Shareholder Succession Planning

As counselors and advisors to community banks and bank holding companies, we often engage with our clients in strategic discussions and planning sessions about senior management succession, new products and services, the acquire or be acquired question, and capital planning. However, oftentimes when we try to engage the board in a substantive discussion about shareholder planning and the need to explore what liquidity options are, or should be, available, we are met with a look of confusion or complete reticence to engage in the discussion. For community banks to survive, even those that are very closely held, it is critical to begin a discussion about how aging shareholders or the next generation who may not be interested in the banking business are going to be cashed out and new shareholders are going to be brought in.

For community banks that are “family owned,” meaning one or several families are the largest shareholders and act in some form of board or management capacity with the next generation expected to step up to manage the bank, the board of directors may not see a need to engage in shareholder succession planning. And while keeping the bank largely family owned and operated sounds appealing (after all, Granddaddy said that we better not ever sell a share of bank stock), according to the Family Business Institute, only 30% of these businesses last into a second generation, 12% make it into the third generation, and a mere 3% operate into the fourth generation or beyond. So rather than leaving the legacy of the bank to chance, wouldn’t it make more sense to deploy those well-earned risk management skills in the practice of shareholder succession planning?

This article provides a brief overview of the benefits of an employee stock ownership plan (ESOP) and how they work. The second article in this series will discuss the use of subordinated debt as a tool for shareholder succession planning and the expanded limit of the small bank holding company policy statement to bank holding companies with assets <$1B.

Questions to ask:

  •  If there are particular individual family members who are interested in and capable of leading the bank for the next decade or two, should the BHC look for a way to allow them to buy out existing shareholders who don’t have an interest in remaining active?
  • While not a fun conversation to have, are there shareholders that need to be taken out because they are not going to provide any long term value to the BHC while other potential shareholders with the ability to create value sit on the sideline
  • Are there aging shareholders who are going to devise their shares to children or grandchildren with no real ties or interest in the BHC?
  • Does the BHC have the ability (retained capitalat the BHC level, subordinated debt, BHC stock loan, etc.) to buy-out large shareholders as they get older and look for liquidity?
  • Does the BHC need to explore the idea of an employee stock ownership plan as a succession planning measure to create shareholder liquidity, motivate employees, and remain locally owned?

As BHCs look for ways to manage their shareholder base and their future, the above questions need to be asked and discussed in a candid and productive way to ensure
the long-term viability of the bank and BHC. Below is a discussion about employee stock ownership plans (ESOPs) and its ability to facilitate the necessary shareholder
succession planning moves that might need to occur.

What is an ESOP?
An ESOP is “tax qualfied” defined contribution retirement plan which is designed to invest primarily in the bank’s stock. ESOPs are regulated by the Internal Revenue Service (Internal Revenue Code) and the Department of Labor (Employee Retirement Income Security Act) just like pension and 401(k) plans. Congress’ purpose in authorizing ESOPs was to encourage employee ownership and the opportunity to build equity and wealth among a broader base of individuals than would normally be possible.

Simply put: an ESOP is a way to provide employees the ability to invest in a BHC’s stock at no cost. ESOPs are also an incredible retirement plan option, as discussed
below under the [E&Y S corp ESOP Study] section.
ESOP Benefits:

Build employee engagement

  • Attract top talent
  • Establish a business succession plan or create shareholder liquidity
  • Manage capital in a tax-advantaged manner
  • Protect employees and the community
  • Transfer wealth in a way no other retirement plan can do
  • Encourage an employee ownership culture

ESOP Benefit as a Retirement Plan
Study Finds S ESOPs Total Return Beats S&P 500 by 62%, Employee-Owned S Corporations of America (Mar. 31, 2015),

Study by EY
WASHINGTON, D.C. (March 31, 2015) – New data compiled by EY’s Quantitative Economics and Statistics (QUEST) practice, shows that private employee stock ownership retirement plans (S corporation ESOPs) outperformed the S&P 500 Total Returns Index in terms of total return per participant by 62%, while net assets increased over 300%, and distributions to participants totaled nearly $30 billion from 2002 to 2012.

The EY study found that the total return for S ESOP participants from 2002 through 2012 was $99,000 for an 11.5% compound annual growth rate, 62% percent higher than the S&P 500 Total Returns Index’s 7.1% growth rate over the same period. Distributions to plan participants totaled nearly $30 billion in the same ten-year period, and paid significantly more benefits per participant than 401(k)s. 

“This striking new study confirms what our members know from direct experience,” commented ESCA Chairman Steve Smith, Vice President-General Counsel of Amsted Industries. “They know first-hand that S ESOPs are providing secure retirements for their workers and economic benefits to their communities. These compelling findings—showing strong and continuing growth in net assets, distributions, average account balances, and number of participants with accounts—make that even more apparent. S ESOPs are a model for how to make retirement security a reality for the broad American middle class.”

“The report finds that S ESOPs are providing an increasingly important role in supporting the retirement security of their participants,” said Robert Carroll, National Director of QUEST and one of the study’s authors.

Prior reports have shown that S ESOP companies have lower default rates and weather economic storms better than their non-ESOP counterparts. In 2014, the National
Center for Employee Ownership compiled new data showing that private employee-owned businesses default on their loans far less than other businesses. In 2010 by economists Phillip Swagel and Bob Carroll, both former senior Treasury Department officials, found that, during the most recent economic recession, S ESOP firms they
surveyed increased employment by nearly 2%, at the same time that overall, employment in the private sector fell by nearly 3%. In his 2013 study, Macroeconomic
Impact of S ESOPs on the U.S. Economy, economist Alex Brill of Matrix Global Advisors wrote, “Beyond the immediate benefit they provide to employees and customers, S ESOPs’ positive outcomes yield benefits to the U.S. economy broadly.” Brill’s analysis found that total direct and indirect output from these companies accounts for nearly 2% of gross domestic product.

How Does an ESOP Work?

An ESOP, like other tax qualified retirement plans, has a tax-exempt trust which holds the ESOP’s assets. There are two types of ESOP structures that may be utilized to acquire BHC stock: non-leveraged and leveraged.

Non-leveraged ESOPSs
A non-leveraged ESOP is funded through annual deductible contributions of cash or stock from the BHC to the ESOP which are allocated to each employee account according to the ESOP’s terms. A BHC can also give participants a special one-time opportunity to transfer 401(k) assets to the ESOP to purchase shares of stock through the ESOP. The later type of non-leveraged transaction is a special type of securities offering which is typically exempt from state and federal securities laws.

Leveraged ESOPs
ESOPs are the only retirement plan which can borrow money. A leveraged ESOP allows the ESOP to borrow funds from the BHC to purchase the stock which serve
as collateral for the loan until they are distributed to participants’ accounts in accordance with the plan document upon loan payments by the ESOP. The discussion and diagram below describe a typical leveraged ESOP where the BHC borrows funds from a third-party lender and then makes a loan to the ESOP.

When the BHC issues a distribution to its shareholders, the ESOP receives the pro rata income for the shares it purchased and can use that income to make a loan payment ot the BHC, pay plan expenses, pay benefits or save the distribution to acquire additional shares at a future date. If the distribution is used to make a loan payment, the BHC can use the loan repayment from the ESOP to make payments on its loan from the third-party lender.

Through an ESOP employees are able to acquire BHC stock without paying income tax on the stock at the time it is allocated to their ESOP account. The BHC receives the benefit of using pre-tax dollars to provide liquidity for shareholders who want or need liquidity while optimizing its shareholder base, and it provides a tool to finance future growth.

Some additional points about ESOPs:

  1. Under Section 1042 of the Internal Revenue Code, if the ESOP acquires 30% or more of the outstanding stock of a privately-held company, any capital gains tax on the transaction is deferred indefinitely, provided that the seller reinvests the proceeds in “qualified replacement property” within 12 months of the date of sale. This is only available to C Corp ESOPs, though legislation has recently been introduced in Congress to extend this treatment to S Corp ESOPs as well.
  2. Unlike a sale or merger, the ESOP enables the seller to sell any portion of his or her stock. A sale or merger usually requires the seller to sell 100% control.
  3. The ESOP enables the company to repay principal on a third-party loan with tax-deductible dollars.
  4. In a C Corp ESOP, dividends paid on stock held by an ESOP are fully tax-deductible, provided that such dividends are either passed through to participants or are used to make principal or interest payments on an ESOP loan. S Corp ESOPs are not subject to federal income tax on earnings or dividends.
  5. In the case of an S corporation, the ESOP’s share of S corporation earnings is not subject to federal or state corporate taxation or to taxed as “unrelated business taxable income,” unless the ESOP runs afoul of certain “anti-abuse” provisions. Thus, in the case of a BHC that is 100% owned by its ESOP, the BHC’s earnings will be entirely tax-exempt.
  6. An ESOP enables controlling shareholder employees to keep control until they are ready to fully retire. When the owner does retire, the ESOP enables the owner to pass control to management.
  7. An ESOP enables an owner to provide for business continuity for the bank he or she has grown and nurtured over many years. Unlike a sale or merger, an ESOP enables a company to retain its separate identity rather than become a branch or division of a larger company.
  8. An ESOP enables a bank to attract, retain and motivate key employees through offering employees the ability to beneficially own stock.
  9. Studies have shown that ESOP-owned companies become more productive and profitable than comparable firms in the same industry that are not ESOP-owned.

As briefly demonstrated above, ESOPs are a powerful tool at the disposal of S corporations willing to devote the time and resources required to effectively implement an ESOP strategy. An S corporation ESOP can generate liquidity for shareholders and aid in succession planning, provide employees with an incredibly taxefficient
retirement savings plan, and ensure the overall health of an organization by creating owners out of the stakeholders (shareholders and employees alike) that are vital to the long-term success of the company.

If you have any questions regarding if an ESOP is right for your financial institution please contact William “Dub” Sutherland.

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