Background
Employee Stock Ownership Plans (ESOPs) present outstanding planning potential for your corporate clients, be they large, not so large, and even relatively small, so long as they are profitable. The aggregation of benefits bestowed upon them by Congress is, I believe, unparalleled throughout the remainder of our tax system. Being qualified plans, they are blessed with the basic benefits encompassed within ERISA, such as: current employer deduction of contributions without concurrent gain to plan participants, tax-free growth during the interim between employer contribution and employee distributions, creditor protection and more. Superimposed on these benefits, however, are a number of others which lead me to conclude that the ESOP alternative should be considered by all businesses (preferably at the behest of their CPA). While not for everyone, ESOPs should be embraced by far more than the relatively few that presently partake of their largess. In summary, the special advantages available only through ESOP include:
The potential for balance sheet and cash flow enhancement through the receipt of a tax deduction for the contribution of capital stock (a non-balance sheet "asset") to the ESOP;
The ability to obtain a tax deduction for repayment of funded debt;
The entitlement to engage in tax-free diversification without loss of control;
The ability to deduct dividends (a tax benefit otherwise unavailable anywhere else within the Internal Revenue Code); and
Where the ESOP sponsor is an S corporation, the entitlement to pass through tax-free to the ESOP its pro rata share of the S corporation's income.
There are, of course, many complexities and requirements that must be understood and dealt with for a corporation to avail itself of these dramatic benefits. The purpose of this article is to focus on one of these, to wit: the valuation process which must be performed whenever an ESOP makes an acquisition of its sponsor's stock, and at least annually thereafter. More specifically, unless an ESOP qualifies for the specific exemption afforded to it under IRC §4975(d)(3), its acquisition of stock from either its corporate sponsor or an existing stockholder would constitute a prohibited transaction. This exemption is, in turn, only available if the ESOP does not pay more than fair market value for the company stock that it purchases. Normally, this would involve only the problems inherent in any business valuation. Unfortunately, however, as a consequence of what I believe to be fallacious reasoning by government agencies, (i.e., the Internal Revenue Service [IRS], the Department of Defense [DOD], and the Department of Labor [DOL]) the ESOP appraisal process has been placed in a quandary which you, as appraisers, must be aware of, and to the greatest extent possible, understand.
Annual Appraisal Requirement.
Section 401(a)(28)(C) of the Internal Revenue Code requires that there must be at least an annual appraisal of ESOP stock performed by a qualified independent appraiser. This appraisal is then used to value the company stock owned by the ESOP and forms the basis upon which ESOP participants are annually advised as to the fair market value of their ESOP account.
What Does it Take to be "Qualified"?
The question as to who is "qualified" is a subjective one. Clearly, CPAs, as a result of the training required to obtain the Certified Public Accountant designation, are qualified to do appraisals. In reality, however, specialized study should be undertaken before accepting an engagement to perform an ESOP appraisal. This is principally because so much responsibility, and with it malpractice exposure, accompanies this engagement in the event that the end product proves to be inadequate in terms of thoroughness, methodology utilized, or application of ground rules which have been judicially hammered out in a number of cases which are, themselves, the antithesis of clarity.
Who is "Independent"?
The next question that you must face is...What does it take to be "independent"? Or, of particular pertinence to CPAs, can you appraise the stock an ESOP holds in a corporation which is already a client. On this point, the IRS Audit Guidelines instruct to the effect that large accounting firms that maintain a separate "valuation division" that is held out to the public as an "appraiser" qualify as "independent appraisers" even for clients of that firm. (Internal Revenue Manual, Part VII 350, "Valuation of Assets") These audit guidelines do not, however, provide details on questions such as: How big do you have to be, to be "large"? What is a "division"? And, what does it take to be considered "holding one's self out to the public" as an appraiser? In all but the most obvious circumstances, the judicious course of action would be to refrain from appraising your own clients and, instead, recommend another firm that you believe to be qualified to perform that particular task.
Appraisal Guidelines
Under ERISA it is never totally clear as to which government agency has jurisdiction over any of a variety of issues. Near the forefront of this longstanding dichotomy is the area of appraisals, and, more particularly, ESOP appraisals. Technically, the DOL has jurisdiction over valuations as a part of its prohibited transaction and fiduciary responsibility oversight duties. Nevertheless, the IRS has also extended its scope of authority to cover appraisal matters as a part of the determination as to whether a prohibited transaction tax is due and an ESOP's entitlement to continued status as a qualified plan. As if this weren't enough, however, the DOD has chosen to exercise independent jurisdiction within this area as a part of its determination as to what are "allowable costs" for which it must reimburse a cost-plus government contractor. And, even the Securities and Exchange Commission (SEC) gets involved in situations wherein plan participants are extended choices that include the investment of employee contributions in company stock.
In 1998, the DOL released a set of Proposed Regulations dealing with the valuation of stock in closely held corporations. (DOL Prop. Regs. §2510.3-18, Fed. Reg. Vol. 53, No.95, May 17, 1988) Although these Proposed Regulations have now been withdrawn (60 Fed. Reg. 23559, May 1995), they are still valuable as guidelines in this rather amorphous area. In short, these DOL Proposed Regulations require that valuations be made in good faith and consider "all relevant factors." They do, however, allow for payment by the ESOP of a "control premium" (or, at least, the avoiding of a "minority discount") under circumstances wherein the ESOP either has, or has the option to obtain, control. Both the DOL and the IRS still adhere to guidelines for assessing the fair market value of stock of closely held corporations set forth in long standing Revenue Ruling 59-60. The guidance methodology set forth in Revenue Ruling 59-60 requires that the valuation of employer securities which are not actively traded be based upon a good faith determination that takes into account, among others, the following factors:
The nature and history of the business,
The economic outlook of the industry involved,
The financial condition and book value of the company,
The company's earnings and dividend paying capacity,
An assessment as to whether the company has goodwill or other intangible value,
Other sales of the corporation's stock,
The relative size of the block of stock to be valued, and
The price of the stock of publicly traded corporations that engage in the same or similar business.
These factors do not necessarily equate, and the appraiser must give them relative weight in the course of the appraisal.
The Interplay between fair market value and stock design.
The only stock which is eligible to be sold to an ESOP must be either "best common" or preferred stock convertible into it. (IRC §409(l)) Even though one might imagine otherwise, there is considerable potential to both comply with the law and design attributes that can add value to stock thereby facilitating ESOP transactions that might otherwise never materialize. Here involved is the ESOP advisor's ability to design a special class of stock so as to infuse through the addition of preferences and entitlements, value to the stock to be sold to the ESOP thereby making such a sale more attractive to the seller (either the company or an existing stockholder) by means of boosting the value of that stock in relation to the residue of the corporation's stock. In this respect, it is appropriate for the ESOP advisor to work hand-in-hand with the appraiser who can be called upon to opine upon value increments that are added by each preference and entitlement.
Use of a specially designed "super common" stock is of particular benefit in this instance. Common Stock can be made to constitute super common through the addition of a dividend preference (i.e., 7% of face value) for a stated period of time--usually the period of the ESOP loan which is commonly seven years. While not only adding value to the particular stock to be sold to the ESOP, this sets the stage for the ESOP company to limit the payment of dividends to only this super common stock and only for the period during which the ESOP loan is outstanding. Thereafter, the super common stock loses its "super" characteristic and becomes just like any other common stock.
Then, if the infusion of even more value into stock to be sold to an ESOP is desired, the next step is to use convertible preferred stock which in addition to preferential dividend entitlements can be embellished with capital preferences such as a "first out" upon disillusion. Accordingly, it is important to understand that the ability to specially design the stock that is to be sold to an ESOP can be an integral part of an ESOP feasibility study.
It must be noted, however, especially now that S corporations are entitled to sponsor an ESOP, that the "only one class of stock" S corporation limitation will prevent use of this stock design potential if the S status is to continue. Sometimes, however, particularly where an IRC 1042 tax-free rollover of stock sale proceeds is desired, S status can be foregone for the five years between the time the ESOP sale takes place and the time when S can be again elected without special IRS permission. During this interim period, super common stock, or even convertible preferred, can be utilized so as to gain the "best of all worlds."
Must the ESOP Loan be considered in Valuing Stock to be Sold to an ESOP?
Remember that is crucial that the ESOP not pay more for the purchase of company stock than its appraised fair market value. Normally, this should present no particular problem since competent appraisers can adhere to established methodology and produce an appraisal which can then be utilized in establishing the price that an ESOP can reasonably pay for the purchase of company stock. This is not to say that this process is simple. It isn't. Matters such as minority discounts and control premiums come into play. But, all that should be required is for a competent appraiser to perform the tasks necessary to complete the job taking into account all relevant factors, whereupon the ESOP fiduciary can proceed to consummate the ESOP stock acquisition transaction. Unfortunately, however, a significant complication has been interposed which has created unwanted uncertainty that needs to be resolved in order for leveraged ESOP stock acquisition transactions to proceed without the fiduciaries assuming an unreasonable degree of risk. The fundamental question here is whether the fact that the stock acquisition involved is financed through indebtedness (i.e., leveraged) should be factored into the fair market value determination. The answer should be no, but confusion abounds.
The Farnum Case
In 1990 the DOL brought suit against an ESOP fiduciary, Mr. Farnum, alleging a fiduciary breach due to his failure to reduce the price that the ESOP paid for stock attributable to the fact that immediately after the transaction, the corporation involved will become obligated to fund the repayment of stock acquisition indebtedness. (Civil Action No. 90-0371d, Rhode Island 1990) This case induced a quite predictable hue and cry within the ESOP community because virtually all ESOP stock acquisitions are accomplished through the use of indebtedness (i.e., the "ESOP Loan"). Accordingly, if the method of acquisition is factored into the transaction, it follows that a seller dealing with an ESOP will never be able to receive the same purchase price that he or she could have received from an outside third party. In short, what difference does it make to the seller how the buyer finances its purchase. Bringing that factor into play clearly places the ESOP at a disadvantage and forces it to compete on an unlevel playing field. It so happens, however, that at the time that the DOL initiated the Farnum action a very high profile ESOP transaction was in the works involving TransWorld Airlines (TWA); persistence by the DOL would have derailed it, and with it, resolution of the labor dispute in which that financially troubled airline was embroiled. The DOL then reconsidered and dropped the Farnum case, announcing that it would no longer take the position that the ESOP loan must be factored in when arriving at a fair market value for stock to be purchased in an ESOP transaction. (See Chernoff, Joel, Withdrawal of Suit Hurts Labor Department, Pension and Investments 10/29/90, pg.31; See also praise of DOL action by Senator Robert Byrd, Congressional Record Oct. 27, 1990, p. S17793.)
The Eyler Case
Now, however, the waters are again muddied. In 1995 the Tax Court decided the Eyler case (Eyler v. Commissioner 69 T.C.M. 2200) in which it cited as one of a number of reasons why an ESOP trustee should be liable for breaching his fiduciary duty his failure to consider the financial ramifications of the ESOP loan to the corporation involved subsequent to the ESOP stock purchase transaction. Then, on appeal, the Seventh Circuit Court of Appeals (88 F.3d 445 (1996)) affirmed the Tax Court and again made reference to this same supposed deficiency on the part of the trustee. The IRS is now utilizing the Eyler case to foist this same fallacious theory upon ESOP trustees in connection with leveraged ESOP stock acquisitions. In addition, the Defense Contract Audit Agency (DCAA) of the Department of Defense (DOD) has joined the fray by refusing to recognize as "reimbursable costs" that portion of ESOP-related costs that they allege can be attributed to a stock value unreduced by the Farnum factor.
The Correct Answer
In my opinion the Farnum issue deserves consideration, but not as a part of the determination of the fair market value of stock to be acquired by an ESOP through use of an ESOP loan. Perhaps the best way to emphasize the illogical nature of the Farnum concept is to ask the following question: Would any government agency condone paying a departing ESOP participant less than the fair market value of his or her aliquot share of corporate stock because the ESOP (or its corporate sponsor) contemplated financing the participant payment by means of incurring additional debt? Obviously, the answer is NO. Accordingly, the same result should apply in the usual ESOP leveraged stock acquisition situation. This does not mean, however, that the trustee should not consider the existence of acquisition indebtedness in the course of the exercise of his fiduciary responsibility. He should--but not in determining the reasonableness of the price to be paid. Instead, the existence of this indebtedness, and the corporation's continuing obligation to provide the where-with-all to fund it, should be taken into account by the trustee in determining the feasibility of the stock acquisition, itself. Do projections of corporate profitability evidence the capability of the sponsoring corporation to make contributions to the ESOP which will, in turn, enable it to meet its obligations to amortize the ESOP loan? If the answer is in the affirmative, then the trustee should feel comfortable in approving the ESOP stock acquisition at the appraised value, unreduced by any factor attributable to the debt. If not, then the trustee may not be in the position to approve the transaction at all. Then, if the seller still desires to consummate a transaction, it can, should it so desire, either reduce the price or relax the terms of the ESOP loan so as to cure any cash flow deficiency that might otherwise appear to be an impediment.
In the interim, leveraged ESOP transactions need not come to a halt. Instead, in my capacity as counsel to the ESOP, I insist that the appraiser factor the ESOP loan into the appraisal process and take into account the projected ability of the corporation to provide the ESOP with the funds with which to amortize the loan. This analysis must then be incorporated as a part of the appraisal, itself. Then, if the parties involved are satisfied to proceed at the fair market value figure arrived at by the appraiser, under those circumstances I feel safe in advising the trustee that it is appropriate to proceed with the transaction despite the Farnum ferment which, hopefully, will be cleared up in the not too distant future.
Buchanan Ingersoll's Tax Group advises publicly held and private business entities, affluent individuals and families, and key executives in a full range of tax, employee benefits and dispute resolution matters at federal, state and local levels. We also counsel clients in the areas of wealth preservation and business succession planning. For more information, contact Tax Group Chairman Francis A. Muracca, II, at 412-562-3950 or by email at muraccafa@bipc.com.