Employee stock ownership plans, praised as a motivator for the rank and file, may also offer you a capital raising option.
By Jeffrey C. Gerrish, chairman of the board, Gerrish McCreary Smith Consultants, LLC, and a member of the law firm of Gerrish McCreary Smith, PC, Attorneys. Both entities are based in Memphis, Tenn.
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Employee stock ownership plans, and leveraged ESOPs, represent a tax-advantaged source of capital. In S corporations they pack a special punch, and they may give management a special edge in troubled-bank situations
In the current environment, regulatory capital demands on community banks have grown commonplace. Although capital can be raised through debt (trust preferred is much harder to come by for a small transaction) or equity, i.e., the sale of common stock to existing shareholders or rich and smart investors, the most tax-effective way to raise capital and provide an employee benefit at the same time may be through a leveraged Employee Stock Ownership Plan.
If your community bank or holding company wants to raise capital through a tax-effective method that will also have employees thinking like owners, then consider a leveraged ESOP or KSOP. Plans can be established quickly, leveraged quickly (provided a lender can be found), and capital injected expeditiously.
Mechanics of ESOPs
An ESOP is simply a trust established to hold the stock of the bank or holding company for the benefit of employees. If the ESOP is combined with an existing or newly created 401(k) plan, then it is generally referred to as a KSOP, i.e., a 401(k) ESOP. For banks under $500 million in assets, the most tax- effective means to raise capital for the bank is through leveraging a KSOP or an ESOP. ESOPs and KSOPs can be established quickly. Capital can thus be injected quickly and relatively inexpensively compared to the other equity-raising alternatives.
From a mechanical standpoint, the bank holding company creates an ESOP, which is a trust, to hold holding company stock for the benefit of the bank’s employees. This plan requires the creation of plan documents; the consideration of plan terms and conditions; and filing for a determination letter with the Internal Revenue Service. If the establishment of a KSOP is desired, then the bank holding company will generally start with the existing 401(k) plan in which the employees participate, and amend it to provide ESOP features.
To raise capital through a leveraged ESOP or KSOP, the ESOP would find a lender; borrow the money from the lender; take the cash generated through the loan into the ESOP; and buy stock from the holding company. This generates cash in the holding company. The cash is then contributed by the holding company to the subsidiary bank as new capital.
Because of the relatively new, expanded small bank holding company guidelines—which do not provide for consolidated capital requirements unless the consolidated assets of the company come to over $500 million—the ESOP leverage works extraordinarily well. Cash received by the bank from the holding company increases the bank’s capital. The debt generated by the ESOP is reflected on the balance sheet of the holding company for regulatory accounting purposes, but since the holding company’s capital is not tested on a consolidated basis, the ESOP debt on the holding company balance sheet is immaterial, provided it is within the tolerance levels of the small bank holding company guidelines. (These guidelines, a discussion of which is beyond the scope of this article, can be found at 12 CFR Part 225. See www.fdic.gov/regulations/laws/rules/6000-2100.html# 6000appendixc)
The primary tax advantages of increasing the bank’s capital in this manner arise because the funding for the ESOP results from tax-deductible compensation expense by the bank. The bank makes contributions to the ESOP (within statutory limits) which it then deducts on its consolidated tax return for the holding company. The ESOP uses the cash to repay the ESOP loan, effectively allowing the consolidated organization to deduct principal and interest on the ESOP loan.
Focus on the leverage
As a practical matter, most loan transactions with ESOPs (particularly where the lender is sophisticated or specializes in ESOP loans) are structured as a simultaneous loan from lender to bank holding company, and then as a loan from the bank holding company to the ESOP. This is primarily because if a lender lends directly to the ESOP, the only collateral the lender can obtain from it is the stock purchased by the ESOP with the proceeds of the loan; employer contributions to the ESOP to meet its obligations; earnings attributable to such collateral; and the investment of the contributions.
In addition, as the ESOP loan is paid down and the principal is reduced, shares held as collateral by the lender must be released proportionately and allocated to the accounts of the ESOP participants.
Generally, a lender that is sophisticated will prefer to make the loan to the holding company and take bank stock as collateral and let the holding company make the loan to the ESOP because of the reducing collateral requirements.
If the bank holding company desires to convert an existing 401(k) plan to an ESOP with a 401(k) feature, the new KSOP can be leveraged as noted above. In addition, some or all of the existing funds in the 401(k) (with full disclosure to and individual approval by the employee in compliance with applicable securities laws) may be used to purchase stock in the bank holding company.
Although many bank holding companies converting their 401(k) plan to a KSOP give the employees this option, an equal number, if not more, take a paternalistic approach and do not allow the employees to invest all of their current 401(k) balances in holding company stock. In a KSOP transaction, however, the “match” provided by the company can be made in holding company stock on a going-forward basis. The leveraging aspects of a KSOP are identical to the leveraging aspects of the ESOP.
The end result of a leveraged ESOP or KSOP is an increase in bank capital, an additional employee benefit/retirement plan, and an ownership position for the employees which will, hopefully, cause them to “think like owners,” resulting in a recapitalized bank and a high-performing, employee-enthused organization.
S corp considerations
If a leveraged ESOP or KSOP is used in an S corporation, the impact is magnified.
The capital-raising abilities of the leveraged ESOP or KSOP for an S corporation are generally the same as described above. In an S corp, the ESOP or KSOP may eventually own a significant block of stock and like other S shareholders, receive income allocations and cash distributions.
The difference between the ESOP or KSOP and any other S corporation shareholder is that the ESOP or KSOP does not pay taxes and, thus, accumulates a significant amount of cash which can be used to further purchase shares and inject capital in the bank or to generate liquidity for those shareholders desiring to sell.
For example, assume an ESOP controls 10% of the stock of an S corporation bank holding company which has S corporation earnings of approximately $3 million. Further assume that the S corporation distributes 35% of those earnings to S corporation shareholders to cover their tax liability, or $1,050,000. In this example, the ESOP would receive 10% of the $1,050,000 distribution, or $105,000, to cover its tax liability (which does not exist).
If the S corporation then distributes another 30% of the profits to its shareholders or another $1 million in lieu of a C corporation dividend, then the ESOP would receive an additional $100,000 as a distribution in lieu of a dividend. The ESOP would obtain and retain the $205,000 of distributed cash since, unlike “human being” shareholders, it pays no taxes. In a Subchapter S, an ESOP becomes a cash cow and a leveraged ESOP can service a significant amount of debt due to the distributions on stock owned in addition to company contributions.
Implications for troubled banks
In a troubled institution situation, an existing leveraged ESOP is not only a more tax-advantaged way to raise capital, it is also easier, from the viewpoint of practical and regulatory hassles.
In a typical troubled bank situation (of which there are many currently), the regulators clamp down on the ability of the bank to pay dividends to its holding company for debt service or otherwise. In fact, a standard enforcement action provision for all the bank regulatory agencies is that no dividends may be paid by the bank without the regulatory agency’s permission—grudgingly given, if at all.
Likewise, the Federal Reserve, as a regulator of the holding company, in its enforcement actions, cites the bank holding company under the “source of strength doctrine,” and requires the bank holding company to conserve the bank’s assets. In this context, that means the holding company cannot receive dividends, pay expenses, and the like.
The unique aspect of the leveraged ESOP is that the debt is not serviced with dividends, but with compensation expense.
Although the regulators can argue that the compensation expense to the ESOP is outside of “safety and soundness” guidelines, it is much more difficult for them to take that position than it is to simply cut off dividends in a leveraged holding company. Even in a troubled bank situation, the payment on an ESOP loan is less likely to be in jeopardy than the payment on the holding company loan, which is serviced with bank dividends. BJ
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