ERISA rules for ESOP Valuations and discount calculations

This article written by ValueMetrics Corp provides an excellent overview of the rules governing the valuation of ESOPs

ESOP VALUATIONS NEW DEVELOPMENTS

An ESOP (Employee Stock Ownership Plan) is a defined contribution pension plan, authorized by ERISA (Employee Retirement Income Security Act) similar to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes shares of its own stock or cash to buy shares of its stock.  The purpose is to provide liquidity to owners of closely held companies who desire to exit and an investment in the company to covered employees.  Congress made employee ownership a priority goal, and provided a number of tax benefits to facilitate and encourage ESOPs.

The ESOP is funded by the company, not the employees.  The ESOP can borrow money to buy shares, with the company making cash contributions to the plan to enable it to repay the loan.  The company may also be required to guarantee the loan by the lender.

Regardless of how the plan acquires stock, company contributions to the trust are tax- deductible, within certain limits.

Shares in the trust are allocated to individual employee accounts.  As employees  accumulate seniority within the company, they acquire an increasing right to the shares in their account, a process known as vesting.  Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual. When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (discounted) or fair value (undiscounted) as per provisions in the plan, unless there is a public market for the shares.  They may, in the alternative, receive a cash buyout of the appraised value of their interest.  Private companies must have an annual ERISA compliant independent valuation to determine the price of their shares.  In private companies, ESOP employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through other voting rights, such as voting for the board of directors, or other issues. In public companies, employees must be able to vote all issues.

 

Department of Commerce figures show that there are in excess of 170,000 companies in the U. S. with 20 to 999 employees, which are potentially suitable for ESOPs.  These are virtually all privately held. The National Center for Employee Ownership shows that there are only about 11,000 ESOPs amongst this group.  Thus the penetration is about 6.5%.  With the virtual collapse of credit markets in 2008, exit opportunities for owners of small businesses have been dramatically and negatively impacted.  Selling a company to an outside party may not be feasible both for tax reasons and availability of financing. However in some cases an ESOP is feasible because the seller can carry back a note for all or part of the purchase price from an ESOP.  This can be combined with institutional debt and possible investment by private equity, to form a new capital structure that effectively “buys out” the selling shareholder. Thus a significant increase of ESOPs is expected over the next several years as retiring “baby boomers” attempt to exit their businesses in this environment.

TAX CONSIDERATIONS

Without use of an ESOP, the selling owner can expect serious tax implications.  In a C- corporation he will be double taxed, with the Federal capital gains rate expected to return to 20% as the Bush tax cuts expire in 2011.  State capital gains tax treatment differs. Some, like California, do not provide for capital gain treatment and tax as ordinary income.  The C-corporation taxes, plus brokerage commissions, other selling costs, and personal income taxes can reduce the net on the sale by 60% to 70% (depending on the state) or more. S-corporation owner’s fare better on a sale, but the total cost of sale is still expected to be 30% to 40% or so, depending on the state. Both C-corporations and S-corporations can sponsor ESOPs however the tax advantages to the owners differ, but in both cases may provide significant benefits.  

A C corporation shareholder, who sells at least a 30% interest to an ESOP, can roll the net sales proceeds into investments in qualified public securities without any income tax liability.  An S-corporation seller does not get this advantage; however, for S corporations there is no income tax liability for income allocated to the ESOP.  There are many other tax considerations, but the details of tax treatment are beyond the scope of this paper.

A drawback of selling to an ESOP may be that the shares are subject to a minority discount to meet the “adequate consideration” conditions, thus providing a lower gross price per share than the gross sales price to competitive outside buyers. But after the comparative tax consequences are analyzed it is quite probable that the net after-tax proceeds of the sale could be significantly higher with a sale to an ESOP.

VALUATION – AN ESSENTIAL COMPONENT OF AN ESOP

IRS Code Section 401(a)(28)(C) requires a non-publicly traded company to obtain a qualified appraisal of the ESOP shares:

Each time the plan acquires shares, and At the end of each plan year thereafter.

The Pension Protection Act of 2006 requires such appraisals, and the appraisers to be

qualified under its regulations.  The applicable standard is Fair Market Value. The two significant issues affecting compliance with ERISA are the concept of “adequate consideration” and appropriate discounts in value for lack of marketability (DLOM).

“Adequate consideration” means that the ESOP may not pay more than qualified Fair Market Value for shares it acquires for the ESOP.  Both ERISA (Department of Labor) and the IRS acknowledge that these shares should be discounted in value for lack of control, and for lack of marketability if appropriate.  A “control” interest is problematic in that though the ESOP may obtain numerical control, it may not be able to practically act on such control due to limitations imposed by the ESOP or other corporate documents.  For instance, though the trust may represent a majority interest, the covered employees may not be able to vote on significant issues by limitation of the ESOP or other documentation.  Further, because the ESOP’s interest is voted by the trustee, there may be no way the employees can vote to determine the trustee’s action, nor to remove the trustee. The effect of this is that the appraiser must take into account a number of issues which have been more or less “codified” by applicable court decisions:

Adjustment for excess compensation to employees.  Because the IRS permits large tax deductable contributions to the plan, which effectively increase employee costs for tax purposes, an analysis must be made to determine if a premium exists, and to appropriately adjust the income statement upon which the basic appraisal of the company is made.  If this is not done, the basic fair value equity may be significantly understated.

Complete analysis of the control and marketability issues. Many appraisals, especially in the past, dealt with the concept of “control premiums.” This concept comes from analysis of publicly traded securities, and really has no relevance to exempt private securities. In these securities the fair value equity of the stock (without discounts) automatically reflects control.  

In privately held companies, the control premium is merely the difference between the fair value equity (equity value of 100% ownership) and the value of minority interests after discounts are applied. Also, stock of the same class may be issued with or without voting rights.  Lack of voting rights can cause impairment in value.

The question of de facto control vs. numerical control must be thoroughly addressed.  For instance, even though an ESOP may hold a majority interest in the number of outstanding shares, the question of who is empowered to vote those shares arises.  The employees usually have no say in the selection of the trustee. And the trustee may be a controlling officer of the company, which could present a potential conflict of interest.

REQUIREMENTS OF ERISA AND PROPOSED REGULATIONS

ERISA sets forth requirements for the trustee to exercise due diligence and good faith in valuation of assets for which there is no active market. Proposed Regulation 2510.318(b) and proposed 29 CFR 2510.3-18 to ERISA expand on the definition of “adequate consideration”, and though not yet officially enacted, industry and government almost universally adopted the same criteria to use until enacted.

Under ERISA, “adequate consideration” means the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the plan and in accordance with regulations promulgated by the Secretary of Labor.

The proposed regulation delineates the scope of this regulation by establishing two criteria, both of which must be met for a valid determination of adequate consideration.

First, the value assigned to an asset must reflect its fair market value as determined pursuant to proposed § 2510.3-18(b) 

Second, the value assigned to an asset must be the product of a determination made by the fiduciary in good faith as defined in proposed §2510.3-18(b) .

For the first criterion the definition of fair market value is set forth as: “…the price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well- informed about the asset and the market for the asset.” (It should be noted that this definition is consistent with that adopted by most appraisal organizations, and is also consistent with the IRS code and IRS Revenue Ruling 59-60, and the Uniform Standards for Professional Appraisal Practice.)

The second criterion sets forth the following:

The valuation must be set forth in a written document

the “good faith” requirement establishes an objective standard of conduct, rather than an inquiry into the state of mind of the Trustee

the fiduciary making the valuation must itself either be independent of all the parties to the transaction or must rely on the report of an appraiser who is independent of all the parties

if donated property, the valuation should follow Rev. Proc 66-49 (IRS Revenue Ruling 83-20) which sets forth the format required by the IRS for valuation of donated property, or

If the property is to be purchased, it requires that Revenue Ruling 59-60 shall apply.

This documentation must contain, at minimum

a. A summary of the qualifications of the appraiser,

b. A statement of the asset’s value and a statement of the methods used in determining that value, and the reasons used to determine the value,

c. A full description of the asset being valued,

d. The factors taken into account in making the valuation, including any restrictions understandings, agreement or obligations limiting the use or disposition of the property,

e. The purpose for which the valuation was made,

f. The relevance or significance accorded to the valuation methodologies taken into account,

g. The nature of the business and the history of the enterprise from its inception,

h. The economic outlook in general, and the outlook for the specific industry in particular,

i. The book value of the securities and the financial condition of the business,

j. The earning capacity of the company,

k. The dividend-paying capacity of the company,

l. Whether or not the enterprise has goodwill or other intangible value,

m. The market price of securities of corporations engaged in the same or a similar line of business (later expanded to include similar fee holdings),

n. The marketability of the securities, or lack thereof,

o. Whether or not the Seller would be able to obtain a control premium from a third party.

Under the Pension Protection Act of 2006, and in ERISA regulations, the appraisal procedures must be in strict compliance with the Uniform Standards for Professional Appraisal Practice, (“USPAP”) Standards 9 and 10 which apply to Business Appraisal procedures, and Business Appraisal Reports, respectively.

MINORITY DISCOUNTS

ESOP fiduciaries and financial professionals involved with the administration of the ESOP need to be aware of the effects of court cases relating to the valuation of minority interests in small businesses and related securities.  Cases brought to the Tax court in recent years have shed light on the relatively obscure subject of discounted values caused by reduced marketability and control for minority interests.  The cases will be pointed out in this article.

Prior to these cases, appraisers generally treated valuation of such discounts as a relatively minor adjunct to the valuation of the basic (majority) position.  Many either used “industry standards” for marketability discounts of, say, 35% without support, or they attempted to support these values with statistics from studies of restricted stock of public companies which can be sold, usually at a discount, from their unrestricted brethren, and by IPO studies of stock values before and after the Initial Public Offering. The courts have virtually all rejected such valuations in the case of closely held securities, and laid down some principles which, if adhered to in appraisals, should significantly limit the chances of litigation.  And, if litigated it should significantly enhance the chances of winning.
Further, some valuators argued that because ERISA provides an implied “Put” option for the employee to sell his stock back to the company, that there is no minority interest generated impairment of value to the ESOP.  This is wrong because the Put is a contract between the company and the employee, not the ESOP and the employee; and the ESOP has no right to put the stock to the company.

VALUATION PRINCIPLES

All appraisals are a defensible opinion of value, prepared by an expert, for an ownership interest.  Such an ownership interest is often referred to as a “bundle of rights.” Normally ownership in fee contains the most valuable bundle of rights, and lesser forms such as ownership of a security interest, lease, license, minority interest, or other such instrument will reduce the bundle of rights – and hence the value.  Further, contractual restrictions on marketability or control of such minority interests results in a reduction of value. If the asset to be valued is a minority interest, and/or if it is subject to restricted marketability, and/or lack of control, appropriate discounts to value must be applied.

Over the years, many appraisers have adopted policies that separated the lack of control discount from the lack of liquidity or marketability discount.  However, this appears to be a difference without a distinction.  All discounts from value appear to be, in the end, evidence of impairments in marketability.  The fact that such discounts, even if treated as separate discounts, are multiplicands which are multiplied by each other to derive a final discount figure illustrates this point.

Though the appropriateness of applying such discounts in these situations has been universally accepted by the IRS and the courts, recent court decisions have shown a fair amount of disagreement over the means of quantifying the appropriate discounts. (IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities,” but  it is silent on “exempted securities,” which make up the vast majority of privately held securities.  Both are defined and described in the Securities Act of 1933.) The cases indicate a complete analysis is required.

To quantify the “marketability discount,” because of a lack of available specific data, some appraisers have been relying on two sources of data from public company transactions: Initial Public Offering Studies, and Restricted Stock Studies to defend their discount opinion.  The “standard” discount often derived from these studies is typically between 30% to 40%.  Three cases against the Commissioner in 2003 found that such studies, based upon data from public companies, were not sufficient basis to value closely held private (exempt and unregistered) ownership.  Upon a deeper look the reasons are fairly obvious:

Initial Public Offering Studies (IPO) show the difference in the price of a stock before the offering and after, and an appraiser may attempt to infer that this is direct evidence to support a marketability discount for an exempt security.  This is erroneous for the following reasons:

Stock values of privately held companies typically are based upon investment value – that is, an investor will be interested in both the current return, and the amortization factor (risk abatement factor) which indicates how long it will take to recover the initial investment.  This is necessary because of the high degree of illiquidity of non-public securities.

 

The IPO price, on the other hand, reflects a speculative value – that is, the investor is looking mainly towards price appreciation.  By its nature once publicly traded, the stock should have high liquidity, so recovery of the investment is not an investment concern.  Thus, this study is relevant only to companies anticipating an IPO.  Unfortunately these companies represent less than 1% of the companies extant in the U.S. Restricted Stock Studies deal with stocks of public companies that have been temporarily restricted from sale for two years (later for one year) in the public markets (usually by virtue of securities regulations under Rule 144). Nonetheless, there is no prohibition in selling these securities in private transactions where they usually sell at an average of 30% or so less than publicly traded stock.  But these are applicable only to normally publicly traded stocks that have only a temporary restriction from public markets, and not on the general ”permanent” illiquidity problem faced by small privately held companies which would make them far less marketable.

Control discounts, (or more appropriately control-based marketability discounts) for privately held companies exist because in privately held companies the only practicable way to recover the investment is liquidation (sale) of the company.  Without control, an investor does not have the right to exercise this option.  Thus minority interests in closely held companies are very difficult to sell and even some majority (by percentage ownership) interests which have their control impaired by agreement have a much lower market value than those which are not impaired.  In practice, in the past appraisers have often attempted to base discounts for lack of control on control premium studies of public companies.  But they are not the same as for private companies at all, and the dynamics of value discounts are not appropriate for them.

The case of Mandelbaum v. Commissioner, T.C.M 1995-255 determined that use of irrelevant data is unacceptable, and sets forth some basic factors which might comprise the discount, but specified that this list was not exclusive, and other factors may (and should) apply as the situation dictates.  It basically states that a complete analysis must be done which is relevant to the subject.  The factors listed to be evaluated included but were not limited to:

Private vs. public sales of stock

Financial statement analysis

Dividend policy

Nature of the company, history, position in the industry and economic outlook

Management

Amount of control in transferred shares

Restrictions on transferability of stock

Company’s redemption policy

Costs associated with making a public offering

IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities”, but it is silent on “exempted securities,” which make up the vast majority of privately held securities.  Both are defined and described in the Securities Act of 1933.

ASSESSING EFFECTS ON SMALL VERSUS LARGE COMPANIES

To put this in perspective the following table shows the number of businesses in each group by employee size extracted from County Business Patterns, 2007, published by the Bureau of Census, for the USA (total of 7.5-million companies).  It shows the overwhelming proportion of small (usually SEC exempt) companies.

Less than 10 employees 79.0%        

Less than 20 employees 90.0%        

Less than 100 employees 99.0%        

Less than 500 employees 99.7%        

More than 500 employees 0.3 %               

The dynamics of marketability discounts for the 99% of small businesses with less than 100 employees is simply not reflected in the studies based upon public companies.  The cases of McCord v. Commissioner, 120 T.C. 358-2003, Lappo v. Commissioner, T.C.M 2003- 258 and Peracchio v. Commissioner, T.C.M 2003-280 all rejected the “cookie cutter” approach to discounts based upon data from public companies.

Discount data from public companies is available, and there are several studies available which document appropriate discount rates for them.  However for small, closely held companies, this data is not available.  Minority interests in such companies are extremely difficult to sell and there are virtually no active markets.

CONTROL DISCOUNTS AS APPLIED TO FAMILY MEMBERS OWNING SHARES

IRS Revenue Ruling 93-12 applies in this instance.  Prior to the issuance of Revenue  Ruling 93-12, the IRS held a position that when transfers of stock comprised a controlling interest within the family unit as a whole, even though individual gifts of stock might not grant a controlling interest, per se, that discounts in value for the lack of control were not allowed. IRS Revenue Ruling 93-12 reversed this position, and holds that in the case of gifts of stock the following policy is in effect:

"If a donor transfers shares in a corporation to each of the donor’s children, the factor of corporate control in the family is not considered in valuing each transferred interest for purposes of Section 2512 of the Code, for Estate and Gift Tax purposes, the Service will follow Bright, Propstra, Andrews and Lee in not assuming that all voting power held by family members may be aggregated for purposes of determining whether the transferred shares should be valued as part of a controlling interest.  Consequently a minority discount will not be disallowed (emphasis added) solely because a transferred interest, when aggregated with interest held by family members, would be part of a controlling interest.”

This would be the case whether the donor held 100 percent or some lesser percentage of the stock immediately before the gift.  In appraisal practice, the appropriate discounts for Lack of Control and Restricted Marketability are applied consecutively and cumulatively. 

BUILT IN CAPITAL GAINS

The case of Estate of Dunn v. Commissioner, 301F 3rd 339 (5thCir. 2002) reversed a previously held notion that a built in capital gains tax which is attendant to a low-basis high asset value situation established that the value should be reduced dollar for dollar for the capital gains tax liability.  Estate of Jelke v. Commissioner, T.C.M 3512-03 U.S. App 11 th Cir. 2007) found an assumption must be made for immediate liquidation rather than spreading the gain over the expected life of the investment.  This now places four Circuit Court of Appeals on the side of taking a dollar for dollar deduction for Built-In Capital Gains tax in a Corporation.  See Estate of Eisenberg v. Commissioner, 74 T.C.M. (CCH) 1046 (2 nd Cir. 1997), Estate of Welsh v. Commissioner, 208 F. 3d 213 (6 th Cir. 2000), Estate of Jameson v. Commissioner, 267 F. 3d 366 (5th Cir. 2001), Estate of Dunn v. Commissioner, 301 F. 3d 339 (5th Cir. 2002), and Estate of Jelke v. Commissioner,T.C.M 3512-03 U.S. App (11th Cir. 2007).  The question of the proper way to reflect this deduction was not determined.  There are two possibilities, (1) show marketability discount in value, or (2) reflect a contingent liability in the amount of the allowance for Built in Gains tax on the balance sheet.

CONCLUSIONS REGARDING DISCOUNTS

The courts have indicated that a complete and defensible analysis of the applicable issues must be made from which an appraiser bases his decision.  Because transfers of minority interests in closely held companies are very rare, and there are no historical data sources available for these discounts, the appraiser must rely upon his experience and judgment in determining the appropriate discounts based upon a hypothetical analysis.

The IRS states that valuation is a question of fact and the trier of fact must weigh all relevant evidence to draw the appropriate inferences.  This begs the question of how can an appraiser draw inferences if there is no published data.

Conventional statistical analysis will neither be appropriate nor possible in this situation.  There is, however, an available methodology called “heuristics” or the “heuristic paradigm”.

The vast majority of people are not familiar with the term “heuristics,” though we all use heuristics, probably without being conscious of it.  The word is derived from the Greek  word “Eureka” meaning “I have found it.” In the past twenty years it has been refined into a modern problem solving and analysis methodology, usually associated with “systems science.” It has been developed to deal with decision-making and judgment- making involving complex systems where specific reliable data is not available, and the time and cost of obtaining such data necessary for a conventional statistical analysis is simply not feasible.

Basically heuristics is the art of drawing inferences when faced with limited, incomplete or fuzzy data.  It is based upon the innate human ability to recognize patterns.  We do this spontaneously.  Even reading the words on this page is a heuristic endeavor.  The reader is not interpreting literally the meaning of each word (which itself is a heuristic endeavor), but is recognizing the pattern of ideas which the words convey. To employ the heuristic approach requires two things:

A human mind, which is genetically disposed to recognize patterns;

and

it must be a mind with, Significant experience in the general subject matter from which to recognize patterns.

Employing these attributes will allow an appraiser to collect heuristic data points, none of which in itself will permit a specific and defensible inference, but all of which serve to frame an array which can be judged for their apparent relevance, weighting them and ranking them to provide insights into the probable effect of specific issues that, in the case of discounts, would foster a reduction of value.  It takes expert experience to do this well. This is likely the reason for the minimum two-years experience in valuing the type of asset being appraised as set forth in the Pension Protection Act of 2006 – which now governs appraisals of this type.

A complete discussion of heuristics is beyond the scope of this article. The purpose here is to introduce the concept so that the reader may understand that such a methodology is not only available, but scientifically defensible, and to look deeper into it. Googling the word “heuristics” will lead to a number of sites, including Wikipedia, which can shed some light on this. But the important point to remember is that as a result of the recent court cases, the analysis of discounts must be as complete and defensible as the analysis of the basic (majority interest) of the security. Rules of thumb won’t work.

CONCLUSIONS

Under ERISA and IRS regulations there are severe potential penalties for improperly determining “adequate consideration” and damages from litigation can be significant (see Reich v. Valley National Bank of Arizona (the “Kroy case”) where damages were $17,500,000 resulting from the ESOP paying more than “adequate consideration” for shares to the detriment of employees. There are likewise serious potential administrative penalties if tax deductibility is denied resulting from improper valuation.  This can arise when the transaction becomes a “prohibited transaction” under ERISA and IRS regulations, and the tax benefits could be disallowed – resulting in penalties and interest, not to mention the payment of taxes. Therefore it is of the utmost importance that all of the parties involved with the administration of an ESOP (the trustee, the company owner, the lender, if there is one, the appraiser, the tax accountant, and the ERISA compliance attorney) be in coordination, and be aware of how the valuation issues affect the situation. And, most importantly, to avoid serious financial risks and penalties, the valuation report itself must address all the nuances engendered by the ESOP, and the enabling legislation, so that the valuation is relevant, defensible, and complete.

Source American ValueMetrics Corp

by Gerald W. Barney 
   Melisa Silverman