Our nonprofit organization plans to grow. How can a C3SOP contribute to the achievement of this goal?
Many nonprofit organizations expect that industry consolidation will provide exciting expansion opportunities if sufficient capital can be secured to meet long and short term requirements. A C3SOP – which is an organizational adaptation that facilitates the sponsorship of an ESOP by a nonprofit - will provide a new source of substantial capital to a nonprofit organization on a recurring basis. Of equal importance, the capital provided to nonprofits through a C3SOP can be utilized for general corporate purposes, unlike tax exempt sources of long term financing. Finally, C3SOPs can provide nonprofit organizations with a competitive advantage stemming from (1) the enhanced alignment of corporate and employee interests and (2) tax benefits associated with the C3SOP that can facilitate certain future acquisitions.
Just what is an ESOP?
An ESOP, or Employee Stock Ownership Program, is a qualified retirement plan designed to invest primarily in employer securities. As a qualified retirement plan, many ERISA plan requirements apply to ESOPs, including the following:
- The plan must be reduced to writing and have a domestic trust.
- The plan must meet non-discriminatory coverage rules of the Internal Revenue code.
- The plan must meet one of several alternative vesting schedules reflected in the Internal Revenue Code.
- Distributions must generally commence no later than 60 days after the plan year in which a participant retires or reaches normal retirement age, whichever is later, and in any event must start by April 1st following the date that the employee attains age 70 ½ years.
Several features make ESOPs unique as compared to other employee benefits. First, only an ESOP is required by law to invest primarily in the securities of the sponsoring employer; second, ESOPs are unique among qualified employee benefit plans in their ability to borrow money. As a result, a “leveraged ESOP” can be used as a technique of corporate finance.
I have heard of ESOPs before, but always in connection with for-profit organizations. How would they fit into a nonprofit corporation like our organization?
Your nonprofit may control both for-profit subsidiaries and nonprofit affiliates. An ESOP - called a C3SOP when sponsored by a nonprofit organization - would acquire shares in one or more of the for-profit subsidiaries or in a subsidiary for-profit holding company. Through a new technique, employees of both the for-profit subsidiaries and nonprofit affiliates would participate in the C3SOP and purchase a minority interest in the nonprofit’s for-profit holding company. The proceeds of the sale would provide the nonprofit subsidiary with funds to finance future growth.
How do C3SOPs work as a source of capital useful to nonprofit sponsors?
A nonprofit sponsor establishing a C3SOP creates a trust (“ESOP Trust”) to which it and its subsidiaries and affiliates make annual pension contributions on behalf of plan participants. The nonprofit sponsor also incorporates a for-profit subsidiary (“Holding Company”), which will in most instances be a holding company that elects to be taxed as an S corporation. (The ESOP Trust is exempt from federal income taxes on distributions from an S corporation). The ESOP Trust invests the employer(s) pension contribution(s) in common stock issued by Holding Company. The Holding Company deploys the cash received to advance its business purpose(s). These purposes might include, for illustration purposes, the acquisition and leasing of real estate to the nonprofit sponsor – or for any lawful business purpose. (In such cases, the real estate acquired by the Holding Company may have been purchased from the nonprofit plan sponsor as part of a sale-leaseback transaction).
Describe the workings of the C3SOPs as a retirement plan?
The employer’s contributions to the ESOP Trust are allocated to individual employee accounts within the ESOP Trust. While a number of different formulas may serve as the basis of the allocation of contributions, the most common allocation methodology allocates employee contributions in proportion to relative compensation. Typically, employees join the plan and begin receiving allocations after completing one year of service with the nonprofit. Shares of the for-profit holding company stock allocated to employees’ accounts must vest before the employees are entitled to receive them. Vesting is a process whereby employees become entitled to an increasing percentage of their accounts over time. Currently, the most generous vesting schedule is immediate vesting, and the least liberal vesting schedule is 20% vesting after three years, increasing by 20% per year until employees are fully vested after seven years. Five year cliff vesting is also an option.
When a C3SOP employee who has at least ten years of participation reaches age 55, the employee must be provided the option of diversifying the investment to the extent of 25% of the employee’s C3SOP account. This option continues until age 60, at which time the employee has a one-time option to diversify up to 50% of their account.
Employees receive the vested portion of their accounts at either the termination of the plan, disability, death, or retirement. These distributions may be made in a lump sum or in installments over a period of years. If employees become disabled or die, they or their beneficiaries receive the vested portion of their C3SOP accounts immediately. In a privately-held firm (which includes all nonprofit organizations) the nonprofit must give the employees a put option on the stock for 60 days after the distribution. If the employee chooses not to sell at that time, the nonprofit must offer another put option for a second 60 day period starting one year after the distribution date. After this period the company has no further obligation to repurchase the shares.
Investing beside the nonprofit sponsor, a C3SOP can provide a market for up 49% of the equity of a retiring owner, or any interested large shareholder of a closely held company. Major shareholders of closely held companies incur no taxable gain on the sale of stock to a C3SOP, provided that the plan owns 30% of the company immediately after the sale, and the sale’s proceeds are reinvested in qualified securities within a 15 month period. This tax free rollover is the most tax favored way for owners of a closely held company to sell their stock, and thus encourages the owners of closely held companies to sell their stock to ESOPs.
Some nonprofits will establish C3SOPs in the hope that making employees owners will increase their dedication to the firm, improve their work effort, reduce turnover, and generally bring a more harmonious atmosphere to the organization. Research shows that giving workers a significant stake in their company can improve staff attitudes toward their company and that these improved attitudes can translate into bottom line improvements.
Our nonprofit currently provides a retirement benefit to its staff. Would the C3SOP require a substantial additional investment in benefits?
The C3SOP is funded exclusively with employer contributions, and so we suggest you continue the existing program if it allows for employee contributions with a discretionary employer match; however, all employer retirement plan contributions should be made to the ESOP Trust.
How much stock would be sold to the C3SOP?
The nonprofit sponsor must own more than 50% of the stock in Holding Company in order for the staff of the nonprofit and its subsidiaries and affiliates to be eligible to participate in the C3SOP.
Describe the “employer securities” that would be purchased by the C3SOP.
The Holding Company securities acquired by the ESOP Trust would be those securities that have a combination of voting power and dividend right equal to or in excess of (1) the class of stock having the greatest voting power, and (2) the class of stock having the greatest dividend rights. In a private company such as Holding Company, the voting of stock allocated to participants accounts must only pass through voting for mergers, consolidations, sales of all or substantially all the corporation’s assets, recapitalization, reclassifications, liquidations, dissolutions, or other similar transactions.
C3SOP participants must have the right to require the employer to repurchase the employer securities under a fair valuation formula. For employer securities that are not readily tradable on an established securities market, all valuations must be done by an independent appraiser.
What are the responsibilities of ESOP trustees?
ERISA requires ESOP fiduciaries to discharge their duties with respect to the plan “for the exclusive purpose of providing benefits to participants and beneficiaries”. Issues regarding the exclusive purpose requirement and ESOPs primarily arise in two situations: The voting of employer securities and the tendering of employer securities.
ESOP fiduciaries must also manage ESOP Trust assets in a prudent manner. Because a fiduciary is often I a position of a conflict of interest, courts have generally required fiduciaries to prove that the fiduciary has employed the proper procedures in arriving at a decision. As interpreted by courts, ERISA’s prudence requirement obligates ESOP fiduciaries to undertake intensive and scrupulous investigations of alternative courses of action. A failure to implement proper investigative procedures may result in liability for breach of fiduciary duty even though the ESOP Trust suffered no apparent economic loss.
What are the disadvantages of establishing a C3SOP?
There are potentially several, as follows:
- Some employees may be apprehensive about the investing of a portion of their retirement assets in company stock.
- C3SOPs entail administrative costs for valuation and trustee services and impose added demands on human resources personnel.
- ESOPs impose a repurchase liability on companies whose securities are not traded in the public market.
- Your nonprofit’s trustees may have concerns about a loss of control in an organization whose employees are minority owners of a nonprofit’s subsidiary.
C3SOP® is a registered trademark of Angler West Consultants, Inc.
