Pub. 9 2014-2015 Issue 4

www.nebankers.org 12 Extraordinary Service for Extraordinary Members. T HE USE OF EMPLOYEE S TOCK Ownership Plans (ESOPs) with banks is not new. Nationwide, banks utilize ESOPs more than any other industry. As bank share- holders age, and capital requirements increase, the use of ESOPs by banks is expected to increase. This article briefly touches on the fundamental advantages of an ESOP in a banking environment. While ESOP transactions can be compli- cated, an ESOP can serve as an excellent liquidity and succession tool, ameans of improving a bank’s capital position, and a great benefit to loyal bank employees. A basic ESOP transaction involves the purchase of stock by an ESOP. The seller can be an existing shareholder or the bank can sell newly issued shares. The ESOP can use existing assets (non- leveraged) to purchase the stock or the ESOP may borrow the necessary funds from a financial institution or a selling shareholder to finance the transaction (an ESOP is the only type of qualified re- tirement plan that can borrow money). As the debt is repaid by the ESOP, the stock is allocated to the accounts of the ESOP-eligible employees. The picture below shows how a typical leveraged ESOP transaction looks. COUNSELOR’S CORNER Effective Use of ESOPs for Banks John Schembari , Kutak Rock LLP The debt repayment by the ESOP is typically funded by a tax-deductible con- tribution to the ESOP by the bank. Ac- cordingly, the stock may be purchased by the ESOP at a discounted value equal to the state and federal tax rates, which in many cases can mean a 40 percent discount. In addition, dividends paid on shares of stock held by an ESOP can be deductible to the bank. The seller in an ESOP transaction sells the stock at fair market value estab- lished by an independent appraiser. If the bank is a C corporation, the proceeds from the sale may be received by the seller without any federal capital gains tax, provided the proceeds are invested in qualified replacement property. This favorable tax treatment means that many selling shareholders prefer to sell to ESOPs as opposed to other buyers, even at reduced valuations. The avoidance of capital gains tax does not apply to Subchapter S corpora- tions. However, where an ESOP owns stock in a Subchapter S corporation, the distributions of income attributable to the stock held in the ESOP are not subject to income tax. In the context of an ESOP owning 100 percent of the Subchapter S corporation stock, the bank essentially becomes a tax-exempt entity. The money that the bank would have been paying to the U.S. Treasury, can be used to finance acquisitions, re- ward employees, or improve the bank’s cash position. Banks across the country have looked at ESOPs as a means of building capital. An ESOP bank’s Tier 1 capital can be improved with the use of pre-tax dol- lars, which allows for a faster build-up of capital. Existing retirement plans Stock Bank Shareholders ESOP Employees