EP10 - Interview with Nick Francia with UBS regarding the 1042 transaction.

Good afternoon, everyone. This is the ESOP guy, and we are on a journey to an ESOP. This podcast was a resource we created to help those that are thinking about going towards an employee stock ownership plan to work through the process to better understand what an ESOP is and how the process works. If you're new to this podcast, I just wanted to say welcome and if you have an interest in any of the other podcast episodes, please go to our website at journey to an ESOP.com. A few weeks ago I did a podcast on episode 39 just to give an overview of the 1042 transaction, and I discussed at that time doing an interview with an expert, and today is that day. Today I'm excited to have the privilege of interviewing Nick Francia with UBS Global Wealth Management to explore the 1042 transaction and particular strategies of using the 1042 for passive or active investment opportunities with the tax benefits. Nick has been with the Capital ESOP Group at UBS for almost 10 years alongside his partner, Keith Apton. Their team helps business owners and entrepreneurs evaluate different options for for exiting their privately held businesses. They have a niche specialty in helping clients navigate ESOP transactions and and on 1042 tax deferrals. With that, I just wanted to say, Nick, thank you for joining us today. Thank you, Philip. I really appreciate you having me here today. Excellent, Nick, can you, um, as we start off the episode, can you give us the listener, kind of an overview, um, as, as you would say, the benefits of a 1042 and really how they're used in ESOP transactions. Absolutely, Philip. Under Section 1042 from the 1986 Tax Act, the seller of a privately held business can sell stock in their company. And as long as they sell that stock to a new stock and under certain structures, they reinvest the sell proceeds into other active US securities that meet the IRS qualifying criteria, which is typically defined as or called qualified replacement property. They can defer with the proper planning permanently avoid the capital gains tax and connection with the transaction. A section temporary to roll over ultimately enables that seller. To defer the capital gains tax in perpetuity. And while avoiding capital gains tax, the owner is often able to maintain a high level of liquidity, typically up to 90% of what they sold the stock to the ESOP, using securities called ESOP bonds or floating rate notes. And although floating rate notes are not the only type of qualified replacement property that you can purchase, you can also purchase equities, you can also purchase corporate fixed rate bonds. There's certainly pros and cons of all those different structures which we'll talk about later in the podcast. Excellent. Yeah, those, those are gonna be quite interesting and you know, it's going into the very beginning of this, one of the things I was gonna point out is the process of asking the question, Should I use a 1042 or not? And I think it's really important to be asking your adviser really early on in the process so that planning. You know, necessary planning can take place, and I think you're gonna hear in this episode with Nick, you know, just the amount of the type of planning that they do and, and help, you know, make a decision related to how you know the client can best use 1042. So with that, who would be a good candidate, Nick, for a 1042 rollover? Before I answer that, Phil, what I always tell individuals that are exploring new stops or exploring 1042 is, is, before answering that question, the first question that you need to ask yourself is, are you a good candidate for an ESAP because 1042 is obviously a section of the internal revenue code that's only applicable to clients who sell stock to an ESOP. So if you are not a good candidate for an ESOP, it doesn't make sense to explore, really try to understand 1042. So without putting the cart before the horse, the first question is, is an ESOP the right exit strategy for you when you compare it to other types of sales? And so if you decide that the EA does make sense, then the next step would be to analyze whether or not 1042 makes sense for you from the seller's own individual situation. And when I, when I think of who really a 104 to rollover makes the most sense for her, obviously it's going to be somebody that's tax sensitive. Uh, someone looking to maximize their overall net worth for purposes of both living off of the money that they accumulate through the liquidity event and and maximizing the amount of wealth that they're gonna pass on to future generations. In terms of who's eligible, uh, more specifically, uh, any individual, a trust or a partnership is eligible to elect 1042, publicly traded corporations are not eligible. The owner of a privately held business who has established or is going to establish an EA that may want to consider a temporary to rollover to defer or even eliminate the capital gains tax on the sale. Um Would want to also make sure that the ESOP owns at least 30% of the company's outstanding stock post-transaction. And additionally, there are also several requirements that the stock itself must meet. To include the company has to be structured as a Corporation at the time of the stock sale. To take it a step further, I would also make sure that everyone understands the tax implications that they're going to face at the state level. So obviously we have about a 20% federal capital gains tax in today's environment. We have a 3.8% Medicare surtax, but also it's important to understand what your state and local taxes are. For example, in California, which is a 13.3% capital gains tax. A seller in California is going to stand to benefit from 1042, much more than a business owner that's selling in, for example, Florida, which does not have a state tax. So, when you consider the federal tax as well as the state. In California you could be avoiding almost 37% in capital gains tax, so. So from that perspective, If you're looking to fully eliminate the capital gains tax on the sale, And you're in the state of California, so long as you structure it properly, it's really a deferral while you're living, and then because of the stepped up cost basis, it becomes a permanent avoidance post-transaction. Yeah, so when you look at those, those particulars in determining who would be a good candidate, um, I think the biggest thing is, is when you start thinking about those types of tax rates, especially if you're in California, the amount of money we're talking about is, is extremely significant to the transaction. And, and I, I think as we get into this, I know one of the reasons I wanted to do this episode was, is the amount of, of. Money that goes out to the IRS in terms of the transaction could be just the differential could just be so significant. So um I think it's probably one of the most important episodes that we have and just so that people really understand the you know the um the the critical nature of understanding and planning it. um, in looking at a 1042. Um, as we go into the actual transaction, I understand the selling shareholder needs to identify and purchase a qualified replacement property within 15 months, 3 months prior to the transaction, and 12 months after. What is entailed in satisfying this part of the transaction? Well, Philip, you're, you're correct. Um, there is a 15 month timeline that is referred to as the replacement period. So in order to satisfy this requirement, selling shareholder must purchase QRP equal to the amount of of the stock sale to the ESOP within that replacement period, which, as you pointed out, is 3 months prior to the transaction and 12 months post-transaction. QRP is gonna include common stock, preferred stock, bonds, convertible bonds of certain operating companies, US operated companies. And to get even more detailed, these companies that are going to qualify under Section 1042 must use at least 50% of their assets in the active conduct of business, and no more than 25% of their gross receipts can come from passive sources. So a great example that a lot of industry professionals use McDonald's. A lot of people hear McDonald's is a US operating company, publicly traded, they think that it qualifies and because so much of their revenue is derived from franchising, they do not qualify. So one of the more popular, I would say. Qualified replacement property securities that's used as we talked about earlier, is corporate floating rate notes, also known as FRNs, also known as ESO bonds. And the reason that they're generally used by most selling shareholders is because they allow for the business owner to sell their stock, reinvest proceeds into these ESOP bonds, and then banks are generally comfortable lending up to 90% of the value of the ESOP bonds back to the selling shareholder, and that's generally where the selling shareholder gets that 90% liquidity. And so very much like most business owners, they're focused on liquidity. You don't want to sell your business and not have access to the capital, and that's usually why people tend to explore ESOP bonds as a way to defer the tax, but also have up to 90% of the proceeds available to them to spend during their life. Um, securities that don't qualify, uh, just so that you know, uh, securities such as bank CDs, government bonds, ETFs, mutual funds, and REIs are not eligible for QRP. Uh, one other point that I would make if we're talking about um. The way to satisfy the transaction is there's 3, there's 3 very important tax documents that need to be filed with any 1042 deferral, and that's going to be the statement of election, the statement of consent, and the statement of purchase. Right. So, kind of, let me dig into that just a little bit too, cause when you, when you go into those types of things, I think a lot of our clients when they, we're doing planning, At what point do you do you guys at UBS in terms of your process come in with the client in terms of the process of working through what should they say, say for instance they're they're they're planning on going ahead and investing in the floating rate notes, do you do that towards the beginning of the process or the end and, and if so in the beginning, like how do you actually help them plan those those types of decisions? It's, it's a great question, and, and, and I would say that we very, very rarely if ever have clients come to us who have already made up their mind that they're going to buy ESOP bonds and they're going to elect 1042 and we're just asked to execute. Most of the time what happens is somebody comes to us and says, I'm exploring an ESOP. I don't know if I should elect the next corporation and Elect a 453A installment sale and pay my capital gains tax, or if I should elect a C corporation transaction and elect 1042 and permanently avoid my capital gains tax, and to take it a step further if I do end up using the Corp transaction and if I do 1042. What should I purchase? Should I buy EA bonds? should I buy equity? Should I buy corporate fixed rate bonds? So typically we're brought in on the very front of a transaction when they're talking about structuring, when you're trying to decide whether or not you're gonna sell Corp or Scorp stock, and then from there, once we understand the client's liquidity needs, once we understand their cash flow needs, whether we whether they're philanthropic or not, how much they want to end up leaving to future generations. Then we can ultimately advise them as to what the best is to purchase. Yeah, so at that point you're, you've kind of designed a game plan for them to, once they complete the transaction, they kind of know what they're going to get into and, um, I think for, for a lot of the clients I have, they're just gonna have, they have a lot of questions related to risk risk and uh reward of those types of potential investments like what are they what are they actually going to risk when they put their money into something. Like a floating rate note or you know some other type of investment vehicle. So with that, um, yeah, so going into the qualification, so let's talk a little bit about the entity type. We talked, you bounced around a little bit with Corp S Corp, um, and again, a lot of people listening this, they're, they're so new to pot to uh to ESOPs. They're like, you know, I guess the first thing I'd say is, you know, as an ESOP, you have to be either a C corp or an S corp to transact. Um, and with the 1042, as you explained, we have to be a Corp to use the 1042. Well, what happens if you have a company that's, that's an S or an LLC maybe taxed as an S or a partnership that wants to use the 1042? So I would, I would argue that I, I, I bet you if you pulled the audience, if you have business owners or C-suite executives on, on the phone today, but the majority of, of businesses today are us corporations. So, so most of the time when we're having conversations with clients, it's around the company currently being taxed as an S corp and what is the process and what does it mean to the company if ultimately the client wants to elect 1042 and the company has to convert to a Corp. So most transactions we work on, most companies that we work with, they start as an S corporation. They convert the S corporation to a C corporation pre-transaction allowing the selling shareholder to sell stock at a C corporation. And then by IRS guidelines, the company has to retain that Corp status for 5 tax periods before converting back to an S corporation. So that's the normal course of action, that's the normal process, which is again, starting as an S corporation, converting from S to C, selling stock as a C corp, waiting 5 tax periods, and then converting back to an S. Now, in a perfect scenario, if you're taxed as a Corp today. You could sell Corp stock today and convert to an S corporation immediately post-transaction, which is a fantastic structure because you're getting the tax benefits at the individual level and also getting the immediate tax benefits as as an S corp on ESO. So there's a lot of complexity that goes into that pre-transaction planning. But that's why it's extremely important to understand the cash flows at both the corporate level and the tax implications at the individual and corporate level in order to make a decision as to what's going to most benefit everybody. Right. So what, so what happens if I'm an LLC and they're like they say they're an LLC tax as a partnership, and they have to convert to, um, can they convert to a C, take the 1042, and then convert to an S? It will, they can. It just depends on how quickly they can convert to an s. So what's going to that's going to be their individual CPA will be able to advise them on that. LLCs are a whole other animal in terms of whether or not they're going to be able to convert to an S immediately or whether or not they're going to have that 55 tax period holding or waiting period before converting back to an S. So with, um, so let's get into the investment side so from going through this type of transaction, um, you know, I know there's as I went through your presentation, there's different strategies for selling shareholder and they may want to be um more on the passive side and maybe you can explain that and then or maybe they want to be more on the active side or maybe they wanna be in a combination of both of those from an investment strategy standpoint. Can you speak to that a little? Yeah, so, so there's obviously several reinvestment strategies. We've talked a lot about them at a high level, and I don't think today's forum is. It's appropriate to get into extreme detail, but obviously we could if somebody wanted to have a follow-up conversation. Um, but the final strategy that the that the selling shareholder chooses should ultimately be decided upon based on a combination of factors, and that's going to include um the overall ESOP transaction design. The overall business succession plan, the treatment of other investment assets, um, the liquid net worth of the seller, the seller's age, their current estate plan and the philanthropic goals, um, their cash flow needs post transaction, and their liquidity needs. Um, so when looking at the, the two very obvious strategies from a temporary two perspective, you have a passive strategy and you have an and you have an active strategy. And so the passive strategy involves purchasing a portfolio of qualified to person property that will basically be held over the lifetime of the current shareholder. And from and the reason it's called passive is it's just typically a strategy. It's typically a basket of equities that you purchase. And you ultimately hold for the rest of your life, but you don't get Any or any significant amount of liquidity out of that transaction because you're buying a passive investment, you're buying the equities and you're holding them, and if you ever want to ultimately trigger the tax, you certainly can. You would just sell the equities and then you'd pay a tax. On the amount of equity that you sold in that tax year. The next strategy is the active strategy, and the reason it's called the active strategy is because this is the strategy in which you were to purchase the ESA bonds. And then you'd have access to about 90%. Of your proceeds through that 90% loan to use an active reinvestment, whether it's actively purchasing other equities, whether it's actively spending, whether it's actively buying real estate, but since you have access to that capital, you can use it however you want, however you deem best appropriate within your financial world. And then the third strategy is just a combination of the active and the passive. So just because you buy equities doesn't mean you can't also buy ESA bonds, and just because you buy ESOP bonds doesn't mean you can't also buy equities. So a blended strategy is basically going to be buying some percentage of equities and some percentage of ESOP bonds and really finding that happy medium as to what's going to make the make the sellers' goals and objectives met. Yeah, so, so a couple of thoughts I have on that, just, just I guess general questions. Um, first off would be what could go wrong if somebody was doing this and what, what should they watch out for, um, if they were gonna, if something was going to really happen and then it was bad um from it, it's like to say an active strategy that they were investing in, um, could they lose their money? Any anyone that anyone that makes any investment, whether it's in equities, whether it's in ESA funds, whether it's in real estate, whether it's in artwork, or whatever you pick, anything that you ever invest in. You should assume that you, of course, can lose money. There's always the option or the opportunity to lose money. Anyone that tells you otherwise is not telling you the full story, so there's always risk and the risk is going to be quantified by what asset you're purchasing. ESO bonds are going to be exponentially safer than equity. In the middle of these top bonds and equities is going to be fixed corporate corporate bonds, fixed rate corporate bonds. So every asset class is going to have with it its own risk profile. What I would advise someone to do if you were to say what do people, what mistake can people make? I think the mistake that people can make is. They don't explore all their options, so you really can't make a bad decision if you go into a decision eyes wide open. So if you explore ESA bonds, if you explore equities, if you explore corporate fixed rate bonds, if you explore all of your options from a 1042 perspective and do the modeling and have a professional run out the cash flows for you and show you what liquidity that you'd get, show you what type of philanthropic planning. You can use these QRP equities or QRP outlines for and really understand what it's going to mean to you, not just in today's environment, but in 5 years and 15 years and 30 years because this is a strategy that you're going into to hold the rest of your life. It's a long term strategy. Once you purchase these securities, exactly, once you purchase these securities, if you ever were to sell them, you are triggering a tax. You're not able to then reinvest back into other securities down the road. So it's very important to purchase something that you are comfortable with holding the rest of your life or that you understand if you ever want to sell, you're ultimately going to trigger the tax. Right. That's why planning's got to be so important, um. When you guys get into it, it's kind of another general question, what would be, um, you know, there's all kinds of size ESOP transactions as we know, there's really large ones and there's really small ones, um, and there's middle ones. What, what would you say is too small of a transaction to even worry about a, a, a 1042? I'm not gonna be able to put a dollar on that. Um, I wish I could give you a black and white answer, but I, I think that, look, it comes down to this. Does it make financial sense for the seller to elect 1042 or not? And so whether we're talking about a million dollars transaction or a $100 million transaction, whether or not it makes sense it's going to depend on the state of residence that the individual shareholders in. It's gonna depend on the structure of the transaction, how much cash it closed are they going to get versus how much are they gonna take back in the form of a seller note. Their age, Um, how much liquidity that they're looking for post transaction, what their goals and objectives are from a legacy perspective, um, there's, there's so many variables that go into each ESOP transaction. That it really isn't about the size of the deal. It's about those variables and the tax implications of the individual shareholder. And then once you have that information. You can ultimately take that, plug it into a model, and figure out, does this make sense financially or not. And then so long as it makes sense financially, are you comfortable with the additional complexity? If you're if you're comfortable with the additional complexity, you know you're making the right decision. Right now I think that that's just logical like walking that through with a client, I think that just makes sense and it's a step by step process with variables that that are gonna be different for every single deal that you get involved with or. Are there additional costs that they'll bear in going in a 1042 if they didn't have, if they didn't do a 1042 at all, are there additional costs that they'll have in the transaction? Are you talking about the, I presume that you're talking about are there costs of of of executing a 1042 transaction? The answer is yes. Uh, what the costs are going to be is going to depend on what security you purchase and whether or not you take a loan off of that security. So if you buy ESA bonds or if you buy equity, there's obviously going to be some level of cost to purchase that security. Depending on on what security is will depend on what the cost is and then the The other cost is gonna be in the FRN model, in the ESOP bond model, if you were to purchase ESOP bonds and then borrow off of them up to 90% of the value of those bonds, there's the cost of that loan. So the cost of that loan, that's the, that's, that's how the client ultimately gets their liquidity, but like anything in life. Whenever there's a benefit, there's a cost. The benefit is you have access to 90% of your money. The downside is there's a cost to that liquidity. And so the question is what's the, what's the cost of that loan? And so there are going to be additional costs, but again, when you're making these decisions, you want to make every decision net of fees, net of costs. So if you look at, if you look at the 453A installment sale and you're in California, for example. We know you have and and you and you do and and you choose to pay your tax, you have no 1042 costs because you did a 453A installment sale, but you wrote a check to the government for close to 63% of your sale proceeds. In the 1042 scenario, you absolutely have some level of cost, but you have to quantify those costs, and then you ultimately avoid 100% of the capital gains tax. So in that example you have 100% of your proceeds. And about 90% in most cases that you have access to the other 10% goes to your state, but you basically paid no capital gains tax and you have a cost versus the other scenario of the 453A installment sale. You had no cost, but you, but you only had access to 63% of your money. That's where the modeling really comes in and that's where you want to quantify it and look at it on a net after cost basis to see whether or not it makes sense. Yeah, and that's kind of what I was alluding to earlier and I think that really. Is the compelling part of the 1042 because we are, you know, we're talking about significant amount of dollars in comparison if we're paying the capital gains out front, especially in a state that has a high state tax capital gains rate, um, so it would, it would appear that you know as you go through that analysis, obviously it's gonna matter the variables as you said, um, but it'll be like I said, a significant, um. Planning item to see what the costs are versus the other side and then what the potential for the for the client to say, you know, I'm I'm more conservative maybe I just do this, but do a passive strategy as opposed to become more um on the active side um and really the only the only thing else I was I was gonna ask you is the floating rate note has a specific interest rate. Where where are the interest rates right now with floating rate notes? Well, in today's environment, rates are so low that the floating rate notes are paying almost 0 because floating rate notes typically pay about 3 months LIBOR minus 30 basis points, and with 3 month LIBOR sitting below 30 basis points, there's a 40, so they're really not paying any income, but The strategy of using ESOP bonds is relatively insulated from interest rate risk because the loan that you take using the ESOP bonds as your collateral is also tied to interest rates. So if interest rates are going down, you're getting less in income from the ESOP bonds, but you're also having a a smaller cost on the loan, whereas the inverse works when interest rates rise. So from an ESOP on perspective. As a as a purchaser of ESOP bonds, you're not as focused on the income as you are about the about the principal protection and the safety of the ESOP bonds from a long-term perspective. Right. And then, and then the idea of freeing up liquidity using that on lever leveraging that to, to get liquidity as well as the other side of it. Exactly, yeah. Um, all right, so those are all like my general questions. I, I was just gonna make some final comments that I thought were, were, were really good. I know like you said, we could go into this so much deeper. We don't have time to do all of that. I really wanted to just kind of highlight some things I heard and um and just kind of let you kind of summarize. Um, it really looks like planning obviously is a critical aspect of 1042 for those that are considering an ESO transaction. And going in and really understanding from this podcast what I got was if you are in a state that has a high state capital gains rate when you combine that with the federal capital gains rate, um, it definitely is gonna make sense for you to to look at this as um a potential um benefit to you, but again with the variables that they're there, um. You know, the essential part of this whole thing is planning and making sure that you have asked the right questions and you have an advisor, um, that can help you do those things and people like Nick who can model out the scenarios and give you really good advice to make sure that you're um you're making the right steps towards, um, a plan that works for your, your goals and objectives. So with that, Nick, any, any comments you have, final comments to summarize? Yeah, the last thing that I'll say, Philip, and thanks again for having me on this podcast, really appreciate that. The biggest misconception that we hear on 1042 or people that are are exploring 1042 is they hear the word reinvest and they believe that they have to take every dollar that they got out of the transaction and put it into QRP and so therefore they don't have any liquidity. And that a lot of times turns them off from 10:42, and I don't blame anyone for that feeling if that were the case, but with a lot of QRP structures today and, and, and as it, it's been this way for many years now, clients can both elect 1042, purchase the qualified place of property they need to, and have access to their capital, and that's the key, because anyone that's selling a business knows. You don't want to sell a business and not have any liquidity out of the transaction. So it's liquidity, it's the liquidity that allows them to live their life, to enjoy. What they've worked very hard to create, which is this business that they're now obviously going to a liquidity event on. So I would say just make sure that you fully understand all your options before making any decisions. And if you do that and you yourself with the right team of advisors, it's tough to make a bad decision. Mhm. Excellent. Great. Uh well, thank you again so much for your time today, Nick, and the uh insight you have and from that, I think people will gain a lot from listening to this episode. Um, as we close out, I just wanted to remind you, um, please, if you like the podcast, please subscribe and, and share it with a friend. Have a great day and we look forward to our next time on our journey to an ESOP. Neither the Capital ESOP Group or UBS Financial Services can provide tax or legal advice. Please consult with a tax or legal adviser when looking to implement a strategy.