Winter 2011


Focus On Employee Stock Ownership Plan
Independent Financial Adviser Issues

Editor for This Issue: Malcolm ("Mike") R. Hartman

ESOP Independent Financial Adviser Insights

Thought Leadership Article:
Sale of an ESOP Sponsor Company: Questions of Time, Money, People, and the Law
Randolph R. Smith Jr., Esq.
When a closely held business owner sells his stock to an ESOP, he may believe that this will be his last corporate transaction. Often, however, and particularly with successful ESOP companies, potential buyers come calling. This discussion explores the processes by which ESOP companies manage a possible sale to a third party, including the roles of the board, the ESOP trustee, and company management. It also considers what documents may be involved in such a sale, including the fairness opinion provided by the ESOP's independent financial adviser.

Standing at the Crossroads: An Integrated Approach to the ESOP Repurchase Obligation
Michael J. McGinley
This discussion outlines some of the fundamental principles of an employee stock ownership plan (ESOP) and presents a framework for analyzing the employer corporation stock repurchase obligation. The ESOP repurchase obligation has several important interrelated variables that require a comprehensive plan encompassing five important factors: Strategy of the corporation, The valuation, Actuarial variables, Repurchase funding sources and mechanics, and Sustainability considerations. This "STARS" framework is designed to promote dialogue and coordination between the sponsor company management, the ESOP trustee, the ESOP legal counsel, and the valuation analyst. This discussion describes these repurchase obligation factors and explores how these factors affect each other.

The ESOP Feasibility Study
C. Ryan Stewart
An ESOP feasibility study is an important first step in the process of establishing an employee stock ownership plan (ESOP) in a qualifying employer corporation. Such a study provides useful information to shareholders who are considering selling shares to an ESOP and to employer corporation managers. This information allows these parties of interest to decide whether or not an ESOP employer stock purchase transaction is an effective strategy for achieving their various objectives. ESOP feasibility studies can be very different depending on the situation. However, most ESOP feasibility studies contain basic elements that should be addressed in order (1) to provide meaningful information to all parties and (2) to avoid costly mistakes that could impair the long-term success of the ESOP.

Tax Increases and the ESOP Alternative: Motivation for Close Corporation Owners
David Burdette
Significant increases in capital gain tax rates are expected in 2011. An employee stock ownership plan (ESOP) continues to be an attractive exit vehicle that allows the closely held business owner to sell his or her close corporation stock to the company employees. If properly structured, the ESOP employer stock purchase transaction provides a tax- advantaged structure related to the sale of the employer corporation stock. With proper structuring, an ESOP can accomplish a tax-advantaged ownership transition for the close corporation owners. At the same time, the ESOP purchase of the employer corporation stock typically provides an economic incentive to the company's employees.

Retained Shareholder/Executive Reasonableness of Compensation ESOP Sponsor Company
Robert F. Reilly, CPA
An otherwise profitable closely held C corporation may be able to minimize its federal income tax liability if it pays a salary or bonus to its employee/shareholders in an amount sufficient to "absorb" all of the taxable income. Whether the C corporation distribution is a salary or a dividend, all such distributions are taxable as ordinary income to the employee/shareholder. However, employee salary or bonus payments are tax deductible to the C corporation. In contrast, shareholder dividends are not tax deductible to the C corporation. So, the taxpayer corporation can reduce its federal income tax expense by characterizing employee/shareholder distributions as salary/bonus rather than as dividends. Accordingly, the Internal Revenue Service often challenges the reasonableness of employee/shareholder (particularly controlling shareholder) compensation during the audit of the closely held C corporation. This discussion summarizes the conclusion of a relevant recent Tax Court judicial decision-with an emphasis on what is called the independent investor test of assessing the reasonableness of employee/shareholder compensation.

Quan v. Computer Sciences Corporation: The 9th Circuit Adopts the Moench Presumption in Favor of Plan Fiduciaries
Katherine Gilbert
This discussion reviews the recent Quan v. Computer Sciences Corporation judicial decision. In that decision, the U.S. Court of Appeals ruled in favor of plan fiduciaries. In addition, this discussion summarizes the "Moench Presumption" and describes the Appeals Court decision to adopt that presumption.

Best Practices
The ESOP Trustee's Independent Financial Adviser Due Diligence Selection Process
Malcolm ("Mike") R. Hartman
For most employee stock ownership plan (ESOP) sponsor companies, the selection of the ESOP financial adviser has typically been an informal process. In the past, little thought was put into documenting the process by which a particular financial adviser firm was selected. With many sponsor companies experiencing decreases in employer stock value as a result of the recent recession, it is more important to document the qualifications of the ESOP financial adviser firm. This discussion uses a questionnaire developed for sponsor companies that are installing an ESOP. The purpose of the questionnaire is to evaluate potential ESOP financial adviser firms. This discussion also comments on the most important information that should be considered in the independent financial adviser selection process.

ESOP Valuation Insights

Valuing Stock Appreciation Rights (SARs) in ESOP Sponsor Companies
Steve Whittington
Stock appreciation rights (SARs) are used in conjunction with ESOP stock purchase transactions as an incentive plan for key executives (including the selling shareholder). It is important for the ESOP financial adviser to understand (1) what SARs are and (2) how SARs affect the value of the employer corporation stock at the outset of a stock purchase transaction. It is also important for the ESOP financial adviser to understand how SARs may affect future employer corporation stock valuations.

Reconciling the Current Employer Stock Valuation with Prior Stock Valuations
Malcolm ("Mike") R. Hartman
The stock of closely held ESOP sponsor companies must be valued at least annually. In this valuation process, valuation analysts (and other interested parties) often consider how the annual employer stock value conclusions compare year to year. The U.S. Department of Labor, in its audits of these plans, pays close attention to how the employer stock valuations change from year to year, in terms of both value conclusions and valuation methodology. This discussion summarizes the need for the ESOP financial adviser to carefully document the yearly employer stock valuation changes. And, this discussion suggests financial adviser procedures for such documentation.

Income Tax Planning Insights

The Offer in Compromise Program May Offer Tax Relief to Business and Individual Taxpayers
Robert F. Reilly, CPA
An offer in compromise (OIC) is an agreement between the taxpayer and the Service. In this agreement, the Service accepts a payment to satisfy the taxpayer's liability of less than the full tax amount owed. Of course, there are numerous conditions related to the Service acceptance of a taxpayer OIC. And, there is a somewhat burdensome process associated with the taxpayer OIC application. This discussion summarizes the OIC application process from the perspective of a business or individual taxpayer. This discussion assumes that the taxpayer simply does not have the cash resources available to pay its federal tax liability.

The APA Application Process and Intercompany Transfer Price Considerations
Robert F. Reilly, CPA
Domestic taxpayer corporations that transfer tangible property (e.g., inventory), intangible property (e.g., trademarks), or services with controlled foreign affiliates must comply with the statutory arm's-length price (ALP) intercompany transfer price requirements. In order to avoid surprises on audit (and statutory penalties), many such taxpayer corporations have entered into an advance pricing agreement (APA) with the Internal Revenue Service. This discussion summarizes (1) the taxpayer procedures in the APA application process and (2) some of the taxpayer management considerations related to the APA application.

NOL Carryforward Use Limitation After the Ownership Change of a Multiple Stock Class Corporation
Robert F. Reilly, CPA
In recent years, many taxpayer corporations have accumulated net operating loss (NOL) carryforward income tax benefits. Internal Revenue Code Section 382 limits the taxpayer corporation's use of the NOL tax benefit when there is a change of ownership. Some change in ownership transactions (e.g., mergers and acquisitions) are obvious. Other change in ownership transaction (e.g., private equity investments, debt private placements with equity conversion features) are less obvious. This discussion summarizes some of the current valuation rules related to an ownership change in NOL corporations that have multiple classes of stock outstanding.

Property Tax Valuation Insights

Hotel Valuation Myths and Misconceptions Revisited
David C. Lennhoff and Heather Reichardt
This discussion summarizes the "whats and whys" of hotel intangible property allocations. And, this discussion reviews some of the recent judicial precedent related to the topic. This discussion will also clarify some of the misunderstandings that have developed about the withdrawal of the Appraisal Institute continuing professional education course, Separating Real and Personal Property from Intangible Business Assets (Course 800). Additionally, this discussion describes the importance of understanding the relationship between real estate and personal property (both tangible and intangible personal property) for a valuation engagement that concludes the market value of the hotel real estate only. Such a valuation engagement typically starts with the income (or the value) of the total operating assets of the hotel going concern business.

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