EP22 - 100 foot Journey - an S-Corp with a side of 1042

Hey everyone, whatever you might be doing today, I just wanted to say hope it's going well and you're enjoying it. This is the ESOP guy. We are on a journey to an ESOP, so glad you could join us today. For those that are new to this podcast, this is a podcast that has been designed to provide a resource to people thinking about going in the direction of employee stock ownership plan with their business. And so there's a lot of reasons to do that and. There's a lot of reasons we've identified already in our episodes, so please go to our website at journey to an ESOP.com if you have an interest in any of those. So with that, I wanted to kick off this episode with this. In the south of France, her restaurant had no equal. Last night we served this in this restaurant. The cuisine is not an old tired marriage. It is a passionate affair until one family. stir things up. I want to buy this restaurant. Awesome. So this is um this podcast is gonna be entitled The 100 ft Journey, and Scorp ESOP with a side of 1042. Wow, what's all that about? So, um, the, the ESOP is, there's so many different things to know about the ESOP, but as we think about it, and this might be new to you, if you're checking it out, the S corporation ESOP, um, is exciting because it, it really does come with a complete tax exemption for the percentage of the ESOP that is owned by the, um, The, the, the whatever the percentage of the S corp is owned by the ESOP is, is exempt from taxes. And we can't do as an S corporation, we can't do the 1042 exchange. So, This podcast is really just about updating everybody about some of the new things that are happening in DC with some politics related to that, but also regrounding ourselves on S corporations and just working through that. And so at the very end, I'm going to talk about some bills that have been proposed, and I think it'll be interesting and insightful for you to, to have a a good a good understanding and a good idea of what's happening there. I also wanted to continue to plug our ESOP Guy live webinar series that's um our 4th one's coming up in the middle of July. So it's July 14th at 20 p.m. Eastern time. So if you have an interest in that, that one's gonna be called ESOP as a strategy. We're gonna continue to move through our webinar series is moving through the ESOP process and we're gonna talk about how on the ESOP strategy side, we're, we're gonna be thinking about and incorporating. The goals and objectives of the of the the owners, the selling shareholders with their management team from a succession and an exit planning standpoint, how do you, how do you work in warrants? How do you work in SARS? So I think it'll be pretty interesting and it's stuff that we've touched on in the podcast, but it'll be more of a presentation with. Um, hopefully, good insight for, for you. So anyway, if you like what you hear on the podcast, please subscribe and share it with a friend. As we start, I wanted to kind of get into the idea behind the movie and the connection between really the topic that we're trying to, trying to go after. So the movie itself, A 100 ft Journey, if you haven't seen it, I'm just going to say it's, it's really kind of a cool movie. I've seen it many, many times. Um, I don't know why, but I think partly because it's, it's a fun movie, and it's interesting, um, because it's got this, um, connection between family, and so this, this wonderful family from India is coming into France. And there's all these dynamics with the family, but then there's this cultural contrast between Um, the Indian culture and the French culture, of course, that takes place within respect to and context to food itself. And then, of course, um, as I think about the movie, I, I just like the whole, the picturesque nature of everything that the, the, the scenery is beautiful in France, the, the food, the pictures of food, I mean, just, it's just beautiful and so, um, it makes me want to cook something or it makes me want to be maybe a a chef. I like cooking. But I'm, I'm not anywhere near something like that, but it is, it's pretty cool. So I would definitely highly recommend it. I just got back last week from Washington DC, so I went to the ESOP Association conference. If you were there and we didn't get to bump into each other, um, I did get to see a lot of the people that I know through the podcast and so and and I had some clients there. So it was, it was a lot of fun, but um the whole point of the, the conference for the major portion of it or the theme of it was the advocacy for and promotion of ESOPs, you know, and if you think about ESOPs, They're really a political creation. There's something that the, the IRS has agreed to from a tax standpoint, the Department of Labor, ERISA. It is, it is basically governed by these agencies of the, of the government, but ultimately, it's been created by legislation. So that means that ESOP advocacy is extremely important. And we've done some podcasts on this before. The idea behind it was to understand like how, you know, how, how could this really be, how it's too good to be true when you start thinking about some of the tax benefits of an ESOP. And it's really true because they've, they've done what they have done a great job of, of passing good legislation. And so this is, um, this is really about now incorporating that. And so if you start thinking about Um, the connection now where we're going to go with this. Um, I wanted to talk about like, you know, the thought process or metaphorically of the food and the best food in the world, and you have to start thinking about the ESOP. But when you think about the ESOP as an S corporation, Because of the tax exemption, it's so powerful, it's so unbelievable. It's like nothing else, right? Now, when you are able to, if this happens, and we were going to be watching this, this is something I want you to be aware of. And if you're politically connected, you know, obviously be an advocate for it. If it happens, what we really want is an ESOPS Corporation that can utilize the benefits of the 1042. Um, as we went into the 1042 and other episodes, um, the 1042 really is a, um, a way that the owner, the selling shareholder can, can defer capital gains on the transaction or even eliminate capital gains, and it's only available right now as an as a C corporation. So, I think from a standpoint of the menu items, if you could have an S corporation with a side of 1042, it would be like the greatest dish in the world. So pardon, uh, pardon myself if it's like I'm stretching too much on that, but it, anyway, I think it's, it's exciting and it's interesting, just like really good food. So let's just go with the foundational stuff first. So like an S corporation, first off, an ESOP has to be either an S corporation or a C corporation. I know that's probably something you already know and ESOPs as S corporations, we start thinking about that and S corporation is a form of a business ownership in which the corporation does not pay tax on its earnings, but what happens is it's what we call a pass through, so the owners of an S corporation pay taxes. On the income that passes through to the owners of the stock. And so you, you might already know that, but it's, it's just important to understand that that part of the what how an S corp is, is created and or structured. So what happens is it's, as as corporations go, um, they usually provide a tax distribution. So distributions are not the same as dividends and C corporations. Distributions are, they, they flow like dividends, but they're, they're called distributions because they're money out of the income of the company that comes to the owners. And then the owners can use that money to pay their taxes. If the company doesn't distribute any money at all. which they don't have to. The owners still are on on the hook for the taxes. So that's just a, that's just an aspect of being an S corporation. When an owner sells their ownership interest in an S corporation, they pay capital gains tax on the gain. Now the gain is calculated as the Sale price or the purchase price minus whatever basis they might have. And so, um, in an S corporation, ESOP, a lot of times we're going to end up analyzing the basis or the AAA, which stands for accumulated adjustment Account, which is the tax retained earnings, and we're going to oftentimes try to separate the two and take a redemption on the stock of the ESOP, and then also have a distribution of the AAA. And the reason we want to do that is because we want to get the AAA out sooner than they, and amortize that quicker than the redemption note. So S corporations um avoid this concept of what we call double taxation. Double taxation exists for Corporation, it simply just means that what happens is the company now pays taxes on what income they make. And then as that money flows out of the company, as we talked about the dividend idea, then the individual owner of the Corporation now is paying taxes again, so double taxation. So, suffice it to say that many companies are really better off as as corporations, when you compare them to see corporations. Because of the double taxation, um, and then there's basis issues at the time of selling to as being a C corporation. So just in general, we would normally see companies just be as corporations unless there's some other circumstances that, you know, require them to be a C corporation just on a, on a general landscape, that's just what we see, you know, and I'm saying that when, when I say we, I'm saying our CPA firm and having, you know, a lot of mid-market type clients. Now originally, S corporations could not have ESOPs because a nonprofit. Trust like an Aesop. Um, could not be an S Corporation shareholder. So what happened in 1996-197, Congress allowed ESOPs, um, to for S corporations and so they this got put in a place, legislated, and then it got put in a place effective January 1st, 1998. So ever since 1998, now S corporations have become, have been able to become ESOPs. The truth is that the law provides that any profits attributed to the ESOP's ownership of of a stock in an S corporation are not subject to federal income tax. And so, um, and this, this is also true for most states. So, you know, some states that have income tax will also honor this as well. And when we get to this point and conversating with people about ESOPs, um, and You know, when, when you do ESOPs for a while, you're like, OK, everybody kind of knows that, but not everybody knows that. So just, I'll say it again, an S corporation ESOP does not pay federal income tax. It passes through to the trust and then the trust is tax exempt. So that's a very powerful part of of an ESOP because it adds a significant amount of cash flow back into the equation and it helps the company itself once the acquisition debt is paid off, it helps the company, um, become more cash rich in terms of, of not having to pay taxes anymore. And so it's able to use those additional funds to manage purchase repurchase liability, but also really invest in R&D and growth and everything else. So where an ESOP owns say 45% of the company, just say for instance, a partial ESOP, then in that situation, there is no tax due on the 45% of its income for so for partially owned ESOPs for for S corporations, this tax exemption exists for the percentage that the ESOP owns. So these are all just foundational again as we go as we go through it. Um So, on the, on the um As we said before, on the, the negative side though, um, as we, as we go into this, as corporations do not receive the same tax benefits that Corporation ESOPs do, um, most notably in this is the ability of the sellers of the ESOPs owning at least 30% of the stock in a C corporation to defer the taxation on the gain, which is what we called, um, which is what is called the 1042. So, responding to um abuses of the law by promoters who created ESOPs that provided few if any benefits for other than one of a few well paid people and companies in 2001, Congress enacted provisions that um ESOPs advocates preventing S corporations from operating ESOPs designed to benefit just a few people. So, part of the issue that S corporations have is they have to meet the 409P responsibilities. So that they don't violate the anti-abuse rules. And so that's part of the planning side when you do an S corporation is look at the number of people and test out 409P to see if there might be some disqualified persons in there. And so we've done episodes on that as well. Um, just so that we can make sure that that's not an issue, go, you know, really early on in the process going into it, so. Um, as mentioned, as we talked about, as corporations, um, that have ESOPs do not have to pay federal income tax and the percentage of the profits attributed to ESOP. No other type of corporation has this kind of blanket exemption from taxation. So, um, one of the things that come up are like, well, what else can I do? Can I use something else? And, and the reality is, is that this is very specific to ESOPs and so all the, all the tax benefits that we get into, um, really aren't going to be available in other, in other places. So, Um, that's really just, that's one of the reasons why the ESOP thing becomes such a powerful component because there's really no, there's nothing else to duplicate what you can do from an IRS standpoint. So in addition to that, one thing I should note is that the way that if, if we have a, a partial ESOP or we have a C corporation ESOP, one of the, one of the aspects from a tax standpoint is that you can deduct contributions of up to 25% of eligible payroll in the ESOP to repay the ESOP loan. Um, C corporations, um, do this on a calculation of principal paid, um, while S corporations must include interest as well. So to meet the 25%. Provision what needs to happen is is that you're gonna need to do a payroll census test and really look at um the 25% limitation and see how much your contribution will be each year under that scenario and so that's it that's just an important planning step as well um but the deductibility of those contributions is a very powerful part of the tax equation because you can't deduct principal. On an acquisition debt or any other debt in your company. So that's a very important aspect of um of ESOP specifically for um Uh, for the benefit of creating additional cash flow and um really helping ESOPs become, have this competitive advantage. So other than taxes, there are operational issues that in choosing between a C corporation and S corporation. So we're, as we split through this a little bit, um, I want to just talk about the idea behind some of the issues that can come up. If S corporations are partially held by ESOPs, it's one of the issues that will happen is, is how do you manage the distributions because S corporations have to do a pro rata distribution um on the company's cash flow. So if, if I'm a, if I'm a partial ESOP, then there's privately held members of that ESOP or shareholders. And so if we had um a 20% ESOP and an 80% um non-ESOP company, you would have every time the 80% distributed um tax or tax distributions, um, I'd have to distribute 20% into the ESOP. And so, What we have to do is manage and think and plan through that from a cash flow standpoint as far as how the cash is being used, is it being used to contribute, um, and make the payment for the ESOP. And as we do that, if, if we can if we can do it right, then the distribution issue doesn't become a problem. Um, the distributions for companies that are significantly owned as as corporations can be an issue. So, If you have a high percentage of the, the ownership being owned by the ESOP, then a big percentage of the distributions is going to the ESOP Trust. And so the issue with that is is that the trust itself then can have all of this cash, this excess cash, um, and so we want to manage that as we go through it but wanted to point out that that that becomes a planning item in terms of managing the cash flow. So As we think about setting up an ESOP and an S corporation, um, S corporation owners considering setting up an ESOP, they have the ability to avoid taxation on the ESOP share of earnings as we talked about. The goal of the ESOP is simply to provide a benefit to employees. There may be no reason to convert to a C status, so as we start thinking about. Um, what that means if the ESOP is meant to cash out an owner and the owner does not need or want the tax deferral treatment available to C corporation owners, um, the ESOP can be a, a way as we convert back or we convert to an S and maybe, um, looking at that as, as an alternative in the planning. So, so some C corporations as they convert to an asset, I wanted to kind of point out a few things um where there might be issues there as well. So, where the ESOP owns a substantial part of the company's stock, this can be very a substantial tax benefit, even reducing taxes to zero as we talked about. Um, the first thing is that if we're going to change a C to an S, the election requires the consent of all shareholders. So that needs to be taken care of in, in the board in the resolution, um, to make sure that that was done correctly. An S corporation can only have 100 shareholders, so there's a limitation um from converting from a C to an S, and for many companies, that's, that's maybe not a problem when the ownership is, is held um amongst, you know, um obviously much fewer. Um, for a 5 year period after the conversions, um, the company, um, sells any asset it held on the day of S corporation election, it will have to pay built-in gains tax. So, um, if we convert from a C to an S and then the company sells, we have to, we have to track the built in gains tax. So within that 5 year period, um, there could be additional tax that would be owed. 11 issue comes up that is very common is that they have the Corporation maybe had stayed a C corporation because they were using up their net operating losses over over the last years. Now, now let me just say this on the other side of planning and we have, we have losses from our historicals that might not even be a good feasible lease up anyways because we we need to predictable cash flow. So, but, but just as a point of converting a C to an S, one time, sometimes it's just better to wait and use up those losses before you consider that. Um, one thing to be mindful of is state laws do vary and so some, um, some state laws are, are going to need to be thought through when you're thinking about converting from a C to an S to make sure that your state, um, will have the same benefits that you would have, um, in terms of, of estimating what, what that might really do for the company. Um, and then typically, this is just standardized as corporations usually operate on a calendar year. So if your company's on an off calendar year, that might be an issue when you're starting, when you're starting to think about the, you know, changing your, your business cycles. So that is kind of the overview of like, again, S corps and Corps and I wanted to just to build that as a foundation. So we, as we start talking about some of these other things, we can, we can understand the, the dynamics between the conversion now that the whole point of this is we start thinking about the possibility of what might happen is if S corporations can use the 1042, then the whole idea of converting to a C corporation. Um, and dealing with, say, the built-in gains tax and some of the other things, the five-year windows, um, that all goes away. So that's one of the things I'm excited about, um, as far as the, the aspect of this possibly passing. So Um, recently, uh, Corey Rosen in the, uh, and CEO had written an article called Tax Deferral for Sellers to S Corporation ESOPs included in bipartisan bills. So, um, what he's talking about is, is a bill that is 17, 1770 Senate bill sponsored by Senators Cardin, who's a Democrat out I think Maryland and then Portman, a Republican out of Ohio. And so the, this bill itself, um, incorporates Corporation ESOPs getting the same treatment on 1042 as a C corporation. So, um, he talks a little bit about this bill and just the, the idea of what comes along with it. Um, and there's some 401k benefits to it as well as changing, you know, the idea of how much people can put away, which, which is all very good for, for people and just in general. But as it focuses in on The ESOP community, um, definitely be watching the 1770 bill, um, in terms of, of that. Now, he, he also references the Secure Act 2.0, um, and the, uh, The, the work towards that bill and working towards kind of some of the other stuff they're, they're doing. And I think the point of the point of all that is um looking at from a house, the House of Ways and Means Committee, looking at how important retirement is as we go forward. So I think that I, the, the whole section here as we talk about it is, is that America really does need to plan better for people's retirement. So with all of that momentum, um, one of the things I want to point out with Corey, Corey Rosen is talking about in the article is the prospects of the bill are promising, but still uncertain, and bills like this, he says, do not pass on their own very often. Passing instead really becomes part of a larger must-pass bill. So they kind of tag on these types of things into um larger, larger bills. The Senate plans to take up the bill. Um, after the August recess. So most observers believe that the bill has a very good chance of passing because of its, it's got bipartisan support, which is something we have talked about before and just this idea that the both Republican and Democrats, um, look at ESOPs as positive. And so it's one of those very few things that they actually do agree on. So I wanted to also look at then the Senate Bill 1300, which is entitled The Promotion and expansion of Private Employee Ownership Act. This bill was introduced by Senator Benjamin Cardin, and also by Rob Portman. And we're looking at this bill specifically, um, It is introduced, um, well, one thing that their ESOP associations is thinking that that will happen is there'll be a companion bill that will be introduced in the House of Representatives. So, um, be looking for that. The legislation, um, it really does provide and seek that that businesses will, um, this, this bill will actually expand financing opportunities for S corporation ESOPs. Um, they'll also provide technical assistance for companies that may be interested in forming an S corporation ESOP. Ensure that small businesses, this is interesting that small businesses adopting ESOPs retain their Small Business Administration AA preference when competing for government contractors at all levels. So if you're familiar with the government contracting, we've done, we've done a couple episodes on helping ESOPs as government contractors. Um, but for a government contractor to have the 8A status, what happens is the 8A provides a window of time. So they usually, I think it's 9 years that they get it. Once they get it, then they graduate out of the 8A and they're no longer an 8A. But if you convert your business to an ESOP in the middle of that, then you would be subject to losing that. So if this if this passes, um, that would really help 8As to be considered for the ESOP as well. The bill expands tax incentives and federal assistance for employee stock ownership plans um that are sponsored by S corporations. The bill also um extends to all domestic corporations, including S corporations provisions allowing deferral on tax on gains from sale of employer securities to an ESOP. So that's, that's specifically um identifying the 1042 portion of um the of the ESOP for an S corporation. The the Department of Treasury must establish the S Corporation Employee Ownership Assistance Office to foster increased employee ownership of S corporations. So the government is looking specifically in this bill to provide resources to help companies um look at this and go through this process. So one of the, one of the things I wanted to point out in terms of this is that if you go into, um, look at these bills specifically and want to get more involved and track it, um, I just, I, you know, as I, as I did my research in this, I really just went into congress.gov, put in the bill that you're looking for and just kind of walk it through to see um where it's going and, and right now, those are just been introduced and so. Um, hopefully, and as we start thinking about the future, these things move through and they do have the bipartisan support, but we will be following it and hopefully have good news as, as time goes on through the, through the year. So with all that, I wanted to say thank you again for listening to our podcast. If you like it, please subscribe and share it with a friend. Um, as we go forward to the next episodes, I just wanted to say thank you so much again for, for listening and for being part of this community of, of uh potential ESOPs or existing ESOPs, where, wherever you find yourself, and we look forward to our next step on this journey.