cash out owners at significantly reduced tax rates and retain 100% control of company
Provide exceptional retirement opportunities for owners
Create an asset protection firewall

5. That tool exists today… It is called an ESOP… an Employee Stock Ownership Plan
ESOPs – like pension, profit sharing and 401(k) plans – are tax qualified plans. They are overseen by the I.R.S. and the Department of Labor. As tax qualified plans, they pay no Income Tax.

6. What are ESOPs? Tax qualified benefit plans (Code Sec. 414)
Stock bonus plan combined with money purchase plan (Code Sec. 409 & 4975)
Two types: C and S – the unique attributes of subchapter S and C corporations create great flexibility and benefits for both shareholders and employees

7. For a business owner, the ESOP is tailored to their specific needs:
Sell some or all of your stock, tax deferred or tax free, while maintaining control of the company
Defer or eliminate federal and state capital gains
Avoid income and estate taxes

8. The Traditional Sec. 1042 ESOP Stock Sale
The best way to explain ESOPs is by a hypothetical example. We will look at two different applications and structures for ESOPs:
The Traditional Sec ESOP Stock Sale
Let’s take a guy named George. George owns a corporation which can be a “C” corporation or an “S” corporation (he will eventually have to change to a “C” but when George sees the tax benefits this won’t be a problem.) George started this business 15 or 20 years ago in his garage with $1.50.
George’s
“C” Corporation

9. One day George’s CPA comes to him and says,
“George, I have great news for you. I just ran the numbers and your company is worth (pick a number) $10,000,000.”
George is all excited and he runs home to his wife Martha that afternoon and says, “Martha, Martha, guess what! The CPA just ran the numbers and our company is worth $10,000,000! WE ARE RICH!”
And of course, you know what Martha says…

10. “Where’s the Money?!?!”

11. Of course, all George has to show for himself is a stock certificate that shows he owns all 100 outstanding shares of the company.
Stock Certificate
George’s Company
100 Shares

12. Clearly he can’t cut off a corner of the stock certificate and cash it in.
George’s Company
100 Shares

13. If he tries to sell 51% or more of the company, a majority of the stock, he will lose his salary, benefits, club membership, the new corporate car, control of the company, not to mention the last 15 or 20 years of blood, sweat and tears he put into building the company.
49% Minority Has No Control of the Corporation
51% Majority Ownership Controls of the Corporation

14. That’s where the ESOP enters the scene.
If he tries to sell a minority position in the company, there’s not much of a market for privately held company stock that pays no dividends.
That’s where the ESOP enters the scene.
An ESOP creates a private marketplace for George’s stock.

15. George’s company adopts an ESOP to create a marketplace for George’s stock.
George’s Corporation
ESOP
If we assume that George’s CPA is doing a good job, then we can also safely assume that the CPA does not have $10,000,000 of cash idly sitting in the corporate checking account ready to finance the purchase of George’s stock. So the first thing we do is go to the friendly bank down at the corner and we borrow the money.

16. The lender loans the money to the corporation.
George’s Corporation
ESOP
$10 Million Loan #1
The Lender

17. Corporation Loans Cash to ESOP
But the Corporation is not the one that needs the money. The ESOP needs the money to purchase the stock from George. So the corporation makes an identical mirror loan to the ESOP.
George’s Corporation
ESOP #2
Corporation Loans Cash to ESOP
$10 Million Loan by Lender #1
The Lender

18. The ESOP doesn’t want the cash because its mandate in life is to acquire stock of the sponsoring corporation. The ESOP looks for a shareholder who wants to sell some stock. George is ready to sell and in our example we will assume that he sells 99 of his 100 shares to ESOP.
In actual practice this would never happen, as the lender won’t loan 100% of the value of the corporation but, for our illustrative purposes, it demonstrates some points.

19. George: Selling Shareholder
The ESOP buys the 99 shares of stock from George and gives George a check for $10,000,000 in payment for George’s 99 shares of stock.
George’s Corporation
ESOP #2
Corporation Loans Cash to ESOP
ESOP buys stock from selling shareholder with cash
Shareholder sells stock to ESOP & receives cash #1
Lender Loans Cash to Corporation #3 #4
The Lender
George: Selling Shareholder

20. We know that George has effectively a zero basis in the value of his company stock and will now have $10,000,000 subject to capital gains tax. He would normally owe the government about $2,500,000 in taxes.
However, under Section 1042 of the Code, George can defer the capital gains tax if he adheres to a couple of fairly easy parameters.

21. Section 1042 Parameters:
George needs to have owned the stock for three years prior to selling it to the ESOP.
The ESOP must end up owning at least 30% of George’s company.
When George receives his check for $10,000,000 he has 12 months to reinvest the cash into Qualified Replacement Property (QRP) which generally speaking is the stocks or bonds of any domestic company: IBM, Xerox, General Motors, Ford, etc.

22. In fact, George could walk across the street and form a new corporation, fund it with the $10,000,000, and this would qualify as QRP.
There are a few things that don’t qualify as QRP:
REITs.
Municipal bonds or any other government paper.
The stock of his own corporation which he just sold.
Insurance products.
Therefore, George purchases his QRP, pays zero capital gains tax and saves $2,500,000 in taxes. Not a bad deal for George!

23. Qualified Replacement Property
George’s Corporation
ESOP #2
Corporation Loans Cash to ESOP
ESOP buys stock from selling shareholder with cash
Lender Loans Cash to Corporation #3
Shareholder sells stock to ESOP & receives cash #1 #4
The Lender
Selling Shareholder
Shareholder invests the sale proceeds in QRP
Shareholder receives an investment income #5 #6
Qualified Replacement Property

24. Now, everybody is happy in this picture
Now, everybody is happy in this picture. George received his $10,000,000 in cash, purchased his QRP and saved $2,500,000 in taxes, and the ESOP received $10,000,000 of George’s company stock.
The only one who is not happy in this picture is the bank. Lenders are very strange. They want to get paid back.
Let’s see how we can pay back the lender in the most tax efficient and cost effective manner possible – with pretax dollars.

25. Recall that the lender loaned the $10,000,000 to the corporation and the corporation, in turn, loaned the same $10,000,000 in the ESOP.
Out of the corporate cash flow, the corporation makes a tax deductible contribution to the ESOP in an amount equal to the principal and interest debt service payment that will eventually be due to the bank.

26. Qualified Replacement Property
George’s Corporation #2
ESOP
Corporation Loans Cash to ESOP #7
Corp. makes tax deductible contributions to ESOP in an amount equal to debt service
ESOP buys stock from selling shareholder with cash #3 #1
Lender Loans Cash to Corporation #4
Shareholder sells stock to ESOP & receives cash
The Lender
Selling Shareholder
Shareholder receives an investment income
Shareholder invests the sale proceeds in QRP #5 #6
Qualified Replacement Property

27. The ESOP owes the exact same amount of principal and interest back to the corporation to service the ESOP’s debt to the corporation.

28. Qualified Replacement Property#2
George’s Corporation
ESOP
Corporation Loans Cash to ESOP #7
Corp. makes tax deductible contributions to ESOP in an amount equal to debt service #8
ESOP repays corp. from contributions received
ESOP buys stock from selling shareholder with cash #3 #4
Shareholder sells stock to ESOP & receives cash #1
Lender Loans Cash to Corporation
The Lender
Selling Shareholder
Shareholder invests the sale proceeds in QRP #5
Shareholder receives an investment income #6
Qualified Replacement Property

29. Then the corporation pays back the lender.

30. Qualified Replacement Property#2
George’s Corporation
ESOP
Corporation Loans Cash to ESOP #7
Corp. makes tax deductible contributions to ESOP in an amount equal to debt service #8
ESOP repays corp. from contributions received
Corp. repays lender with cash from loan repayment from ESOP
ESOP buys stock from selling shareholder with cash #3 #4
Shareholder sells stock to ESOP & receives cash #9 #1
Lender Loans Cash to Corporation
Selling Shareholder
The Lender
Shareholder invests the sale proceeds in QRP #5 #6
Shareholder receives an investment income
C-Corporation ESOP Schematic Section 1042 Sale of Stock
Qualified Replacement Property

31. This is a $6,500,000 total tax savings in a $10,000,000 transaction!
What we have accomplished is the repayment of the debt service with pretax dollars. The interest would normally be deductible but George’s company also received a tax deduction for the principal payment.
This means that in the 40% corporate tax bracket it only cost George’s company $6,000,000 after tax to pay back a $10,000,000 loan.
And in the process we saved George individually $2,500,000 in capital gains tax.
This is a $6,500,000 total tax savings in a $10,000,000 transaction!

32. The Control Issue
Every client who owns a small business is fanatical about control. George still owns one share of his company stock. This one share represents 100% of the stock which is outside of the ESOP.
Therefore, with this one share, George can appoint himself as President of the Company, Chairman of the Board and most importantly, he appoints himself as ESOP Committee Trustee. It is the Trustee which votes the 99 shares in the ESOP.

33. The Control Issue 100% control!
Therefore, even though George received $10,000,000 and saved $2,500,000 in capital gains tax and the corporation saved $4,000,000 by paying the debt service with deductible dollars, George still controls the corporation by voting the one share he still owns and, as Trustee, by voting the 99 shares in the ESOP.
100% control!

34. The C to S Combination ESOP
In the traditional ESOP sale of stock which we just reviewed, we put $10,000,000 in George’s pocket, saved him $2,500,000 in taxes and showed the corporation a way to pay for the transaction and save $4,000,000.
This entire transaction all happens on day 1.

35. The C to S Combination ESOP
What would happen if, on day 2, we implemented a discretionary corporate planning program and then changed George’s corporation from a C corporation to an S corporation?
George’s “C” Corporation Implements a Discretionary Corporate Planning Program
Discretionary Corporate Planning Program

36. George’s Corporation Changes from a “C” to an “S” corporation
The discretionary corporate planning program is an obligation of the corporation which now exists prior to the change in the filing status from a C corporation to an S corporation. Now we change George’s company to an S corporation.
George’s Corporation Changes from a “C” to an “S” corporation
Discretionary Corporate Planning Program

37. During the course of the year, George’s restructured business receives gross revenue income and pays expenses and salaries. At the end of the year, there is taxable income left.
Just as with all S corporations, the taxable income at the end of the year is distributed on a form K-1 to the outside shareholders.
In our example, there are two outside shareholders: George, who owns one share, and the ESOP, which owns 99 shares.

38. Discretionary Corporate Planning Program
Therefore, two K-1’s are distributed for the taxable income, one to George for 1% of the taxable income and one to the ESOP for 99% of the taxable income.
George’s
“S” Corporation
ESOP:
K-1 for 99%
K-1
K-1
Discretionary Corporate Planning Program
George:
K-1 for 1%

39. Discretionary Corporate Planning Program
The key point here is that it is only the Form K-1 that goes to the ESOP. The ESOP is in a zero tax bracket, receives the K-1 and pays zero taxes. The cash stays in the corporation. This is now “pretax dollars” because the ESOP accounted for the taxable income in the zero tax bracket.
George’s
“S” Corporation
ESOP:
K-1 for 99%
K-1
Pretax cash
K-1
Discretionary Corporate Planning Program
George:
K-1 for 1%
The company now has pretax dollars to fund this pre-existing obligation.

40. The C to S Combination ESOP
S Election
# 11
K-1 to ESOP to extent of ownership
# 10
S Election
# 2 Corporation loans cash to ESOP
# 12
Tax savings from ESOP funds discretionary corporate planning program
# 8 ESOP repays corporation from contributions received
Corporation
ESOP
# 7 Corp. makes tax deductible contributions to ESOP in an amount equal to debt service
# 3
ESOP buys stock from selling shareholder with cash
# 9
Corp. repays lender with cash from loan repayment from ESOP
# 1
Lender loans cash to Corp.
# 4
Shareholder sells stock to ESOP & receives cash tax free
Discretionary Corporate Planning Program
Selling Shareholder
Lender
# 5
Shareholder invests the sale proceeds in QRP
# 6
Shareholder receives an investment income
Qualified Replacement Property