EP15 - Did Uncle Sam Go Crazy? ESOPs - issues and opportunities related to tax exempt S-corps.

Thank you so much for joining us today. I am the ESOP guy. And if you've been with us before, let's continue on this journey to an ESOP. If you haven't, and this is your first podcast, I wanted to encourage you to go to our website at journey to an ESOP.com, where all of the podcast episodes are available for download. This podcast had really been created and designed around the notion that there are a lot of people that are interested in ESOPs. And there's a lot of information, but really to try to simplify and clarify the information that's out there. It's a great option for business planning, even in a growth planning scenario, uh, succession planning or exit planning. Today's episode is entitled Did Uncle Sam Go Crazy? Now, I'll just jump to the chase. I'm not gonna talk about PPP or EIDL today. I'm going to go right into the nature of being an ESOP company and being a tax exempt company. There is no other entity in the United States that can be tax exempt. As an ongoing business, the ESOP is the only one. Now, there's a very straightforward notion here with ESOPs are tax exempt, and I could spend 10 seconds and tell you that's what they are. But what we're gonna talk about today are really the issues behind being tax exempt and. What you should prepare to know or understand as you start building your plan of going towards an ESOP. If you like what you hear on the podcast, please subscribe and share it with a friend. Um, so today when we talk about um tax exemption. I wanted to start with just the idea behind the power of being tax exempt, especially considering today's economic environment, which just absolutely radically changed on all of us and over and almost overnight. It was unbelievable what has happened. Take a company with an average Ebi of a million dollars a year. Uh, they're going to be paying as a non-ESOP company, $300,000 in federal taxes. Which is a significant amount of money and, and obviously just keep going up um in terms of higher IEA and you're gonna have higher, higher federal taxes. I'm just using a uh maybe a smaller example. So over 10 years, that's $3 million of extra money. Now, as a, as a 100% S corporation, that's $300,000 a year that's available to service the debt that you have as an ESOP company and then to also put into other things and in addition to that, whether downstorm downturns like we're we're facing right now. So how did this come to be? I'm going to give you a quick history, a timeline history of actually tax. Uh, taxation in the country and then work into um how that kind of blended into where we are today with ESOPs. So in February of 1787, Congress approved Articles of Confederation that gave the power at that point to levy and collect taxes. In September of 1789, Congress then established the Department of the Treasury and appointed Alexander Hamilton as the first secretary. And you'll remember Alexander Hamilton if you like to play Hamilton and the music. Um, so that's just a fun, um, sidebar. On February of 1913, the 16th Amendment officially became part of the country's Constitution and granted Congress the authority to levy taxes on corporate and individual income. And therefore, the Bureau of Internal Revenue was established in a personal income tax division, as well as a correspondence unit to answer all the questions that were going to come in as as they taxed income. So I love history only because it makes us stop and think, but really asking the question, how did we get to where we are? And just like with the taxation history in the in the United States, there's history related to ESOPs. In 1974, the Employee Retirement Income Security Act was passed by Congress. And this brought about strong regulation related to retirement benefits for primarily for worker protection measures. This law also established a formal legal framework for employee stock ownership plans. And at that point in time, what was happening is it was only really applicable to see corporations. Because in 1997, so since 1974 to 1997, the Taxpayer Relief Act of 1997 then allowed S corporations to be set up as ESOPs. And so in that moment, there was just a lot of movement then as S Corp started to look at the benefits that they had as an ESOP. And we're gonna, we're going to explore that, you know, much deeper here in this, in this episode. The question is, in this, why did Uncle Sam go crazy and just give companies the right? To have, uh, no, the right to not pay any taxes. Um, and if you look at it really from a comparative of economic stimulus, this is an ongoing economic stimulus program that was, that was set up, um, this long ago, you know, over say 40 years ago, that really helped, um, Those companies really move wealth from owners to their employees. So it is a not only an economic stimulus, it's also um a way to um move wealth from the wealthy to um employees of businesses. And so, there's a lot of reasons why both sides of the parties, the Republicans and the Democrats agree on ESOPs and politically speaking, Um, I think it's a very popular notion, um, because it does a lot for the economy and it does a lot, um, for the individuals of this country that are working for ESOP companies. So, Did Uncle Sam go crazy? I don't know, but I can tell you that this works tremendously well. And as we walk through the next um several months um and into the next year, um, my prediction is ESOP companies will do better in a downturn than non-ESOP companies. So having said that, that kind of sets the the stage to talk a little bit about um The, the nature of an S corporation and their tax exemption. As a CPA firm, we are handling the uh a lot of tax planning and as a CPA firm handling that goes in and handles the sales site advisory for ESOPs. What I like about what we provide in the process of managing and planning with our clients is the tax consultancy is so important in the framework of building out your ESOP. And it really needs to happen at the front end of the process because the numbers, you know, if you just sell your business anyways, you know, the numbers um that you're going to have to deal with significant numbers are going to be related to the tax on that transaction. And looking at tax on the ESOP, it's not just the tax on the transaction in this case, it's going to be the tax related to the ongoing sustainable entity that's been created out of the transaction as well. So, tax consultancy is, is critical. And having the benefit of being able to blend in those disciplines as a CPA firm, and the disciplines of of valuation are really kind of key when I'm looking at providing a holistic picture to a client, um that is wanting to go through this process. So if I start with S corporations. It just, it's important to understand and this is pretty basic, but I want to kind of point these out as we go through the, the logic of, of S Corporation ESOPs. As corporations make distributions to their shareholders on a pro rata basis. Primarily they're, they're distributing money not only to, to their owners, but to meet their income tax liability because S corporations are known as pass through entities, which means the income that the S corporation makes. passes through the individual taxpayer and they are paying the taxes on their individual tax rate when they report what their K1 shows from the income of the business. So the portion of the S corporation, um, and as they move that into an ESOP, once an ESOP purchases an S corporation, whether in part or in whole. The Aesop now. Basically receives the K1 that the individual received prior to for the percentage that they own. And so, as the ESOP receives that portion of income, because it's an ESOP, that is exempt from taxes. So because of this fact, as corporations became extremely popular and are still popular today. And when I, when I bring this up to um a person who doesn't understand this, and it's still, you know, if you, if you do understand, I know it's going to seem impossible. Some people don't really get that, that that is an aspect of an ESOP, then the response is, what would, why would the government do that's what I kind of already covered, um, their, their notions behind it, um. And so it's really you just get the, you get over that hump of of um incredulity of like, hey, this is, I don't believe this is possible, but it is possible. Um and it's an exciting aspect of business planning for ESOPs. So when we look at, when we start breaking down that part of it, um, the benefit of, of this process is gonna, we're going to break it down from a selling shareholder standpoint for a second. There, when we, when we model out those tax benefits in the feasibility model, we're going to have this, we're gonna pick up this additional cash flow. And what that's going to do for the selling shareholder is it's going to allow the buyer who um is either going to buy this on a note with a selling shareholder or seller financing note, or in combination, they're gonna, the buyer is going to also finance it with the bank. They're the buyer is going to have more cash available to pay the payments that are available. So the selling shareholder, what they get out of this transaction. is they have a stronger buyer with more cash flow available to purchase their redemption of their, of their stock. And so that's a really important way to mitigate the risks when we go through a modeling exercise and we model out this type of transaction, compared to a popular way to sell a business internally as a management buyout. So when we model that out in comparison, the managers are buying out after they've paid taxes. And so there's a significant amount of cash left over in the ESOP to pay that, um, to pay that payment. Um, and what that does then for the for the selling shareholder is it really mitigates the risk of the repayment, especially as we start to continue to draw connections to the economic downturn. Um, there are compliance expenses that have to be paid and so there are minimum profitability measures that we have to have, that we have to look at when we look at a, uh, an ESOP company. But if the company is making, if the company is making profit and there's income, then there's significant and there's significant money there, um, then that's the money that we're going to use to um buoy those payments and mitigate the risk to the seller. So one issue that has, has to be brought for S Corps is that. The reality is the selling shareholder cannot defer the capital gain tax on ESOP. So capital gains is what you get taxed on in the transaction. It's not ordinary income tax, so it doesn't apply to your ordinary income tax rates. It's the current capital gain tax rates that apply for the transaction and it's the amount of money that you're going to be um receiving from a purchase price minus the actual basis of that transaction. And so the difference is going to calculate out at some capital gains for an S corporation that cannot be deferred for a C corporation, however, it can be using a qualified retirement plan or a QRP. And so that's really important to understand and so there, there's definitely um room in the model to determine what is the more important part of the benefit. Is it that you get the QRP as a C corp and convert your company, your Scorp to a C or is it that you're an S corp and you get to mitigate this risk of repayment with the benefit, the tax benefits of tax exemption? So, in addition to that, though, both entities, when we look at deductibility of the contribution of the ESOP, um, are able to deduct the ESOP payments as contributions. And for an S corporation, they can deduct those contributions up to 25% of eligible payroll. And when you make that calculation though, and we do this in feasibility um of the transaction, you also have to add in the contributions of the 401k plans as well. And so, assuming that the payments are there and there's enough payroll that you have, then there that contribution is, is deductible and this is going to apply primarily to partial ESOPs that are S corps because the full 100% Scorp is already tax exempt. So as a C corporation, what happens is you are able to uh deduct those contributions, um, but there the limitations don't apply to interest, they only apply to um principal. So as a sea corporation, you can actually deduct more of those contributions than you can um at the limits of the of the eligibility. So that's one is we look at the issues, that's one of the things when we look at comparative between S Corp and Corp and, and we really do try to do just like we do uh an ESOP by purchase compared to an MBO by purchase, um, we're going to compare the same thing with S and C just to determine the differences. One other aspect of tax planning is going to be early on in the process is to identify for an S corporation, what the existing AAA of the business is, which AAA stands for the accumulated adjustment Account for the individual selling shareholder. And what we're trying to accomplish is an estimate at the very front end of what their AAA is also going to stand for tax retained earnings. So what the owner's tax retained earnings is in the business. And that's important because what's happened with S corporations, what happens with S corporations depending on their distribution policy. is that some S corporations build up a very big balance sheet. Because in some cases they just build up a big balance sheet because it's easier to get bonding and banking and they have very big working capital, they have a lot of cash on the balance sheet, um, and then they have this, all this kind of flows back into a higher tax retained earnings. So what we're wanting to do in planning for the ESOP is to normalize that balance sheet or, or look at what we need to keep on that balance sheet. Um, which is primarily, um, required working capital. And so what we have to do as, uh, estimators or valuation, um, analysts is we have to estimate What the transaction is going to require from a negotiated required working capital when we get to that stage with the trustee and we're asking, and we're negotiating out what that, what that needs to be. And so part of the planning that we do is we, we will estimate uh with financial ratios, their current, their cash conversion cycle down to the number of days it takes for that cash conversion cycle to turn. And we'll apply that to the existing cost of goods sold to come up with a a very good estimate, I think, of what required working capital is. And once we apply that back to the balance sheet, we're then ready to then estimate um what their excess working capital um is going to be. If there's a deficit working capital, then we're going to have a different discussion, which is, hey, your balance sheet isn't capitalized correctly. Um, and that's gonna talk, we're going to then talk about the purchase price and how that might be affected by the purchase price. But if it is, um, excess cash flow or excess working capital, We're going to Look at that in comparison to the existing AAA, and we're going to then estimate at year end and then estimate the point of transaction to determine their AAA distribution for the transaction. So there's a, there's a lot of detail there, but it's very important and I think that the the major gist is for those companies that Again, on a journey to an ESOP tax planning at the front end is extremely important and the significant dollars that we're talking about for the ESOP transaction are going to occur relative to the changes in taxes. And it's very important to understand as a uh an advisor and to be able to explain this to you as, as a client or a potential client, that the, the um estimate of these is going to be important because you're gonna want to estimate at the end what you're as a, as a seller going to get out of the transaction. And the worst thing that can happen is you go into the transaction with the, with an idea or an estimate of something being higher than it really is. And so the way that we accomplish that is by building models that are updable through the process of doing the transaction. And I think that's really important, um, that the client understands the models, what the assumptions of the models are, and you don't have to be a tax expert, but you do have to understand the nuances of how the tax, how tax affects your potential ASOP company. Now, one specific issue that comes about with S corporations. Is that because of the anti-abuse rules that were put into place. The uh regulation of 409P comes into play and what it's trying to do is make sure that the company, the S corporation that sells to an ESOP, doesn't have, say, the extreme example of one owner who sells the business. There's one owner, one employee, and he sells the business and he creates a tax-exempt business where he's the beneficiary of all that. And so that would be obviously abusing the tax rules. So what 409P does is it Requires that the um there's enough ownership breakdown within the um the existing employees after the ESOP is closed. Um, and what it does is it takes the fully allocated and the unallocated shares and it assumes everything is allocated. And each of those specific owners of the ESOP, which are now owners from the standpoint of the transaction, cannot have more than 10% ownership of the entity. And this would basically render them disqualified in the plan. It would also um create a 50% excise tax on the, on the business, and then the plan would lose its status as an ESOP if they triggered um a problem with 40 IP. And therefore they would, they would owe the taxes and the whole thing would get unwound, and it would be a bad scenario. So in planning for the ESOP, it's very important to look at your payroll census and understand how many employees you have, what would those shares be, how would those be allocated among um your partic your potential participants on a fully allocated basis to make sure that that your business doesn't trigger the 409P problem and have a, have a disqualified situation. And so that's, that's important and it's, and again, those are models that, that are created and the models are created to help um adjust for things that are going to change and in an economic downturn, what can change is you might have less people going into an ESOP. So I wanted to leave with this, and this was an interesting article that I was reading by Oaktree Capital. And it referenced the economic crisis. Right now, it's talking about in the article, one of the greatest pandemics ever to reach us since the Spanish flu 102 years ago. One of the greatest economic contractions since the Great Depression 80 years ago. One of the greatest oil price declines in the OPEC era that we've experienced. And one of the greatest central bank government interventions of all time, which we all have seen through this economic stimulus package. So with that, I, I leave you with that article on those reference points to understand we are going into a downturn and we don't know how long it's going to be. We don't know what that uncertainty means. We don't know how much the PPP loans are going to help get us through that, but it's important that um we look at the benefits of being an ESOP company. Um, I certainly am um a promoter of ESOPs and for, for as we look at these reasons right now, I'm a promoter of ESOPs because um a tax exempt company. It's gonna simply have a attack as an advantage over any company paying taxes. And, and they will get back quicker to where they were going before, um, because of that, because of that notion. So I think that's such a powerful aspect of the ESOPs and, um, and I think it's something that you, as you consider your journey to an ESOP, need to really think through. So with that, thank you again for listening to this podcast. I hope this is helpful information as you think about your plans, um, as you go through the uncertainty, as you think about your plans and focus on this as a potential opportunity for you in your business. Um. Check us out next time on our journey to an ESOP, and please, um, if you do want to get more of the podcast, go to journey to an ESOP.com. Share the podcast with a friend and subscribe and with that, have a good day and we will see you next week.