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INNOVATIVE FINANCIAL MODELS

TO SPUR WORKER TO OWNER CONVERSIONS Evaluation of three financial models for the purpose of expediting the conversion of private companies to employee ownership.

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Sections 1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

3 Characteristics of ‘Insiders’ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 3.1 Transitioning from Workers to Owners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 4 Scope of the Study. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 4.1 Transaction Tools. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 4.2 Methodology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 5 5.1 5.2 5.3

Stock Purchase Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Advantages of a Stock Purchase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Disadvantages of Stock Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Recommendation for Tools for Successful Implementation of Stock Purchase Model. . . . . . . . . . . . . . . . . . . . . . . . . . . 18

6 “Bargain sale” Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 6.1 The ‘Bargain Sale’–Why it Could Work for Employee Buyouts. . . . . . 20 6.2 Difficulties Uncovered with ‘Bargain Sale’. . . . . . . . . . . . . . . . . . . . . . . . . . . 23 7 7.1 7.2 7.3

The Alternative: Charitable Remainder Trust. . . . . . . . . . . . . . 26 Potential Uses of a CRT for Employee Buyouts. . . . . . . . . . . . . . . . . . . . . . 30 Benefits of Using CRTs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 CRT Strategy Implementation Recommendations. . . . . . . . . . . . . . . . . . 33

Appendix A: Articles and Readings . . . . . . . . . . . . . . . . . . . . . . . 34 Appendix B: Employee Conversion Case Studies. . . . . . . . . . . 36 Appendix E: Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40

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Introduction The purpose of this study is to create replicable and scalable financial models for conversion of private companies to employee ownership. The work was generously funded by Sustainable Economies Law Center (the Law Center) via a grant from the W.K. Kellogg Foundation. This report is prepared by Concerned Capital, Inc. a California social benefit corporation based in Los Angeles, California, with support from Democracy at Work Institute. The following report evaluates three traditional ownership transaction tools used to transition ownership of privately held businesses (organized as a C corporation) to broader worker ownership, whether that ownership be a cooperative, collective, ESOP or a simple partnership. Our work was not restricted to any specific form of ownership or governance model but principally sought out incentives that favored employee owned cooperatives, such as deferral of taxes on capital gains from the sale of the company to an employee stock ownership plan (ESOP) or cooperative.1

1 Britton, E. D., & Stewart, M. C. (2009, May 5). Retrieved from http://www.oeockent.org/download/succession_planning/coop1042rollover.pdf.pdf

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Background At the end of 2018, Concerned Capital was commissioned by the Law Center to test and evaluate three financial models for the purposes of supporting transition of ownership of ongoing businesses to the workers. Concerned Capital was selected for the task because its principals have been working on worker ownership in Southern California for more than 25 years and the company has a track record of successfully transitioning ownership of businesses to workers. Concerned Capital was founded in 2003 as a for-profit economic development firm with a goal to promote community stabilization and resilience by encouraging local entrepreneurship and the local ownership of place based small businesses. Its Transition of Ownership (TOO) program was designed to address the oftenignored economic development issue of job loss resulting from merger and acquisition activity or transfer of ownership. Since 2013 more than 200 jobs have been saved via the award-winning program. We work with businesses and local governments in large and small communities across the nation as investment bankers finding loans for the acquisition of small businesses by their employees, relatives, and/or other community stakeholders–what we call ‘insiders’–who are committed to keeping a company local when they purchase it. We focus on employee ownership because it furthers our social impact mission to keep jobs local, create wealth for workers and promote minority business ownership.

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Our role in employee buy-outs is on the transactional aspect of transitioning a deal. Armed with our expertise in banking, finance, securing government sponsored debt and/or deal structure, we help negotiate and navigate accounting and legal rules to get the best outcome for our purpose – saving jobs and keeping a ‘going concern’ in business. While we work with accounting and legal tools, we are neither accountants nor lawyers. Their perspective and transactional structures have traditionally looked to advantage sellers and financial buyers who are able to afford their services. Our approach offers a more affordable alternative and has proven to be successful in a competitive, marketplace economy.

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Characteristics of ‘Insiders’ Our clients are often, in effect, buying their own jobs in order to prevent company liquidation, sale of the firm outside of the community, or a strategic acquisition by larger competitors whose cost cutting efforts lead to job losses.

These insiders’ jobs are at risk not because the business is no longer competitive, but because of the owner’s retirement or other life event that is forcing the sale of the company. They have a different profile from traditional speculative buyers, competitors, or those who see companies as commodities. Insiders have a number of advantages when it comes to purchasing the business. First, their perspective on the business’ value and operations is based on their motivation to grow profits for the group and is not hemmed in by the potentially competing considerations a sole proprietor has–for example, the need to restart a depreciation schedule to shelter personal income from taxes.2 They also have the advantage of working knowledge of the company coming from years of employment by that company. Their relationship with the company makes them connected to it and their coworkers, which may be a strong influencer on their decision to invest in it. Finally, unlike an outside buyer, ‘insiders’ are focused on this particular company (unlike speculative buyers who may be considering alternative business purchases) and loss of their targeted acquisition means having to start-up a new company or find a new job–and either option is often not tenable.

2 Stranahan, S. (2019, June 26). Retrieved from https://medium.com/fifty-by-fifty/two-publishers-illustrate-why-ownership-matters-fifty-by-fifty-ee412720afc

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3.1

Transitioning from Workers to Owners

Based on our experience, we believe existing private sector tools for acquisitions could be employed to give ‘insiders’ an edge in a competitive marketplace. This study focused on transactional aspects of converting an existing company to employee ownership. We evaluated strategies that relied on traditional tools of ‘merger and acquisition’ specialists, such as tax savings tools and deal structures, to effectively ‘level the playing field’ and compete more effectively against financial buyers. The strategies use financial modeling and engineering to expedite company sales from owners to employees, increase the odds of success for the resulting transactions, and provide financial incentives and sound business reasons for more sellers to work with ‘insiders’, and increase the number of employee owners nationwide.

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Scope of the Study We do not believe that one ‘silver bullet’ exists which would magically overcome the myriad of difficulties facing ‘insider’ groups when they seek to purchase the companies they work for. Every company has its own challenges, corporate culture, and specific DNA. Employee ownership has been tried in virtually every industry, service or income generating structure that uses employees. Accordingly, we did not limit this study to any one industry. We did restrict our scope of work with smaller companies (under 300 employees that are eligible for SBA financing) and to those whose current controlling ownership interest is restricted to a limited number of parties and companies that are not publicly owned.

4.1

Transaction Tools

The sale of sustainable small businesses is a highly competitive marketplace. In many urban areas stable, profitable companies that can run without an active owner are extremely hard to find because investors are all looking for those companies as an alternative to an overpriced stock market. Employee groups need to identify these opportunities early and quickly to secure their spot at the table.

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In urban areas, for every viable, profitable company there are dozens of financial buyers who buy to ‘flip’ and exploit a company or strip the firm of assets and liquidate.3 In order to compete with financial buyers, employee groups need to find a competitive edge in the business sale marketplace. Our work focuses on three financing strategies for the ‘transfer of ownership’ that hopefully provide that competitive edge.

We examined three traditional transaction tools to accomplish this and viewed these tools through the prism of gaining a competitive edge. Specifically, we examined:

1. Using a stock sale model, vs. selling assets only, as a tool to transfer business ownership 2. Involving a non-profit sponsor in a ‘bargain sale’ to buy a company at a below market price 3. Potential use of a Charitable Remainder Trust as a means of lowering a company sales price

3 Premack, D. (2019, October 9). Retrieved from https://www.axios.com/private-equity-employment-job-losses-40bbf941-0815-4046-b777-e95a29e925d8.html? utm_source=linkedin&utm_medium=lisocialshare&utm_campaign=organic

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4.2

Methodology This report drew on following sources for its content:

Case studies found in Appendix A – Ariza Cheese, Woodworking by Degree, and Ward Lumber. All three were stock transfers to employee groups and all three currently operate under their original DBA attached to their corporation. We interviewed owners and sellers and extracted advantages and disadvantages of using this mechanism to acquire the company. We also did an exhaustive study of information and legal archives regarding the strengths and weaknesses of this approach. Our research regarding the use of donations to nonprofits was greatly facilitated by the Law Center’s compendious work, “Think Outside the Boss–How to Create a Worker-Owned Business”.4 The legal information contained in the Law Center’ study was used as a springboard to provide a foundation for possible deal structures and ideas that would help generate new transactions for workers seeking to purchase their company. Appendix B lists numerous sources of information from Exit Planners, CPAs and lawyers providing much of the information about the tax consequences for donors. Appendix C lists the 15 conferences, workshops and webinars that Tomás Durán, Concerned Capital President, attended/made presentations at, that focused on employee ownership. Contacts and referrals from these events helped inform the finding of this study. Concerned Capital’s work is often done under the umbrella of a Non-Disclosure Agreements (NDA). As such, unless we have explicit permission from the clients to talk about our work with their business, we took care not disclose the specifics of company identities or describe the client in a manner that would to step outside of our NDA. 4 Think Outside the Boss, How to Create a Worker Owned Business, Sustainable Economies Law Center, Chapter 4Nonprofit Organizations Incubating Cooperatives

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Stock Purchase Model Purchasing a company’s stock is one strategy for employee buy-outs that seek to maintain business continuity. This mechanism calls for employees to purchase an existing C Corporation’s privately held stock. Currently in outsider buyer transactions, the ‘Asset only’ purchase method is a more typical means of purchasing a small business. In an ‘asset only’ purchase each named asset that constitutes an operating company is acquired as part of a purchase agreement and the corporate shell is retained by the seller. By contrast, a stock purchase converts an owner’s equity interest (or net proceeds to capital gains) from the sale of business assets to capital gains, which is taxed at a much lower rate than proceeds from the sale of assets only. Sale of assets only results in ordinary income tax for the seller. Naturally, sellers favor a stock sale because it lowers their tax liability. Financial buyers commonly want to buy assets only so that they can ‘step-up’ the tax basis of company assets to fair market value and thus capture more depreciation. Employee buyers generally don’t need depreciation to shelter their personal income. This gives employees an advantage in bidding for a company by offering to buy the company whole via a stock sale–‘lock, stock and barrel’as a corporate entity and thereby allowing owners to convert sale proceeds to capital gains.

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A clear example of the tax consequences of a Stock Sale vs. Asset Sale can be seen in the example below.

C Corporation: Stock Sale vs Asset Sale Example: Sale of Corporation ASSET SALE

STOCK SALE

DIFF

FMV of company

1,000,000

Entity Level Tax

(315,000)

Individual Level Tax

(91,500)

(138.750)

47,250

After Tax Proceeds

593,500

861,750

267,760

ASSUMPTIONS:

OBSERVATIONS:

- FMV of assets = $1,000,000 - Inside basis of assets = $1,000,000 - Sole shareholder’s outside basis in stock of = $75,000 – In the asset sale, the assets are sold, then the company liquidates and provides cash to shareholder.

- In asset sale, the seller recognizes double tax, decreasing net proceeds on sale. - In reality, the sales price of the company in stock sale would likely be adjusted for lack of step-up to buyer.

Source: Plate Moran (2019)5

5 C Corporation: Stock Sale vs Asset Sale, webinars.plantemoran.com

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In the above example the ‘inside basis’ belongs to the corporation which pays taxes twice; once at the entity level for a sale of its assets AND again at the individual shareholder (seller) level. Conversely, the sale of stock generates no corporate tax paid at the entity level, only capital gains taxes for the shareholder. Assuming the company’s stock is sold for its Fair Market Value (FMV), the result is the seller gets to keep $ 861,750 from a $ 1,000,000 sales price. When assets only are sold the seller get to take home only about 60% of the sale price. (Note-An asset sale can also result in capital gains treatment for a portion of the sales price in some cases for a privately held LLC or sole proprietorship if a qualified asset is sold).

5.1

Advantages of a Stock Purchase

The seller’s tax advantage is only one of many reasons why buying a company ‘lock, stock and barrel’ via a stock purchase makes sense for an employee group. There are more significant reasons learned from practitioners such as Cooperative Development Institute in the Northeast in their recent conversion to employee ownership of Ward Lumber. The other advantages of a stock purchase are primarily related to continuity in the business’s operations and access to credit. These include: Uninterrupted Trade Credit. Stock buyers can normally obtain the selling company’s non-assignable contracts, permits, and licenses without the consent of the party to these contracts. Trade credit is crucial to the continuation of most companies. This often is the single largest source of renewable credit for most small companies. Capital gains shelter for seller. A stock sale to employees through 13

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a qualified Worker-Owned Cooperative or an Employee Owned Stock Plan (ESOP) allows owners to shelter capital gains with the IRC § 1042 rollover provisions. Since 1984, federal tax law has permitted Owners who sell 30% or more of the stock in their closely held company to their employees through an eligible worker owned cooperative to defer capital gains tax. To qualify for this shelter of capital gains, the company being sold must be a C Corporation. Seamless billing. Accounts receivable can also be transferred to the stock purchaser without notification to customers. This helps give new buyers a cash flow cushion as they seek to establish lines of credit with banks for working capital. State sales tax reduction. State sales taxes for the transfer of asset can be avoided on all or some of the assets being transferred in a stock sale–these costs are generally shared. Corporate assets retain same identity after transfer. ‘Asset only’ transactions require that corporate assets be re-titled in the buyer’s name if the buyer plans to get financing in the future. Working capital and equipment loans require that vesting be the same for corporate assets or that an ‘identify of interest’ between the company owner and borrower can be documented. This is especially true of U.S. Small Business Administration financing that normally requires a blanket Uniform Commercial Code (UCC) filing against borrower’s assets. No public notification requirement. A stock purchase is a private contract that does not require any public notification. Assetonly sales do. Most states, including California, require that a ‘bulk transfer of assets’ be publicly announced in a local journal of record. This often means a notification period of 60 days must occur prior to 14

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sale in the case of an ‘asset only’ sale. This can cause delays and add to closing costs. Nothing prevents a ‘bulk transfer of assets’ public notice from being used with a stock purchase IF the buyers suspect there are undisclosed owners or unsecured creditors with claims but it is not required. Assumption of Credit Facilities. Banking relationships may be continued uninterrupted if the bank of account approves of an assumption of a credit facility. Most bank notes are due and payable if 20% or more of a company’s ownership transfers unless the Bank agrees to a loan assumption.

5.2

Disadvantages of Stock Purchase

There are some distinct disadvantages to purchasing the stock of a C corporation. Many of these disadvantages are mitigated by the fact that ‘insider’ purchasers often have a long history with the firm and already know about its defects and operating challenges. The disadvantages of a stock purchase and the risk(s) created are as follows: Contingent risk. Buyers accept more risk by purchasing a company’s stock, including all contingent risk that may be unknown or undisclosed. Future lawsuits, environmental concerns, other claims from undisclosed partial owners are all risks if not handled properly before closing. To address these issues, a purchase agreement needs to be negotiated by a lawyer that shifts responsibilities back to the seller. Warranties and representations must have clear consequences when violated. When the purchase involves an ‘owner carry-back’ note, the outstanding balance of the note needs to be placed ‘at risk’ if an undisclosed liability attaches 15

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to the buyers. Because employee deals are more likely to have an owner-carry note, this risk can be mitigated if the note is crafted correctly. Buyer could inadvertently take on the debts and liabilities of the seller. In a stock sale, the buyer takes on the debts and liabilities of the seller. Employee may not know about all the liabilities when beginning the process of seeking to buy, and these debts may have been incurred for items or events outside the business. Due diligence is required to uncover them, and some negotiation or pre-emptive action may be required to strip them out of the deal. No stepped-up cost basis. Assets will not have a “stepped-up cost basis” in a stock sale. This means they retain their book value as listed on the balance sheet and will not be given a new valuation as of the date of acquisition. The result is a lower depreciation schedule for assets purchased in a stock transaction. It also means less depreciation expenses to shelter the buyer from taxes. Financial buyers rarely do stock purchases for this reason. Employee groups are less concerned about sheltering personal income when they first take over a company because generally employees are not in a tax bracket where this is an important consideration. Delays due to transfer of unrelated assets. The corporate shell may contain unrelated assets that don’t contribute to running the company or are not essential to transferring ownership but add to the purchase price. A common example might be the real estate that the company occupies. In the case of older companies, where the owner seeks to retire, it is often the case that the business owner wants to sell the business but retain ownership of the land or building. Before the stock can be transferred to a new owner, these non-essential assets are transferred or sold, and this may cause 16

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a delay. It also represents an opportunity for the buying group to negotiate a ‘right of first refusal’ for the eventual sale of a real asset as was the case in Ariza Cheese. Costs to comply with securities law. Securities law violations may be triggered if a debt instrument is created . Employee groups who transfer stock ownership to a newly formed cooperative may be able to protect themselves from potential violations by having the stock owned in the co-op’s name and not personally. Lack of personal guarantees and co-op restrictions against sale of voting stock to outsiders provide some protection against unauthorized stock transfers or sales that frequently trigger these sorts of violations. One of the most interesting aspects of stock purchase sale vs. ‘assets only’ approach is that Lawyers, Accountants, and Business Brokers generally abhor stock transfers. They routinely counsel buyers not to attempt to purchase a company’s stock. This is done largely out of fear of lawsuits resulting from undisclosed liabilities that may be transferred in a corporate shell. Their concern often centers on their own professional liability for non-disclosure or malpractice. It has been our experience that professionals involved in the sale of an operating business will base their advice to clients on their own convenience and the perceived risk to themselves.

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5.3

Recommendation for Tools for Successful Implementation of Stock Purchase Model

In order to increase the utilization of a safe and sound stock purchase strategy we recommend the following tools be developed: Business Purchase Roadmap. Develop a purchase contract checklist that incorporates many of our findings and can serve as a roadmap for the unique due diligence required for a successful stock purchase to occur. In some cases that involves reconstructing corporate minutes and records, search for legal filings across the United State and a very thorough search of public records, and identifying minority stockholders even if they own as little as 1% of the outstanding stock Training on Tax Law. Provide Tax Law training and workbook for Worker to Owner specialists and other technical assistance providers geared to demonstrating why a stock sale can help company owners better transition their companies. Advisors like to say “It’s not what you sell a company for that matters. It’s what you get to keep after taxes.” A capital gains tax rate vs. that for ordinary income can make all the difference and can allow an employee group to acquire a company at a lower sales price than financial buyer can. Marketing Materials to Promote Stock Purchase. Craft an informational piece that illustrates the pros and cons of a stock purchase and can be applied to each specific purchase situation with a simple questionnaire that helps screen a potential conversion for feasibility. The key is to understand which assets and liabilities go with the purchase. Some liabilities may need to be addressed prior to a transfer, such as loans payable to officers. Vetting a transaction from this perspective will help employee buyers better understand what they’re buying. An ‘asset only’ transaction may make sense if a 18

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substantial portion of targeted company will not be useful to the new buyers–it may also lower the business purchase price. Another example is the treatment of accounts receivable–if they will be assigned to the new buyers, this effects sales price. Contact your local Worker to Owner Conversion Specialist. Workers to Owners is a national collaborative of organizations working to transition small businesses to worker- and employeeownership. For a list of local Worker to Owner Conversion specialists, refer to http://becomingemployeeowned.org/workers-to-owners/

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“Bargain sale” Model

The “bargain sale” model is often discussed in the conversion community as friendly path to ownership for workers. When we started this study, we thought we would find numerous examples of it being employed. After a nationwide search we were not able to identity one that could be used as a case study like the examples in the previous section. Therefore, the following section describes the how the model could potentially be used to facilitate the transfer of ownership to workers as well as the challenges with implementation and suggestions for overcoming them.

6.1

The ‘Bargain Sale’–Why it Could Work for Employee Buyouts

A ‘bargain sale’ is defined as a “purchase of property (securities, real estate, or other assets) for less than its fair market value, by a nonprofit entity (501c3). In such case, the difference between the fair market value and the sales price to the non-profit constitutes a charitable gift. Thus, the donor/seller can recoup some cash, perhaps equal to their investment in the property, and use the balance as a charitable gift.” 6 Non-profit organizations commonly use the ‘bargain sale’ approach when they acquire property at a discounted price–a common example is selling/

6 Normandin, J. (2001, August 7). User Bargain Sale - “Overlooked and Under-Used Gift-Planning Arrangement” Retrieved October 9, 2019, from https://calfund.pgdc.com/pgdc/bargain-sale-overlooked-and-under-used-gift-planning-arrangement

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donating your old car to your public radio station. In this section we will examine how this traditional tool can also be used by non-profits to purchase a company. The ‘bargain sale’ tool is interesting as a transfer of ownership model because it could produce a win-win scenario for the non-profit and the employees. For example, if a non-profit organization purchased a company at a discount it could later ‘resell’ it to employees on favorable terms, facilitating an acquisition that might not otherwise occur while realizing income from the eventual re-sale of the asset at market value. It would also allow time for an employee group to solidify its ownership culture and ready itself for the take-over. The business acquisition market is full of speculators and bigger companies who routinely buy older, small businesses; dissolve the assets and jobs and/or relocate the companies. In a highly competitive marketplace employee groups seldom have enough time or financial wherewithal to compete with financial buyers. We believed that larger, well-funded non-profits could act more quickly to acquire a company and have more financial resources than a young employee group. Our research for this paper proved that this was not necessarily the case. The bargain sale may address another dimension of business transfer: employee capacity. The missing element needed for greater employee ownership is having enough qualified employee buyers ready to assume ownership. Many of the best candidates for buyouts are already run by employees with aging owners increasingly absent from the workplace, winding down the company and getting ready to retire. To take over ownership, employees need preparation in financial literacy, marketing, sales, management, delegation and group decision making. 21

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Entrepreneurial training and guidance for employees is required to make a transition of ownership practical and successful and it is NOT currently available on the broad economic development landscape in California. SBA sponsored Small Business Development Centers, CDFIs, and other non-profit lenders offer training geared to owners only. An employee must decide to leave a company and start his/her own company to qualify for this assistance. A nonprofit organization can receive public and/or private sector grant funding to provide entrepreneurial training that builds employee capacity to become owners, while the nonprofit owns business. This training can prepare employees with all the skills and information they need to make effective decisions as business owners and begin to build a culture of ownership. A mechanism is needed to create a ‘culture of ownership’ among employees if an existing company is to be successfully transitioned from a private owner(s) into the hands of many employees. A ‘bargain sale’ could serve as the first step in a process that will create time and space– and bring training and capacity-building–for employees to prepare to take over the company when they purchase it in the second step. We considered Social Enterprises owned by non-profit parent companies as one vehicle to incubate existing companies for employee ownership conversions. But very few nonprofits get funded to serve as a ‘holding company’ for a business in ownership transition and it wasn’t clear what source of grant funds could be used for nonprofit organizations to buy and operate companies. A social enterprise is defined by Social Enterprise Alliance as, “An Organizations that address a basic unmet need or solves a social or environmental problem through a market-driven approach.” A slightly broader definition is: Social enterprises broadly encompass 22

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ventures of nonprofits, civic-minded individuals, and for-profit businesses that can yield both financial and social returns. Nonprofits have the distinct advantage of taking charitable contributions and offering donors tax breaks in various forms. Even if there is no apparent source of grant funding for purchasing companies, there is nothing that prevents nonprofits from operating holding companies, especially with the purpose of transitioning them to employee ownership after capacity is built. As we see below, the real barrier is risk and perception of risk. At the start of this study, we had hoped to find non-profits that were already in the business of using the ‘bargain sale’ model. It seemed to be consensus among the professionals in the worker ownership community that this ‘two-step process’ is a promising tool to transition private companies to worker ownership, however we could not find any single example of where this had occurred.

6.2

Difficulties Uncovered with ‘Bargain Sale’

After an exhaustive search, we could not identify an economic development entity that had acquired a company for the purpose of reselling it to employees nor an example of a conversion of an existing, privately held company facilitated through non-profit ownership. We knew from experience of non-profit organizations incubating a start-up business that will eventually be owned by employees. For example, in Amarillo, Texas two local non-profits, Saint Anthony’s Legacy and Redevelopment Corporation and the North Heights Advisory Association, came together to sponsor the development of a new business that will become a co-op after the first few years of 23

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operation. There are other examples of non-profits incubating startups but not using a ‘bargain sale’ technique. We also polled several well-established economic development providers (California Community Economic Development Association, Valley Economic Development Corporation, Koreatown Youth and Community Center, Community Health Councils, Vermont-Slauson EDC, and the Jewish Community Foundation), with regard to the use of their non-profits as part of a bargain sale. The nonprofits all thought that the purchase, ownership and sale, of a business poses too much unacceptable risk to their organizations. They did NOT like the holding time needed to incubate the company for eventual resale or the resulting liability. They also expressed concern that an employee group might be unable to purchase the company after the holding period. Last, and likely most importantly, they did not like the idea because it had too many unknowns associated with it–such as placing the nonprofit’s tax-exempt status at risk.

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We eventually reached the conclusion that a ‘bargain sale’ of a company to a non-profit for the benefit of a future cooperative or other employee ownership group was not viable for many existing non-profits. The reasons it is not used have less to do with whether it is feasible from tax, legal or accounting perspective and more to do with practical considerations such as the following: 1. Small business stock is not generally publicly traded and as a result establishing fair market value is more costly and time consuming than establishing value for real estate. Nonprofit organizations are required to use outside experts to establish the fair market value of assets being used for a bargain sale. 2. Takeover of an operating business, even for a one-year incubation period, has unforeseen risks associated with it –not the least of which whether an employee buyer group will be qualified to purchase the company in a reasonable time frame. This would leave the nonprofit owning the business for the foreseeable future, and/or trying to sell it. This may drain their already-tight capacity. 3. Most non-profits simply don’t have the surplus cash to ‘buy’ a business in the hopes that they will able to recoup their investment after a period of time. 4. The perceived risk to their non-profit status. Nonetheless, if a nonprofit organization were able to address and mitigate these risks and had the appetite, capacity and cash to undertake a ‘bargain sale’ transaction, it would have a substantial advantage in the marketplace of small business buyers.

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The Alternative: Charitable Remainder Trust

We learned of another method for non-profit organizations to facilitate the transition of ownership of a business to employees, the Charitable Remainder Trust (CRT) used by the Jewish Community Foundation (JCF). The JCF is a Los Angeles-based non-profit that specializes in charitable giving for individuals who own closely held businesses. It refers small business owners with potential estate and/or capital gains tax liability to resources that show owners how charitable giving can reduce or eliminate taxes. JCF also allows a small business owner to establish a ‘donor advised fund’ that he/she advises as to where charitable proceeds can go once the donor’s business is sold. For many years, wealthy individuals have been legally avoiding the tax on the sale of appreciated assets by creating CRTs. CRTs are recognized and accepted by the Internal Revenue Service. By using a CRT, the sale of the appreciated asset is exempt from all taxes. Business brokers, insurance salesman and ‘exit’ service providers commonly utilize CRTs as estate planning tools that overcome sales resistance from business owners.

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The way a CRT works is that all or a portion of the company stock is donated to a Trust (as described in Internal Revenue Code section 664) that is managed by a foundation or a non-profit organization. The foundation serves as trustee of the trust. The Trust sells the company’s stock and uses the proceeds to provide the donor with income for his/her lifetime. After the donor dies, the Trust terminates and transfers its assets (or the remainder) to a charitable organization the donor had selected. Income payments would be based on a fixed percentage of the trust’s annual value. When all or part of the stock in a closely held business is transferred to a CRT, the CRT takes over the donor’s holding period and cost basis for tax purposes. When the Trust sells the property, it realizes the same amount of capital gain as would have the donor; however, it pays no taxes because the Trust’s income is tax-exempt. This feature is of tremendous value when highly appreciated property, such as Stock in a long established, closely held C Corporation, is sold by a CRT because the entire amount of the net proceeds can be reinvested to produce income.

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Table 1 illustrates the difference between selling an appreciated asset via a CRT and selling it subject to capital gains tax. The example assumes the real estate was purchased for $100,000 and sold for $1,000,000. The table illustrates the how a seller will have higher proceeds from the sale when a CRT is involved in the sale.

Table 1: Net Sale Proceeds Difference WITH A CHARITABLE REMAINDER TRUST

WITHOUT A CHARITABLE REMAINDER TRUST

Asset Sale Price

$1,000,000

Asset Purchase Price

$100,000

Capital Gain

$900,000

Capital Gains Tax Rate*

25%

Capital Gains Tax

$225,000

Net Proceeds From Sale

$1,000,000

$775,000

* All illustrations in this article ignore income tax on recapture of depreciation. The inclusion of such tax in the illustrations would obviously significantly increase the advantage of the sale via CRT over a private sale of appreciated assets. Additionally, all illustrations in this article assume a combined 25% federal and state capital gains tax rate.

INNOVATIV E FIN A N CI A L M O DE LS

Retiring business owners are particularly partial to CRT’s because it gives them a higher after-tax value for their company, and it allows them to escape estate tax. The CRT does not pay taxes on investments it makes to generate income for the donor. Funds in a CRT compound tax-free and taxes are only paid on distributions.7 Interesting characteristics of the CRT include: CRTs require a C Corporation donor and many older companies are C Corps. (Unlike S Corps–a common IRS elective that can be reversed–C Corps can be partners with Cooperatives, or other entities that are not individuals, S Corp partners must be individuals.) Business owners seeking to use a CRT must first transfer ownership of their company to an irrevocable trust. The trust then sells the asset and re-invests proceeds in income producing assets. The amount of the donation is governed by the Fair Market Value of the corporate stock at donation time. This triggers a valuation by an outside expert. This is required by the IRS. The CRT is administered by either the donor or an appointed Trustee and can provide lifetime income for the donor or his/her heirs. Upon the death of the trust’s beneficiary, the ‘remainder ‘of the proceeds go to a Foundation or other charitable concern. Because the trust pays no taxes, all the proceeds from the sale of the business go directly into CRT and no capital gains taxes are paid.

7 Rubinstein, Kenneth. Bypassing the Capital Gains Tax with Charitable Remainder Trusts. https://www.gdblaw.com/bypassing-the-capital-gains-tax-with-charitable-remainder-trusts

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7.1

Potential Uses of a CRT for Employee Buyouts

Knowledge of how CRTs are used for estate planning and how they promote charitable giving in general are useful to employee groups that work with ‘mission aligned’ non-profits who are exempt from taxes. Some examples of how this could theoretically work are below: Bypassing the Capital Gains Tax with CRT SCENARIO 1:

The CRT could arrange an installment sale for its portion of company ownership over time. It would depend on the donor’s need from income from the Trust. By terming out a portion of the sales price through a CRT, an employee group could, in effect, reduce or eliminate the need for financing. This also eliminates any estate tax the owner might normally need to pay since the donated asset is removed from his/her estate at time of the donation. SCENARIO 2:

A common means of reducing capital gains tax is the use of a CRT. Foundations and other 501 (c)(3) charitable organizations routinely assist with estate planning services to help potential donors understand how to reduce tax liability through donations. They focus on sellers of highly appreciated assets to show them how to use a donation to save taxes. A CRT that also incorporates insiders may expedite this donation by providing a readily available buyer. In this scenario, a nonprofit or foundation working with a donor to set up a CRT could connect to a nonprofit that helps employees buy businesses to structure the deal using a CRT.

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SCENARIO 3:

The Sustainable Economies Law Center (the Law Center) team suggests that the real promise of this model is for nonprofits to train and organize employees to be ready to buy the business, then help sellers understand the benefits of and establishing a CRT. The non-profit intermediary can help negotiate the sale between the employees and the trustee, while also receiving a future donation in the form of the remaining assets after the grantor dies (assuming that nonprofit is named as the beneficiary of the CRT). Non-profits that are established to expand economic activity and build wealth for community members can justify holding stock in a portion of a for profit company due to ‘mission alignment’. For example, helping ‘low-income’ workers build wealth in order to combat the national crisis of income inequality. The Law Center also points out that the seller gets an automatic tax deduction for the whole value of the business even though they are also guaranteed an income stream for years to come. The nonprofit also doesn’t need to have the capital up front to purchase the business (as is the case with the ‘bargain sale’ model). However, the downside is that the workers will need to secure financing sufficient to pay the fair market value for the business. Unless an installment sale can be worked out with the Trust that provides the business owner with the lifetime income needs, he/she seeks, employees may have to come up with a higher percentage of the total price than they would otherwise.

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7.2

Benefits of Using CRTs

CRT’s only work if the business owner intends to make a charitable donation at the end of his/her life. The general idea of deploying CRT’s as a strategy for converting a company from private ownership to employee ownership is that it offers several distinct advantages to employee groups. The first obvious one is that it opens a conversation on estate planning and long-term transition planning that gives potential employee purchasers a ‘win/win’ opportunity to bid for the company and engage the owner about the future. In the process it also protects against one of the most common causes of agingowner business closure: an unplanned ‘life event’, This could be incapacitation or death that results in the liquidation of the business because no other provisions were made. The next is that it offers a means for the seller to convert business ownership into more predictable retirement income by having a trust administer proceeds once the business is sold. By suggesting this idea, employees can create a ‘non-adversarial’ relationship whereby the issue is not the ‘best’ price for the company but rather the CRT’s legal requirement to sell the company for a ‘fair market value’. For tax reasons, a CRT is required to have a professional valuation done before accepting a donation. This makes the value more of an objective consideration rather than an adversarial negotiation between the seller and the buyer. When employees try to buy the company, the sales price of the company is frequently a difficult issue. Using a CRT can remove that difficulty.

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7.3

CRT Strategy Implementation Recommendations

To utilize Charitable Remainder Trusts in furtherance of worker-to-owner goals, the following activities should be undertaken by practitioners. 1. Undertake a survey of non-profits in the community that support economic development activity and see if they receive charitable donations for their work or if their staff have the capacity to learn how they work. 2. Widely disseminate tax planning information specifically geared to older owners who face large capital gains taxes upon the sale of their company–generally companies that are owned 10 years or longer. 3. Help worker/owner groups incorporate CRT plans into the early planning stages of preparing an offer to purchase a company. It may give their offer the edge necessary for acceptance over competing offers. 4. Identify local estate planning providers familiar with CRTs and engage with them for mutual referrals.

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Appendix A: Articles and Readings 1. Fifty by Fifty Goal: 50 Million Employee Owners? Or 50 Million Empowered Employee Owners? September 18, 2019. Keeling, Michael. https://www.fiftybyfifty.org/2019/09/fifty-by-fifty-goal-50-million-employeeownersor-50-million-empowered-employee-owners/ 2. Donor Advised Fund: Easy, Flexible and Effective. The Jewish Community Foundation of Los Angeles. https://www.jewishfoundationla.org/donor-advised-funds 3. Selling Stock to Employees Through a Qualified Worker-Owned Cooperative and Sheltering Capital Gain. The IRC 1042 Rollover. Britton, Eric D. and Stewart, Mark C. 4. Buying Assets vs Shares: Everything You Need to Know. Upcounsel. https://upcounsel.com/buying-assets-vs-shares 5. New Owner Liability Issues When Buying a Business. https://www.bdc.ca/en/articles-tools/start-buy-business/buy-business/pages/ ownerliability.aspx 6. Asset Purchase vs. Stock Purchase: Advantages and Disadvantages. FindLaw. https://www.findlaw.com/ 7. Understanding Charitable Remainder Trusts. WealthCounsel.com. www.estateplanning.com/Understanding-Charitable-Remainder-Trusts/ 8. Case Study: Selling a Closely-Held Corporation with a Charitable Remainder Unitrust. Planning Giving Design Center. https://www.pgdc.com/pgdc/case-study-selling-closely-held-corporationcharitable-remainder-unitrust 34

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9. Bypassing the Capital Gain Tax with Charitable Remainder Trusts. February 23, 2013. Rubenstein, Kenneth, Esq. https://gdblaw.com/bypassing-the-capital-gains-tax-with-charitable-remaindertrusts 10. Think Outside the Boss: How to Create a Worker-Owned Business. East Bay Community Law Center, Green-Collar Communities Clinic, Sustainable Economies Law Center. April 2016. https://www.co-oplaw.org/legal-tools/manuals/

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Appendix B: Employee Conversion Case Studies Ariza Cheese Ariza Cheese Company, Inc is a fifty-year-old artisan Mexican cheese company located in Paramount, CA. The first minority owned company to sell these distinctive cheese products in mainstream grocery stores throughout Southern California, it led the way for widespread market acceptance of Mexican cheese. Four long-term employees took over day-to-day operations of the company in 2009 after the owner’s death. Committed to the wellbeing of the company, key employees began a savings and investment program with the hope to eventually buy and revitalize the Company. Ariza Cheese Company was purchased ‘lock, stock and barrel’ on January 23rd, 2015 by 4 of its key employees using the services of Concerned Capital. The new owners formed a collective and wrote a business plan. The Ariza Family was also able to reduce their tax liability from the sale of their company by converting sales proceeds to capital gains. Concerned Capital assisted the employees with finding the working capital for the take-over. Woodworking By Degree Gary Pietruszka built a custom cabinet manufacturing and installation company with 60 employees in North Hollywood during the 70’s. His success enabled him to launch a real estate investment company that quickly took over his time and caused him to look for a purchaser of the woodworking company. Gary’s company grew steadily as North Hollywood became more popular for the expansion of movie studio offices and the company’s sales grew to $ 5 million. 36

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Gary wanted to retire from the company to pursue a career in real estate development and started to explore with his key employee, Eddie Bupon, how he could transition the company’s contracts and vendor trade credit. They decided on a stock sale that allowed Gary to sell 70% of the company to Eddie and retain a profit-sharing agreement. The full transition of the company occurred with 2 years of the purchase. With a favorable EDA Revolving Loan, Mr. Bupon was able to take over the company and retain all employees. Ward Lumber Ward Brothers Lumber is a 129-year-old, 4th generation, building materials retailer and wood products manufacturer located in Malone, NY. Two years ago, two brothers split the business into two separate corporations, with one retaining the wood products manufacturing part (Ward Brothers) and one retaining the building materials retail part (Ward Lumber). The Cooperative Development Institute helped Ward Lumber convert to a worker cooperative via a stock sale. The business was a C Corp and the transaction agreement called for the employees to incorporate a worker cooperative corporation under NY law and engage in a stock purchase from the C Corp. This allowed for the seller to take advantage of an IRS 1042 Rollover to defer capital gains taxation of the sale. The stock sale also allowed the co-op to assume the trade credit established over 3 generations by Ward Lumber. All employees were retained in the transition.

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Appendix C: Employee Ownership Webinars, Workshops and Conferences DATE

EVENT

TOPIC

10/11/2018

Opportunity Finance Network

Urban manufacturing and working within the economy and workforce development systems

10/17/2018

CITI CDFI MeetingFinancing the Preservation of Legacy Businesses

Innovative Models: Private Equity and Social Impact

10/31/2018

College of Business – Loyola Marymount University-Jason Francis D’Mello. Ph. D

Employee Entrepreneurship

11/26/2018

Funding Employee Ownership in Opportunity Zones

Aspen Institute Webinar

1/10/2019

Non-Profit Quarterly

Employee Ownership/Income Inequality

2/6/2019

Sorenson Summit

Community Ownership of Land

3/5/2019

LA City Worksource/ Business Source

Layoff Aversion Funds-TOO

3/21/2019

W20 National Convening

Field Training on Deal Structure Entity Consideration 38

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DATE

EVENT

TOPIC

4/16/2019

Aspen Institute

How Opportunity Zones Can Spark Entrepreneurship, Small Business Growth, and Business Ownership

5/295/31/2019

Ford Foundation

Investing in Good Jobs

6/11/2019

Opportunity Fund Webinar

TOO for Business Owners

6/25/2019

Succession Planning Training

Succession planning options/models

6/27/2019

Cooperative Development Institute Webinar

Layoff Aversion Funds to fund TOO

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Appendix E: Glossary Asset Only Sale – an asset sale is completed only when the assets (as opposed to the common shares) of a company are acquired by a buyer. Asset Purchase –an asset purchase involves the purchase of the selling company’s assets–including facilities, vehicles, equipment, and stock or inventory. Bulk Transfer of Assets –sale of all or most of the materials, supplies, merchandise, or other inventory of a business at one time that is not normally done in the ordinary course of the seller’s business. Irrevocable Trust –a trust that cannot be modified or terminated without the permission of the beneficiary. Stepped-up Basis – A step-up in basis is the readjustment of the value of an appreciated asset for tax purposes upon the purchase of the business. This means that the new buyer gets to start the depreciation schedule for the asset(s) at a higher basis and can shelter income with increased depreciation expense. Stock Purchase –a stock purchase involves the purchase of the selling company’s stock only. Trade Credit –a business to business agreement in which a customer can purchase goods on account (without paying cash up front), paying the supplier at a later date. Warrants and Representations –a term used to describe the assertions that a buyer and/or seller makes in a purchase and sale agreement. Both parties are relying on each other to provide a true account of all information and supporting documents to close the transaction. 40

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Innovative Financial Models to Spur Worker to Owner Conversions