BankDirector.com: Charting a course for America's banking leaders

BankDirector Cover

Committees : Compensation

What Offers Capital Creation, Employee Benefits and Untaxed Profits?

November 30th, 2012 |

money-gift.jpgAn ESOP is a retirement plan designed to purchase the highest and best class of stock of a corporate plan sponsor with tax-deductible contributions and/or tax-deductible dividends from the company. The ESOP is indifferent to the source of the shares (i.e. shareholders or a new issuance). There are limits to how much a company can contribute to an ESOP annually and the shares must be independently established at fair market value. An S or C corporation bank or bank holding company can sponsor an ESOP.

Who Should and Who Should Not Create an ESOP?

The bank must have sufficient number of employees, adequate ongoing earnings and sound capital/leverage ratios. The bank must:

  • have at least 30 employees and sustainable annual pre-tax profits of $500,000 or more
  • be a viable, long-term going concern
  • make a market for shares (either new issues for capital or from outside shareholders) of $500,000 or more at some point, and be well capitalized, both for valuation and regulatory purposes (e.g. Tier 1 capital ratio of 10 percent or better)
  • be willing to support the complexity and cost of the plan (small stock plans can cost $20,000 annually to maintain due to requirements for annual independent valuations, record keeping and additional accounting)
  • have the ability to make annual plan contributions in stock or cash averaging $200,000 or more; some variability downward (even zero) in bad years is possible, but good years should offset that

One Example: An ESOP Benefits a Bank or Thrift

A single-bank holding company which had taken TARP is now profitable, making $2 million in pre-tax earnings as a C corporation with 200 shareholders and capitalization of $400 million. The board wants to improve key executive benefits, hopefully increase capital (to help with the retirement of the TARP obligation) and mitigate taxes.

By establishing an ESOP and pre-funding it with cash for two years ($500,000 annually) at a level which did not degrade capital ratios, there is $1 million in cash available to purchase new shares in a capital stock transaction.  The resulting $1 million  tax-free cash arrives on the balance sheet at the price of some shareholder dilution, but represents Tier 1 capital and a possible source of a partial TARP repayment. The effects are:

  • The company has $1 million of tax-deductions spread over two years.
  • The tax arbitrage (taking dollars to the balance sheet at dollar-for-dollar vs. 60 cents per dollar of taxable income) results in better capitalization.
  • The non-ESOP shareholders have some minor dilution with the purchase of newly issued shares.
  • The 57 employees eligible to participate in the plan do so irrespective of TARP—key executives with compensation above $100,000 received 43 percent of the allocations in the ESOP. (A non-qualified discriminatory key executive plan was out of the question with TARP, and even without TARP, would be non-deductible.)
  • The 8 percent ESOP is controlled by the trustees, appointed by the board.

Here are Five Key Do’s and Don’ts

1. Don’t install an ESOP just for a near-term tactical tax advantage—implement a coordinated strategy tying the ESOP market/benefits to key executive programs, capitalization, shareholder market needs and all the regulatory requirements.

2. When considering an ESOP, get a competent feasibility study done (at a cost of $10,000 to $25,000), even if the threshold criteria are all met – there may be something lurking in the weeds.

3. Be prepared to deal with complexity in the coordination of employee benefit law with the management of both cash and stock flows between the bank, shareholders and ESOP, with clear definitions of the roles of the board, trustees and supporting professionals.

4. Don’t consider the ESOP stock repurchase obligations something to be dealt with in a few years as the plan matures: analyze and understand the strategy for the funding and management early on.

5. Do engage and educate your ESOP participants in the benefits of the plan to loyal, long term employees.

Some Resources:

1. The National Center for Employee Ownership (www.nceo.org) is an excellent source of educational materials.

2. The ESOP Association in Washington, D.C., is an ESOP advocacy organization and has helpful publications (www.esopassociation.org).

3. A booklet expressly for bank boards considering the ESOP alternative is: “The ESOP Handbook for Banks: Exploring an Alternative for Liquidity and Capital While Maintaining Independence”, 83 pp, Peabody Publishing, 2011 (ISBN 978-0-9825364-4-5).

ltilley

Lisa Tilley is the senior management consultant for Corporate Capital Resources. Lisa develops and coordinates the design effort with her client's team of professionals in law, banking, insurance and financial services. You can reach her at lisa_tilley@ccrva.com.

 

mcoffey

Michael Coffey is the managing vice-president of Corporate Capital Resources. He is responsible for the design and oversight of stock transactions, business succession and executive compensation strategies for closely-held corporations. You can reach him at Michael_coffey@ccrva.com.

 

blog comments powered by Disqus