EP32 - Tommy Boy - "A reorg"...what does that mean? Trying to get both the 1042 and S-Corp exemption for ESOPs!

Hey everyone, this is the ESOP guy and we are on a journey to an ESOP. So glad you could join us today. I really appreciate everybody that has, has continued to listen on to the journey to an ESOP podcast. Um, so excited. It is crazy right now, so busy. And as we close the summer and we start into the fall, I will tell you that the pulse for ESOP deals is just getting stronger and stronger. I know I've got a lot going on and a lot of deals want, they want, they want to get closed before the end of the year. And one of the main reasons behind that. is that everybody is focused on the, the increases in potential increases in taxes as if it's a sure thing. So just sharing that little tidbit, I don't know where you are with your plan for your ESOP if you're doing one, this year, but I do, I will tell you that things are filling up fast with trustees and, and firms in terms of getting things done, you know, by the end of the year. This podcast is a really a resource and, and it create, we created this um about a year and a half ago, in order to help companies better understand the ESOP process, seeing that there was really a need. To break it all down. And so that's what the podcast is all about. It's taking the journey to an ESOP, the beginning steps of, is an ESOP right for your company? And it just breaks it down and say, all right, I want to learn more about it. I don't have time maybe to attend every conference, and so I can listen in the car. So if that's you, welcome to the podcast. If you're new and you have an interest in other episodes, please go to journey to an ESOP.com. We are going to kick off this podcast with this. Our new brake pads are really cool. You're not even gonna believe it. Like, um, let's say you're driving along the road with your family and you're driving along, then all of a sudden there's a truck tire in the middle of the road and you hit the brakes. Whoa, that was close. Now let's see what happens when you're driving with the other guys's brake pads. You're driving along, you're driving along, and all of a sudden the kids are yelling in the backseat. I gotta go to the bathroom, daddy. Not now, damn it, re. I can't stop. There's a clip. and your family's screaming, Oh my God, we're burning alive. No, I can't feel my legs. It comes a meat wagon. And the medic gets out and says, Oh my God, new guys in the corner puking his guts out. All because you want to save a couple of extra pennies and to me it doesn't get out. Now This is the, I think one of the most It's the, it's OK. So this is from Tommy Boyd. This is like one of the best scenes of all time, as far as the worst possible sales meeting ever in maybe history of maybe the cinematic history. So anyway, it's Tommy Boy, the episode today is going to be called. Tommy Boy, a reorg, what does that mean? And so we're gonna focus on a thing called the A reorg. And this is really a A selling proposition, I think at the same time, um, what I want everybody to understand is how it works and what's out there and what, what may be pitched to you in a sales meeting, which is in a meeting with an investment bank or somebody that comes in and says that I'll do your ESOP and this is how we're going to, you know, add value to the process. So, And a reorg real quick for those that want to understand what we're gonna do today and, and see if you want to continue to listen to what we have is when you take the company that is already an S corporation. And you revoke the S selection, and then what happens when you revoke it is you become a C corp automatically. Now, an ESOP has to be an S or a C. So you revoke it, you become a C, you, you then use the 1042 election to defer your capital gains or eliminate capital gains as the selling shareholder. Then, The, what happens is then it gets, it gets reorganized as an S again. So immediately after the, the transaction, you're an S, instead of what happens typically is that you have to wait for 5 years in order to get the S selection. Now, the reason that people do that is so you can also take advantage of the Scorp tax exemption. So that your entity that's buying you out is now not paying any taxes either if it's assuming 100% ESOP. So anyway, that's a real quick clip of what we're going to talk about. What I want people to really understand is understand what's behind this, um, and what the opinions are in the ESOP world about this specific type of strategy. I know it's a little bit technical, but if you uh can, can follow on, I think it'll be worth it today to just listen to the whole podcast. So, with that, I just wanted to kind of give a shout out to anybody that Um, really likes the podcast, and if they do, they should subscribe and also help your friend if they are thinking they might, might want to look at an ESOP and share this episode or uh other episodes with them. This might be a little more for a little more advanced for the first person listening to it, but you never know if they start getting more and more involved in ESOP. So, With that, as we start off this episode, I wanted to go back and connect the dots between the movie Tommy Boy. So the whole, the whole movie starts off with this, you know, you have a, um, this college kid who really takes forever to graduate and really kind of forever to grow up. And he's got this really cool dad and His dad owns his own business and basically falls in love with a real mean, scary woman who eventually becomes the, the kid's stepfather, stepmother, I'm sorry. Anyway, so, um, and then his dad dies, which is really tragic. And so now, in order to save the business, um, Chris Farley is the, is the actor here. And in order to save the business, he's got to go and Basically learn the business overnight. And the main thing he's got to learn is how to sell these brake pads. So we go back to our, our scene and this is really him kind of going into a sales meeting with a potential company or client and, and totally just, just not doing a very good job at obviously selling, but he's learning and he's learning and it's, it's hilarious. Um, as he does, because him and David Spader really funny and anyway, so how do, how do we connect the movie to uh what we're going to talk about today. So this idea that you, you as the ESOP are a potential company that thinks about an ESOP. You're going to get referred into all kinds of different people. You're gonna ask questions, say, who should I talk to, who should be my advisor, and all that. And so, um, When, um, when we go into that kind of idea that there's gonna be this possibility that you're gonna get like a, a, a really sharp company coming in and advising you and they're going to be really good at sales. So, so Tommy Boy is not really good at sales, but eventually he does get good at sales. And the point is, is that don't be sold to do your ESOP, you know, and, and all these things I'm kind of saying to you, um, You know, the ESOP is so much more than I, I, I, I've read about it, I heard about it, and then you have a sales pitch and then somebody's coming in and saying, hey, this is, um, you know, this is such a good deal, and you're choosing between advisors and the one advisor comes up with this idea. And then now you can ask some questions. Now the idea and this is going to be um the a reorg and now what happens with salespeople in the, in this space, is there a lot like, um, You know, they're a lot like, hey, I'm going to try to get you to, to hire us and pay a lot of money for us to do your ESOP, which, you know, either way, I mean, if they, if they do a good job and you think it's worth it, then, then that's great. Um, so when I say they, I keep talking about the, the ubiquitous they, um, who are they? And so if you imagine yourself sitting in a, in a boardroom and you come in very sophisticated people sitting around the boardroom or they're, or they're going through their PowerPoint slide deck, and, or they're zooming with you even, and you're like, wow, I don't even know what you're talking about, buddy. Um, you already automatically, um, are gonna feel like, yeah, I should just take their advice because it sounds really good. And I, I don't want you to be that way. I want you to be able to ask the question. So that's what this today is all about is, is managing through the sales process with really smart people that know ESOPs, and how do you make sure you ask the right questions. Now, this is a, this is something that I know it's not just a sales tool, but um when somebody's differentiating themselves as their ESOP advisor, and they mention, hey, you could do an a reorg. Um, I would definitely ask, you know, some questions, but let's go through that. So as we're, we're going to do the, as we're going to do that today, this is, that was really the point of this episode. And a reorganization is technically a statutory merger or consolidation. Now, these are mergers are consolidations that um are part of the normal corporate law. And when you think about a merger, a merger is really just a union of two or more corporations. So that's what what happens when you, when you um put a company together, you're just gonna merge them into one. And so what happens is, is that one corporation retains its existence and absorbs the other. And so that's what a mergers and a consolidation is basically when you consolidate um two or more corporations into one. So corporate radar is a tool and it's used by many businesses to, for a lot of reasons. We, we do some mergers that um when we're, we're kind of rolling up the company and you have maybe entities over here, you know, that are sister companies that are not part of the other company, we want to pull all that together and maybe you have one owner, or maybe you have multiple owners. And so we'll do that and blend the ownership. To make sure it's, it's correct. And, and primarily we'll do that not for the reorg, it's really more for um the purposes of having the main entity that we want to sell with other parts of the company that may not haven't been added. So, So when you, when you think about this. Um, what you're, what you're getting into is now, how do we use something like an like a reorganization or an a reorg in this case, to um try to step into the benefit of having the both the 1042 capital gain capital gains tax deferral and keep the Scorp collection. So let's, let's unpack that for a few minutes so we're all on the same page and this might be new to some people. Um, in the ESOP world, you can only do, uh, you can only sell your company to an ESOP, which is a trust. Um, if you are either an S corporation or a C corporation. So that's the, that's the only two, You know, entities that you can have. So you can, you, if you're an LLC you're gonna, you're going to have to convert that. Um, as an S corporation, the benefit that an ESOP has is that once it's set up, whatever, whatever the ESOP owns of the S corporation is going to be tax exempt. So they're not paying any taxes at that point. If you are a C corporation, you are not tax exempt. You still have to pay taxes, but you can reduce your taxable liability because you can um basically reduce um your income by the amount of the ESOP contribution each year. And so, it's still very, very valuable, but it's still not completely exempt. Now, for the selling shareholder on an ESOP, what they're concerned with is if they are going to sell, and this is one of the things that kind of led off at the beginning, if they're going to sell their business. They're going to have to pay capital gains tax, right? And currently, the capital gains tax is around 20%. And one of the issues that we're seeing coming forward, going forward is, say, that capital gains tax could really go up. And so the 1042 is a way that they can defer that capital gains tax. And, and real quickly, what they're doing is they're going to take what they are selling in stock. And they're going to transfer and do a like kind exchange into a qualified replacement property, so QRP. And so with that, um, because they, they are putting it in a like kind exchange from stock to stock, and then borrowing off of it, they're actually not. Um, receiving the proceeds, they're just exchanging it. So that's how the IRS would um allow a 1042. Now, the 1042 is, is only available for an ESOP, but it's only available for a C corporation without, with the current tax code. So, you really have to be a C corporation and So what happens is, if I'm an S corporation right now, What, what basically I have to do is I have to revoke or get rid of my S selection. And what happens when I revoke it is I immediately default to a C corporation, because um the S corporation, you have to actually elect S corp status when you're a C to become, to become an S. And so you just do the opposite, you revoke it and then you're a C. Now, if I do that, and I do the 1042, the normal rule is that you're going to have to wait for 5 years in order for you to Um, to turn back to an S and have the tax exemption. So you can kind of see what, what we're kind of presenting in this is there's a, I have my cake and eat it too type of uh proposition and, and when we're, when you're sitting in the boardroom and you're being sold that, I wanna, I wanna talk through what it really would look like, you know, having your cake and eating, eating it too. So, if you're with me so far, uh, let's keep going. So, I talked to a trustee about this recently, and I said, hey, how does this all work? And what do you, what's your experience with an a reorg? And what is really happening, you know, so, so the problem is, is that you can't just go flip and flopping back from a C to an S, but essentially, that's what's being sold under the A reorg is that you can go from a C, get your 10 1042, and then flip it right back to an S immediately. And basically, the idea behind it is, is that you, if you merge into the holding company, Another entity. And so what he was talking about is, is one of the way that that he sees this being done, is that the owners have, like, say, real estate in one entity, that's like an LLC over here. And the other entity is their operating company. Now, what we're doing is we're targeting in the sale, the sale of that operating company. So what they're, what they're proposing is, is you do a reorg, you merge the two entities together in a holding company and elect C. And then immediately after that, because you put two companies together, then you can bring that back to an S corp, you know, and then pick up the tax benefits. So that's kind of how he explained it. He kind of said you kind of always have to have, you know, what he saw mostly was like a real estate entity. Well, again, you know, I've been talking about this with some people and different folks all over the country, but I, I will tell you there's, there's a lot of attorneys that are not actually Completely on board with this strategy. So, um, just working through some of that dialogue with them, I'm gonna go through some of their opinions on the structure. So, um, they reviewed the legal authorities, you know, and legal authorities kind of say, hey, we have a, um, we have a private letter ruling or we have some type of legal opinion on this. So, um, that have really, those legal authorities have offered support to the notion that you can create a newly formed C corporation. That would then be the sole shareholder of a current S corporation, merge those S corporations into the Corporation, sell the Corporation to the ESOP, claim section 1042 on the sale, and then immediately after the sale, elect S Corporation status for the Corporation. And basically under those legal authorities, Um, they don't, they don't necessarily stand for the proposition that 1042 treatment would be available in the type of transaction they described. So one of the legal authorities cited this is known as the private letter ruling, which I was, I was alluding to, um, which is a ruling that the IRS um would issue to one party that cannot, can that then could not be relied upon by anyone else, but that really generally reflects the position of the Internal Revenue Service. So that ruling addresses how to apply the rule that says a corporation that revokes its S selection and becomes a C corporation must keep its S status for at least 5 tax years before it can re-elect S status. So this is, this is the general rule. So anybody says um that, hey, I want to take my S and I want to revoke it. I want to be a C, kick the 1042, the normal rule of thumb is under this ruling is that you're going to have to wait for 5 years. The ruling says that you can merge an S corporation into an existing C corporation. And immediately thereafter elects status for the new corporation. The technical holding in that private letter ruling is that the loss of the S corporation status for the S corporation that is merged in the Corporation is not treated as a revocation of S corporation status, thereby triggering the 5 year waiting period for re-electing S corporation status. In the context of merging an S corporation into an existing Corporation. That makes perfect sense and they believe that the ruling accurately reflects the IRS's position on the issue. Because of that private letter ruling, if Section 1042 were not an issue, then they see no reason why an S corporation could not be merged into a newly formed C corporation with the surviving corporation then immediately electing S corporation status. So in that situation, there is no policy reason suggesting that S corporation status should not be available to the surviving entity. Now, the biggest concern here um is that none of the legal authorities cited involved a 1042 election. So all of the things we talked about, um, were not involving the actual 1042 election. In fact, there is another IRS private letter ruling, PLR 199952072, in which an S corporation converted to a C corporation status. The Corporation stock was sold to an NISA. The selling shareholder claimed 1042 treatment, and the corporation asked the IRS for special permission to re-elect S corporation status before the five-year waiting period. In that case, the IRS rejected the request to allow re-election of S status before the expiration of the five-year waiting period. Holding that doing so would circumvent the congressional, the clear congressional intent of Section 1042. So, What is the congressional intent of, of Section 1042 and that intent was to grant tax deferred treatment upon the sale of C corporation stock only to the extent of the corporation is a legitimate C corporation and has been so for some meaningful period of time, preferably at least 5 years. So you can kind of see where this is going. Most S corporations that are going to contemplate this strategy, obviously weren't see corporations for a meaningful period of time. Allowing a C corporation to be created out of thin air. And used to effectively facilitate the sale of what would otherwise be an S corporation to an ESOP in order to obtain section 1042 treatment completely circumvents the purpose of Section 1042. I mean, let's start, let's just pause for a second right there and just hold that. That's common sense, right? When you think about it, right? It's, it's, uh, you know, and I think that. Um, I think that if you, if you just walk that out. And and ask yourself the question, like, yeah, that's exact, the only reason we're doing this or suggesting this is so that the client can have their cake and eat it too. And, and this is why I'm I'm telling you from the perspective of being sold this idea. That, that's, that's, you know, of course, if you can feel like you're, you know, this is gonna, you know, make sense to you, but this is just the details behind it. So this is where I would say, you know, and again, we're gonna go back through some of the details here, but this is where I would say, this is a good opportunity for you to kind of stop and ask your advisor some of these things. So, um, you know, you might want to listen to this episode a couple of times, um, contact us, we can always get you some more details on it, you know, through our website at journey to an EA.com. So, so as we go through that, while others have argued that having a legitimate business purpose for creating the Corporation would adequately address this concern, we believe a couple things, and this is just going through some of the notes that we took, um, that A, this is not an accurate statement of the law, that this would hold up and B, it would be difficult or impossible to prove a business purpose separate and apart from the real reasoning of the establishing the new Corporation, which is As we said, commonsensically, it is to obtain section 1042 treatment. So, kind of, I always say this to clients and we've been working, I've been working at this CPA firm for 21 years. And they want to do something on the, on the tax side. And I always say, look, if you're sitting there in front of the IRS auditor, and they're, they're looking at you, and you're telling them the story of what you did, how will you feel about it at the time that you're telling them? Will you feel good about it or not? And it doesn't even matter to some people. I don't know. But I can tell you right now, it's obvious that this was done solely for the purpose of obtaining section 1042. So based on all this, and talking to the attorneys and different, you know, research that we've done, if someone were to create a C corporation, merge an existing S corporation into that Corporation, sell that stock to a newly formed ESOP, and then re-elect S corporation status immediately after the closing, the IRS would challenge the Section 1042 election or alternatively take the position that the corporation did not make a valid S S corporation election. You know, the question is how soon after the closing with the corporation RXS status will it affect the likelihood of being able to preserve Section 10402 treatment if the IRS were to audit? If the corporation immediately elects S corporation status right after closing, we think there is a significant risk that the IRS would deny Section 1042 treatment to the selling shareholder. So, keep that in mind. If the corporation retains the Corporation status for 5 tax years, We believe there is no risk for the section 1042 treatment of the sale of your stock. If on the other hand, you retain C corporation status for at least 1, but not less than 5 years, it may be possible to argue that the Corporation legitimately existed and that the IRS ruling would not prohibit you from re-electing S corporation status before the end of the 5 year period. And so under this approach, if the IRS were to challenge the structure of the transaction, uh, they believe that there is a better chance, um, that they would challenge the S selection rather than try to take away the 1042 treatment. So, Some of this would just be thoughts and advice in terms of you are going down this ARA reorg route, um, then what is, what's more important, keeping your S selection or keeping your 1042? And now, now, again, one of the things I will stop and say, if you're, you're going to be depending on the people that just sat there and sold this to you, right? The question I would have for the people that are selling it is, where are you guys when all of this comes down? What is the risk and of the advisor who's recommending the strategy? Will they be liable? To you if the 1042 gets revoked or gets unwound and you now have to pay the capital gains tax. Will they be paying less taxes? Will they be there to um help go through the IRS audit? Will there be any um support and, and I'm gonna say most likely not if they're not your CPA firm. And the most likely your CPA firm is the one that's going to have to buy off on this, you know, and do all the, the documentation, but at the same time, they're not even going to be liable when you get down to it. So, Might sound great in a sales meeting, but when you start getting into it, um, you really do need to ask the question, do you want to deal with that type of risk? So going through that, we, you know, the, the loss of status for the corporation would not have a really, maybe a significant tax effect or maybe even inhibit the corporation from being able to repay its debt. Um, so it may be better just to be a C corporation. Get the 1042 and then wait the 5 years. And so under that strategy, the longer you retain the Corporation status, you know, really the better the argument. So, um, there's really no way to know exactly what the minimum period of time that you should retain the Corporation status. I guess the safest bet is the 5 year period. And then flip it back to an S. So when you think about Um, listening to the ESOP advisors and going through this process of evaluating whether or not you should use the AEOg, um, I think that there's a lot of questions there. So, and again, we we covered a lot of ground in terms of some of the technical private letter rulings and just some of the Um, the ways that you might want to ask some very educated questions. So I really hope that that really helps you in terms of honing in on what you, what you're hearing, um, you know, and I think if you get down to it, and you decide you want to do the reorg and you have, you feel like the advisors are steering in the right way, hey, I, that's, that's your choice. You just understand the risk that you have in those. Um, my, my hope is that the people that say, I, if I'd known that, I would have never gone down that road. And so that's really partly one of the reasons I wanted to do this episode is just to kind of point that out. And I do think that people, one of the things that I really am passionate about with this podcast, is that I, I would like people that are thinking about ESOPs to as a selling shareholder, as the leadership team to be far more educated. On how these things work. And I feel like when you hire somebody to represent you and you, and you really don't even understand what they're doing, but you're like, OK, that sounds good. And they, and they tell you, hey, we're going to sell, we're gonna give you the benefit of the 1042 and you'll also get the benefit of the S selection, um, or whatever they're selling the thing on, I think you're just in a position where you have to make a good a good decision. Um, but I would suggest that some people Um, unfortunately, use the information that they have to their advantage. And what I'm hoping with the podcast is that you have the information that you need to ask the right questions of the advisors that are approaching you. So, with all of that, uh, thank you so much for, for listening today. This is a Friday, so we got a big weekend coming and excited for that. Look for our next episode on um the ESOP Guide journey to an ESOP, and have a wonderful weekend and we'll see you next time. Thanks.