ESOPs and Ag Businesses – Part Two

Overview

In last Friday’s post, I examined what an Employee Stock Ownership Plan (ESOP) is, the basic structure of an ESOP, and the benefits of using an ESOP.  In Part Two today, I look at an ESOP’s potential pitfalls, how the U.S. Department of Labor might get involved (in not a good way), and the impact of the Tax Cuts and Jobs Act (TCJA) on ESOPs. 

ESOPs and ag businesses – part two.  It’s the topic of today’s post.

What the DOL Looks For

The U.S. Department of Labor (DOL) has a national enforcement project focused on ESOPS.  The Employee Benefits Security Administration (EBSA) is an agency within the DOL that enforces the Employee Retirement Income Security Act of 1974 (ERISA) and is charged with protecting the interests of the plan participants.  One of the primary concerns of the DOL is the belief that ESOPs suffer chronically from bad appraisals.  As a result, the EBSA has increased its level of scrutiny of ESOP appraisals, and litigates cases it believes are egregious and could not be settled or otherwise resolved.  In these situations, the basic allegation is that the fiduciaries of the ESOP didn’t exercise adequate diligence in obtaining and reviewing the appraisals as part of the transaction process. 

Appraisals that are based on projections that are too optimistic can result in an overpayment by the ESOP in the transaction.  This can be a particular problem when the appraisal is prepared by a party to the transaction – the same people that are selling the stock to the ESOP or who are subordinates of the sellers.  I.R.C. §401(a)(28)(C) requires that all employer securities which are not readily tradeable on an established securities market must be valued by an “independent appraiser.”  An “independent appraiser” is a “qualified appraiser” as defined by Treas. Reg. §1.170A-13(c)(5)(i).  For example, in Churchill, LTD. Employee Stock Ownership Plan & Trust v. Comr., T.C. Memo. 2012-300, pet. for rev. den., No. 13-1295, 2013 U.S. App. LEXIS 11046 (8th Cir. May 29, 2013), the appraiser did not satisfy the requirements to be a qualified appraiser.  The court also upheld the IRS determination to revoke the ESOP as a disqualified plan from 1995 forward (total of 15 years) for failure to meet certain statutory requirements (i.e., failure to timely amend plan documents necessitated by tax law changes and failure in addition to not having a qualified appraiser) to which ESOPs are subject.

If the ESOP fiduciaries simply accept the projections without determining whether the projections are realistic that will likely constitute a breach of their fiduciary duties.  So, simply plugging management projections into the ESOP appraisal without a critical review by the fiduciaries is problematic.  Clearly, an ESOP’s fiduciaries should be communicating with the appraisers about the projections and asking questions.  Similarly, if the appraisal incorporates a control premium when the ESOP is not really buying control, that will bring scrutiny from the EBSA.  The reason for the scrutiny is that the result will be an enhanced stock value over what it should be in reality.  Relatedly, an issue can arise where the ESOP pays full value for the stock but does not get all of the upside potential because of dilution caused by warrants, options, or earn-outs that are not considered in determining adequate consideration. That results in overpayment for the stock. The EBSA is also concerned about the use of out-of-date financials on which the appraisals are based which don’t reflect current corporate reality.

Also, EBSA looks for situations where the plan effectively owns the company, but is not exercising any of its ownership rights in the company.  In other words, in this situation the claim is that company management is effectively “looting” the company of its value and the ESOP fiduciaries are doing little or nothing to protect the value of the corporate stock. 

The Cactus Feeders Case

Basic facts.  The concerns of the DOL and the EBSA were illustrated recently in a matter involving Cactus Feeders, Inc. (CFI), a large cattle feeding business.  In early March of 2016, the DOL filed a lawsuit in federal district court in Amarillo, TX, against CFI and various fiduciaries to the CFI ESOP for allegedly causing the ESOP to pay tens of millions of dollars more than the DOL claims it should have paid for company stock.  The court filing points out ESOPs require care in their implementation and usage to avoid government scrutiny and the possible fines and penalties, and revocation that can accompany failing to meet all of the technical requirements. 

The DOL alleged that Lubbock National Bank (the ESOP trustee) violated its fiduciary obligations under the (ERISA) when it caused the ESOP to overpay for company stock.  The DOL also claimed that CFI, as the ESOP administrator and acting through its board of directors and designated ESOP committee members, knew of the trustee’s breaches of duty and didn’t stop them.  The ESOP, which already owned 30 percent of corporate stock, bought the remaining 70 percent for $100 million which DOL claims was too high of a price to pay because it failed to account for warrants and stock options that would dilute the ESOP’s equity from 100 percent to 55 percent when exercised; a lack of marketability discount; and a price adjustment for an investors’ rights agreement that allowed the selling shareholders to retain control over CFI for a 15-year period. 

Settlement.  On May 4, 2018, the DOL and CFI settled.  The settlement also involved CFI’s insurers, certain parties involved with the ESOP committee, and the ESOP trustee.  The settlement involved the payment of an additional $5.4 million into the CFI ESOP.  Acosta v. Cactus Feeders, Inc., et al., No. 2:16-cv-00049-J-BR (N.D. Tex. May 4, 2018).  In addition, the settlement placed additional requirements on the ESOP trustee that are comparable to an agreement the DOL reached in 2014 with GreatBanc Trust Co.  Basically, the agreement requires the CFI ESOP trustee to follow specified procedures when serving as a trustee or other fiduciary of an ESOP that is subject to ERISA when non-publicly traded employer securities are involved.  But, it did not require the CFI ESOP trustee to do a number of things that the DOLwas seeking – such as reviewing financing options for ESOPs; obtaining “fairness” opinions; obtain sufficient insurance to provide liability coverage as a fiduciary; perform oversight of a valuation advisor; and maintain documentation of when control is given up via an ESOP transaction. 

Impact of the TCJA

The TCJA retained the existing tax benefit when an ESOP owns an S corporation.  In that situation, the portion of ESOP earnings that are attributable to the S corporation are exempt from federal (and most state) income tax.  In other words, the flow-through tax status of the S corporation is recognized.  However, when an ESOP owns a C corporation or less than 100 percent of an S corporation, the TCJA will have an impact.  Under the TCJA, the C corporate tax rate was changed to a flat 21 percent, effective January 1, 2018.  Depending on the prior applicable tax rate for the corporation, this could be a benefit.  As for interest expense deductibility (which could be an issue for an ESOP where the company borrowed funds to finance the acquisition), the TCJA limits the deduction for business interest to the sum of business interest income; 30% of the taxpayer’s adjusted taxable income for the tax year; and the taxpayer’s floor plan financing interest for the tax year. Any disallowed business interest deduction can be carried forward indefinitely (with certain restrictions for partnerships).  But, the limitation doesn’t apply to a taxpayer with gross receipts of $25 million or less.  A “farming business” can elect out of the limitation (with some “pain” incurred on the depreciation side of things).  

On the ESOP valuation issue, the reduction in the top C corporate tax rate (federal) from 35 percent to 21 percent may result in enhanced after-tax corporate earnings.  If so, it will trigger higher valuations when the ESOP is valued using the discounted cash-flow method (which is a common ESOP valuation approach).  This rate reduction could also result in higher ESOP repurchase obligations. 

Conclusion

If an ESOP transaction is treated seriously, is minimally complex (e.g., the plan buys shares of common stock at fair market value), and the trustee considers how the structure of the transaction can either help or hurt plan participants, it is likely that the ESOP will avoid scrutiny.  Clearly, the trustee should be communicating with the appraisers, analyzing company projections by comparing them with industry competitors and historical numbers, and determining whether the plan should be paying for control (it shouldn’t when the plan can’t control who manages the company or how it is managed).  In addition, the use of an independent appraiser is required.   

Certainly, ESOPS are useful primarily as a management succession vehicle for a closely held business.  Also, they tend to work better for lower income, relatively younger employees compared to the typical company retirement plan.  But, they are very complex and potentially dangerous.  They do require meticulous compliance to avoid catastrophic results, and should never be used as a tax shelter for a closely-held business when the owner wants to maintain control.  They require compliance with complex qualification rules on an annual basis, which requires significant legal and consulting bills.  So, in the right situation, an ESOP can be useful and may even outperform a more traditional retirement plan.  But, that’s to be expected given the greater inherent compliance costs and risks. 

Is an ESOP a good tool for your farming or ranching operation?  It depends.