Owners all: CPA firm sweetens deal with ESOP.

What's an ESOP?

To those of us who are directors at the San Luis Obispo-based firm of Glenn, Burdette, Phillips & Bryson, an employee stock ownership plan is many things:

* An employment sweetener that attracts and keeps good employees;

* A vehicle for owner buyouts;

* A tool for corporate finance;

* A cash-flow enhancer; and

* A productivity booster.

To an individual owner, an ESOP can provide an effective way to diversify out of a large block of highly-appreciated stock without paying taxes on the gain.

TECHNICALLY SPEAKING

The technical definition of an ESOP is a qualified, defined contribution employee benefit plan designed to invest primarily in securities of the sponsoring employer. Created by the 1974 Employee Retirement Income Security Act, traditional thinking about ESOPs has restricted their use to major corporations with publicly traded stock.

However, because the potential operational and tax benefits are so favorable, smaller companies with the right characteristics should not dismiss ESOPs without a careful look. Size really doesn't matter, nor does industry. There are two characteristics which distinguish good ESOP candidates from those who need not apply--profitability and relatively high compensation levels.

WHATEVER WERE WE THINKING?

As we did our due diligence--and since we adopted the ESOP--we have been hard pressed to find other California CPA firms who have chosen this route. So what were we thinking when we adopted an ESOP in our closely held CPA firm?

We were in the midst of a three-year hiring drought and were competing with CPA firms across the state for good candidates. To make matters worse, several of our own productive staffers were hired away by clients in private industry, so just to keep a full lineup of players we were being forced to pay steeply increased salaries and benefits.

At the same time, five of our nine shareholders were in their late forties. We faced the undesirable prospect of paying for five unfunded owner buyouts simultaneously. Although we had successfully transformed into a second-generation CPA firm--we bought out the original shareholders in accordance with terms of our buy-sell agreement--that arrangement never contemplated the possibility of paying multiple shareholders during the same time period.

To solve the problem of unfunded owner retirements, we investigated insurance-backed buy-sell agreements and selling out to a consolidator. Although funding buy-sell arrangements with permanent insurance seemed realistic, the hit to current compensation to pay nondeductible premiums on policies was more than the owners were willing to bear. Essentially the time frame we were working with was too short to effectively accumulate enough dollars to accomplish our goals without curtailing the financial incentives for new owners to join.

For a time, consolidation seemed like the answer and we travelled down that path with multiple suitors. In the end, our geographical isolation in San Luis Obispo County hindered our attractiveness to outsiders and the prospect of an ever-rising performance bar set by corporate evaluators from elsewhere soured us on the sell-out solution.

AN EPIPHANY

Last spring, Managing Director Dan O'Hare was researching ESOPs for an S corporation client when he experienced an epiphany of sorts. "All the pieces fell into place," says O'Hare. "I wondered: If it could work for my client, why couldn't it work for us?"

In fact, it might not have worked for us, except for a little-noticed 1999 change in the California Business and Professions Code that allowed non-licensed employees to hold up to 49 percent of a professional accounting services corporation's stock.

After introducing the idea to our shareholders, we contacted an ESOP consultant who helped us negotiate the maze of legal and practical considerations. We performed a feasibility study and hired an independent appraiser to do a preliminary valuation of the company.

GETTING DOWN TO BUSINESS

Valuation principles in the context of a services firm are based almost entirely on gross billings and bottom-line profitability or earnings before income tax (EBIT). Our initial valuation came in very low primarily because we were operating as a C corporation and paid out all profits as compensation to avoid a corporate-level tax.

It took a major paradigm shift to realize that by reducing compensation and leaving profits in the corporation, our appraised value would increase. For example, if EBIT is 12.5-percent gross, the capitalization rate in the market is eight times EBIT.

We ran projections to see what the change would mean in terms of owner compensation. Our study indicated owners' salaries would decrease by almost a third initially, but payments from the ESOP for purchase of their stock could offset the difference. It also could replace ordinary income with long-term capital gain.

Those owners who continued to work bet the long-term rise in value of their ESOP shares would more than replace the annual reduction. Although our shareholders were all eligible to make a Sec. 1042 deferral election--not one did.

"You cannot participate in future ESOP contributions if you make the election," explains shareholder Dave Bryson. "I felt I would be working enough more years to make the buildup in ESOP value worth it. I also measured the risks of being on the hook for debt in the event outside stock investments went down. Receiving the buildup in firm value plus an annual ESOP contribution made more sense."

After evaluating the options, our shareholders agreed to sell 85 percent of their outstanding shares to the ESOP. In exchange, the ESOP gave a promissory note, payable with interest annually over nine years. Although we chose not to, the ESOP could have borrowed money from outside sources if any of the shareholders had desired cash to make a deferral election.

The corporation's annual ESOP contribution provides funding to repay the note. Since the ESOP is a leveraged plan, the corporation can contribute and deduct up to 25 percent of employee compensation annually. The corporation also can deduct dividends paid to the ESOP to enable it to repay its loan more rapidly.

ESOP IN ACTION

Day-to-day management decisions are made by an executive committee comprised of directors, including two of the selling shareholder/owners; the human resources and information services directors; and the accounting manager. Long-range direction and ultimate decisions rest with the director group--all former shareholder/owners.

What has the ESOP meant to the employees? Initially, staffers generally adopted a wait-and-see approach. While a few could see the obvious benefits of being owners, others were more concerned that our existing 401(k) plan was frozen to avoid exceeding the current contribution limits. At the federal level, this is no longer a concern for plan years beginning in 2002, however conformity in California is still pending. On average, the company had been contributing roughly 4 percent of salary to the old profit sharing plan. This was replaced with a contribution approximating 22 percent of salary.

HAPPY ANNIVERSARY

With a year of operations under our belt, we recently held a firmwide meeting to announce the results. To make it special, we provided brunch for all employees and shared key financial information, including gross income, compensation, employee benefits, operating costs and firm profits. Afterward, employees received their ESOP share certificates.

The reaction this time was overwhelmingly positive. "It was good to see some numbers," says Jan Jensen, tax manager. "A year ago it was hard to understand what the ESOP meant or how it would affect me. Now I see how my production and how I use my time affects the whole picture."

Employees receive their benefit in the ESOP in two ways. First, a contribution to the plan is made on their behalf. The contribution is based on a percentage of compensation. Second, as the per-share value of the company rises, the account balance value of each participant goes up as well. Conversely, if the company suffers a downturn, the ESOP account balances will decline.

At GBPB, we have committed to contribute 12.5 percent of gross billings annually to the ESOP plan. This provides a source of funds for the ESOP to pay off the loans it took on to purchase GBPB stock from the former shareholders. When the loans are paid off, the ESOP can accumulate cash to diversify into other investments, pay out the account balances of retiring employees or acquire more stock.

Maintaining an ESOP in a non-publicly-traded firm requires an annual independent appraisal to establish value. Now that we have become more familiar with the objective performance indicators underlying value, we have found it beneficial to share this information with all our employees. If nothing else, it has raised their awareness about how their efficiencies, use of time and care of clients translates into bottom-line profits, which, in turn, enriches the balance in their individual ESOP accounts.

IT'S WORKING FOR US

Adopting an ESOP is not a panacea for the closely-held CPA firm. Costs to set up a basic plan will range from $15,000 to $30,000. The administrative hurdles alone and the requirement for annual appraisals will prevent many likely entities from making the change.

In an era when the pool of existing qualified employees is shrinking and fewer candidates are choosing public accounting, we have found it pays to make the workforce become a real part of the team by making them owners.

Paraprofessional June Barkley sums it up, "Last year my 401(k) plan went down 30 percent, but my GBPB stock went up 10.5 percent. In a year like 2001, that's pretty hard to beat."

Jeanne A. Potter, CPA, is a director/shareholder in the San Luis Obispo-based firm of Glenn, Burdette, Phillips & Bryson. Potter is the Central Coast Chapter's incoming president.

PROFILE OF GBPB

tax & business advisor

                       MAY 31, 2001  MAY 31, 2000

Gross receipts (app.)  $5.5 Million  $4.8 Million

Payroll                $3.1 Million  $3.2 Million

Plan Contributions     $680,000      $120,000

Employees              60            55

Started                1965

Owner/Directors        9             9

Owners, including      60            0
ESOP holders

RELATED ARTICLE: HOW DOES AN esop work?

A sponsoring corporation makes an annual contribution to the benefit plan, based on compensation.

A contribution of up to 15 percent of covered payroll for a non-leveraged plan, or 25 percent of payroll for a leveraged plan is allowed. If there are other employee benefit plans in place, they must be coordinated with the ESOP to avoid exceeding the 25 percent limit. Under 2001 rules, employee deferral contributions to a 401(k) plan need to be considered for purposes of the overall Sec. 415 dollar limitations. In 2002, under EGTRRA, employee deferrals are ignored when calculating the employer contribution maximums.

AN ESOP'S

circle of transactions

The steps outlined below are common to most ESOPs. However, their order is arbitrary. For example, either the contribution by an employer, a sale by a shareholder or arranging a loan for the ESOP could come first.

* A sponsoring corporation makes a contribution to the ESOP benefit plan, based on a percentage of eligible compensation. The contribution may be in the form of cash or shares of employer stock.

* The ESOP acquires shares of the employer, either by contribution or by purchase from existing shareholders. If the ESOP purchases shares, it may pay cash for them or finance their acquisition by borrowing. Financing may be accomplished with a loan from an outside lender or with purchase money notes carried by selling shareholders.

* If the ESOP purchases shares by borrowing, it repays the loan with interest, over time. Until the loan principal is repaid, shares are not allocated to individual participant accounts. As the principal is repaid, shares are released to the employee accounts. Retiring employees receive cash as they sell their shares back to the ESOP.

* Individual shareholders may sell shares to the ESOP and elect to defer their gains. If 30 percent of the outstanding stock is acquired by the ESOP, selling shareholders may defer recognizing their gains for tax purposes by making a Sec. 1042 election. Shareholders making a 1042 election must reinvest their proceeds in qualified replacement securities within a 15-month period beginning three months before and ending 12 months after the date of sale.

* A sponsoring employer may arrange for outside financing and reloan those proceeds to the ESOP. As annual contributions are made by the employer, the ESOP will accumulate funds to repay the loans.

TRADITIONAL

leveraged esop

1 The lender makes the loan directly to the company based upon security agreements, collateral, guarantees, etc. that would be appropriate for a conventional term loan to business.

2 The company reloans the amount to the ESOP trust under the terms and interest rate that are identical to the loan in the first step.

3 The ESOP trust immediately pays the cash proceeds to the stockholders in exchange for common stock of the company.

4 The company makes contributions to the ESOP trust which are fully deductible for federal corporate income tax purposes and the ESOP returns the same dollar amount back to the company as debt service on its loans from the company.

5 The company makes payments on its loan to the lender, the net effect of which makes such payments (principal and interest) fully deductible.

SELLER.FINANCED esop

1 Shareholders sell their stock to the ESOP trust in exchange for a note to be repaid over a term of years. The company guarantees the loan.

2 The company makes cash contributions to the ESOP to coincide with the debt service required under the loan. These contributions are fully deductible for federal income tax purposes to the company.

3 The ESOP trust, in turn, uses the cash contributions to pay the selling stockholders according to the terms of the note between the ESOP trustee and the selling stockholders.