Nonprofit Innovations (The C3SOP)

Nonprofit Innovations (The C3SOP)

Large and growing nonprofit human services organizations routinely confront two formidable challenges to the effective execution of their expansion strategy: limited access to capital and high employee turnover. A recent innovation, the C3SOP, offers a means of addressing both issues.

C3SOP is an adaptation of the employee stock ownership plan ("ESOP"), a type of qualified retirement plan sponsored by eleven thousand U.S. businesses. Adaptation of the ESOP concept to nonprofit organizations is somewhat counter-intuitive, since ESOPs are designed to invest primarily in employer securities (which nonprofits do not issue) and are encouraged by a series of incentives related to federal income and capital gains taxes (which nonprofits do not pay). Nonetheless, ESOPs are unique among qualified employee-benefit plans in their ability to borrow money, and as a result "leveraged ESOPs" have become a familiar technique of corporate finance. Leveraged ESOPs borrow to finance the purchase of employer securities; the loans are then repaid from the employer's ESOP plan contributions.

While ESOPs have been associated exclusively with for-profit enterprises, it is increasingly common for large and growing nonprofit organizations to control both nonprofit affiliates and for-profit subsidiaries. In a C3SOP, a nonprofit parent company ("Parent") will acquire and hold the equity of its for-profit subsidiaries in a holding company ("Holdings") in which the Parent will be the controlling shareholder. Through the new C3SOP technique (patent pending), employees of both the for-profit subsidiaries and nonprofit affiliates will participate in an ESOP sponsored by the Parent, and the ESOP (via the ESOP Trust) will purchase a minority interest of up to 49 percent in Holdings. As a result, the Parent effectively will be able to acquire corporate control of a target company by purchasing 51 percent (rather than 100 percent) of the target acquisition's equity. In this manner, the C3SOP provides a new, substantial, and perpetual source of investment capital and can augment transaction financing otherwise available to the Parent, thereby enabling Parent and Holdings to grow more rapidly than would otherwise be possible.

Of equal importance, the C3SOP can provide the Parent with a competitive advantage stemming from (1) the enhanced alignment of corporate and employee interests — and its demonstrated impact on employee turnover and service quality; and (2) tax benefits associated with shares sold to an ESOP.

The tax benefits enjoyed by shareholders selling to an ESOP can facilitate many acquisitions. To illustrate, an ESOP can provide a unique market for the equity of a retiring owner of a provider operating as a "C" corporation. Shareholders of "C" corporations incur no taxable gain on their sale of stock to an ESOP, provided that the ESOP owns at least 30 percent of the company immediately after the sale and that the sale's proceeds are reinvested by the shareholder in qualified "rollover" securities within a fifteen-month period. This could prove especially attractive to shareholders of closely held companies anticipating sharp increases in capital gains tax rates in 2011. As long as the seller continues to own the rollover securities, he or she does not have to pay capital gains taxes. If the rollover securities become part of the owner's estate, capital gains taxes are never paid.

It is common for selling shareholders to invest ESOP sale proceeds in extremely high-quality rollover securities that can be used as collateral for a loan. These securities are often floating-rate notes (FRNs) issued by blue-chip companies. FRNs are designed so that interest payments float in tandem with interest expenses incurred by the borrower using the FRNs as collateral. A seller will purchase FRNs with the proceeds of the sale of stock to an ESOP and borrow against the FRNs. The amount available to borrow varies, but is typically between 85 percent and 95 percent of the face value of the FRNs. The process effectively enables selling shareholders to utilize ESOP sale proceeds while avoiding capital gains taxes.

ESOPs can also play a key role in the acquisition of providers operated as S corporations. Effective with 1996 changes to the Internal Revenue Code, an ESOP can hold shares in an S corporation; these changes also provide ESOPs with exemption from the application of the unrelated business income tax on earnings from S corporation shares. Accordingly, neither the S corporation nor the ESOP Trust incurs any federal income tax liability with respect to S corporation shares owned by the ESOP Trust.

In the short term, many economists are forecasting continuing low U.S. interest rates, increases in both capital gains and income tax rates, and growing pressure on government to curtail budget deficits. In the intermediate term, there is a significant probability that the U.S. will face an interval of high inflation. In these circumstances, the timing is ideal for consolidation of the large and fragmented nonprofit human services industry. The C3SOP can play an important role in that process.