EP34 - Office Space - An analysis on ESOPs as C-Corps

Hey everyone, this is the ESOP guy and we are on a journey to an ESOP. Today is a one of those days. It is my birthday. So, yes, I'm working on my birthday and I have to say that I actually enjoy doing the podcast and it was one of the things I was looking forward to. I am actually working all day today and have several things happening. I have to go to a company today to, to roll out an ESOP that we're, that we are in process of creating, so that's going to be exciting. So anyway, we are on this journey to an ESOP. This podcast is a resource that we've created to help you determine whether or not you want to use an employee stock ownership plan in your strategic plan of, of succession and exit. So hopefully, um, if it's your first time, um, hopefully, you know, if you have an interest in this, you will go further and look at our website at journey to an ESOP.com and find all of our episodes. If you have been on this journey with us, I'm so happy to have you and, um, just again, continue to, to, to share the time together. So with that, um, 11 thing I would, I kind of point out as we get started is if you are contemplating a succession and exit plan. Um, there are a lot of resources and so I'm I'm happy that you're here. Um, there's a lot of associations that you can kind of check into. Um, what I like about this podcast is it does provide maybe more of an objective opinion. I like to think I'm objective about the ESOP world. And as you do enter into getting more and more information, Um, I do, I do really hope that you asked good questions. And so a lot of the episodes that we have done have been to really help you determine what those questions might be and making sure that you select the right people to help you with your ESOP journey, so. With that, I want to start off this episode with this. Uh, when he was speaking Hello Peter. What's happening? Uh, we have sort of a problem here. Yeah, you apparently didn't put one of the new cover sheets on your TPS reports. Oh yeah, I'm sorry about that. I, I forgot. Yeah, you see, we're putting the cover sheets on all TPS reports now before they go out. Did you see the memo about this? Yeah. Yeah, yeah, I have the memo right here. I just, uh, forgot, but, uh, it's not shipping out till tomorrow, so there's no problem. Yeah, if you could just go ahead and make sure you do that from now on, that would be great. And uh, I'll go ahead and make sure you get another copy of that memo. OK? Yeah, I have the memo. I got it. Hello. All right, totally classic scene. You have to know this. Um, the title of this episode today is what is in your Office Space? Corporation ESOP tax, not in the TPS report. So what this is gonna be about today, if you want to continue to listen, is we're gonna talk about C corporations and we're gonna talk about just tax in general. And um so I think it's important because we do talk a lot about S corporations a lot. We talk about the, the exemption that the S Corporation has for an ESOP, and I, I wanted to take a little time and go deeper into just to see Corporation and, and what, what that entails. So with that, if you um do you like what you hear, please subscribe to the podcast. If you think it might be helpful for somebody that you know, please share it with a friend and let's get started. So the, the movie itself is the office space, as we've Um, kind of leaned into a little bit. It's one of those movies that I would say is like, you might disagree with me, but it's like kind of like Princess Bride or Nacho Libre or um Napoleon Dynamite, which is like movies you can watch a million times, um, they don't get old. Maybe that says something about my intelligence, I don't know. I just think it's funny. So, um, it does, though, this movie specifically does help us all appreciate our jobs, I think. And I think it just keeps us, that's one of the reasons we keep watching this kind of movie. It's like, oh, it just makes me think of, you know, how, how good I have it, I guess. Peter is the main character in this movie. He is not a motivated employee and the office culture is ridiculously terrible. Um, it's one of those big, big companies that, you know, it just kind of starts to, everybody just starts to exist. They don't really, you know, they just do their thing and they act like they're working for the most part. Um, so it's really about that. And what I like about using the office space today is that I think it does. And this isn't really what the, this podcast is gonna be about today, but it, I think it does give us good reasons to all appreciate. And think about and like the idea of ESOPs. And what I mean by that is that ESOPs, because you're selling your company. To the employees. ESOPs are generally a great motivational tool, you know, that could take a good culture and make it better. It also they an ESOP company really protects people from these kinds of work environments, which I am a believer in philosophically that any large company that gets bigger and bigger and bigger, ultimately becomes like the office space. That's why it's such a funny and popular movie is because it exists so much in in corporate, in the corporate world. So instead of selling your company to a behemoth company, that really doesn't um exist for any other purpose but to make money. Or to a private equity group, which is really kind of the same thing, which is a, you know, going to have this big roll up design. The ESOP allows a company, if the selling shareholders choose this path, to stay certain size and to and to and to keep a culture that I think is, is wonderful and and good for people. So partly I wanted to, I wanted to play the office space because of that, but also it kind of makes us think about the corporation in general. So we're going to do a segue into The corporation and then we're gonna, then we're gonna get into the C corporation discussion. So I, I thought it'd be interesting to kind of talk about what uh just because definitions are important, what exactly is a corporation. A corporation is a legally distinct entity that has many of the rights attributed to individuals. These rights include the ability to enter into contracts. Take out loans, sue others, be sued, own assets, pay taxes, and so on. A corporation is formed when individuals exchange consideration, usually in the form of cash for shares of the corporation, which in turn creates a right to a portion of profits. Generally, the losses incurred by a shareholder of a corporation are limited to the amount invested. This concept is known as limited liability. Limited liability allows individuals to avoid personal liability for a business entity's losses. Thereby allowing risk averse goals. Thereby allowing risk averse individuals, I'm sorry, to assume risks that they otherwise would not have undertaken. Corporations also allow individuals to pool resources to achieve goals that would be unattainable by a person acting in an individual capacity and can last longer than an individual's lifetime, so they can keep going, transcend beyond the individual. So the benefits of a corporate form are also, they also um Basically provide this place where, as we talk about ESOPs, um, that these shares can be owned by other people, and those shares have value. So, um, I'm going to borrow some information from an article entitled A Brief History of the Corporate Forum and Why It Matters by Tyler Halloran. Um, this was written back in 2018, but I think it's just interesting history. So, I'm taking parts and pieces of, of the history because I think it's important to, to think about where corporations came from. So this is called the development of the corporate form. The roots of the corporate form can be traced into antiquity. Early notions of limited liability when the corporate form emerged from economic arrangements that mirrored the concept of limited limited liability offered by modern corporations. One such arrangement was the Commenda, a system developed in the 11th century Italy, wherein a passive partner provided funding for a merchant vessel to be sailed by a managing partner who invested no capital. Upon completion of the voyage, the partners divided up the profits under a predetermined formula. This arrangement allowed the passive partner to limit his or her liability of their investment while the managing partner assumed the risks associated with the cargo and the voyage. This makes me think of um the Moby Dick book, if you ever ever read uh read Herman Melville's Moby Dick. So soon investors began pooling their funds to diminish the risk of losing their entire fortune on a single voyage. In doing so, the investors realized the benefits of pairing limited liability with diversification. So the development of the joint stock companies in the 1600s, um, through the British Crown began granting monopolies to groups of investors willing to undertake certain ventures. These monopolies took the form of joint stock companies that allowed labor and capital to be aggregated for the purpose of undertaking tasks that would be too large for any one person. A famous example of this was the East India Company, in which investors pooled capital into a single joint stock company from which profits would be distributed according to capital invested. Only members of the East India Company had the privilege of conducting trade with India. So, obviously, that creates issues because then you completely eliminate competition, but this is kind of like the development of how corporations, you know, um, as they went through it. In Alexander as they went through history, I guess, in Alexander Hamilton's second report on public credit, he argued for a federally chartered national bank to help provide centralized direction for the financial sector. The bank was soon established thereafter in his report on manufacturers, Hamilton argued for a comprehensive federally backed plan to expand public works, which was now immediately accepted. So in later years, the government would embrace its ability to direct industry through the creation of industrial corporations. So this was the foundation of corporations in America. A famous example of this was the chartering of the Union Pacific Railroad and other railroad companies for the purpose of constructing. Um, the Transcontinental railroad. So emergence of truly private corporations through the 1800s and particularly in the late 1800s, corporations began to shift away from the strict limitations of their legislature approved charters. This shift was illustrated in 1896 when New Jersey passed a statute allowing corporations to find the scope of the charters themselves independent of the government. So then this became the the impetus for corporations and, and then we get into some issues. So for example, John D. Rockefeller's Standard Oil Company came to control 90 to 95% of the oil refineries in the US, um, and this basically, um, was great, but then it created major problems. So, um, What happened was the um journalist, um, Ida Tarbell exposed the nefarious methods used by John Rockefeller to push out honest competitors. And so they were able to do is, is shift, so then basically control everything just like, like um the monopolies of what we talked about earlier. So then the Sherman Antitrust Acts, you know, were legislated in order to control and create more competition. Um. Then basically, after all this, as corporations developed, um, the Great Depression happened and the abuses of corporate form, which caused the 1929 stock market crash led to a passage of Securities Exchange Act of 1934 under President Franklin Roosevelt. So I think all this history is important because sometimes we just say, hey, we're, you know, we're a C corp or an S corp. How did we get here? How did we become all that? So what this does is it kind of illustrates in pockets, um how we've come to create really um the concept of what a corporation is. And what this does is it helps us to learn several things. The historically, corporations have had a vast impact on our economic, political, and social relationships. Um, this is a phenomenon that will likely continue into the future. Corporations have the beneficial capacity to facilitate large scale risk intensive endeavors that would be impossible for individuals or governments to achieve. And then third, the opportunity for abuse in the corporate form may be inappropriate cases call for government regulation to ensure that corporations serve legislatively defined social interest, societal interest. So, That being said, that applies also to ESOPs because ESOPs were a legislative creation that happened that was able to take the ownership of these shares and move them into a private, um into retire retirement shares for on the behalf of employees. So, really nice quick overview history of of how corporations started. So as we focus now, the idea behind C corporations and when we think about C corporations, um, we, we understand these to be companies that um are entities of themselves and they're really not what we call, they're the opposite of what we call pass through entities. So C corporations were for a long time, the only thing you could be. And it's interesting when, you know, in our practice, our CPA practice, what we found is mostly because we operate in the mid-market section of the of the economy, um, most of our clients are S corporations, and the reason is is because C corporations for mid-market companies just are not very desirable from a tax standpoint. And so when you do find a C corporation, you just wonder, OK, what, basically they, what was the story behind it, why they become a C, why are they still a C? Um, because of the, of some of the issues that we're we're going to get into. Um, but if you are a C corporation and moving towards an ESOP, I will say you have, you have the benefit of being able to con of using the elections that are available to you with like say 1042, and then convert immediately into an S corp. I think that's a strong advantage. So if you are a C corporation and you're thinking about being an ESOP. I think I'm just gonna give you an applause because you've put up with all the other stuff going through. You know, um, the history of not really probably should be, you know, uh, a C corporation. So, um, so having the Corporation, it gives you the ability to use the 1042, and the 1042 really is this idea that you can actually defer your capital gains on the transaction. Mm So, um, what that means is you can, um, you can basically set up a qualified replacement property when you actually sell your stock to this, to the ESOP. And what happens, and I'm not, this is really an episode not on the 1042, so there's, there's other episodes we've done. A lot more of a deep dive, but just a quick overview. What's happening is, is that um if you own a Corp, um you can basically defer the capital gains on the stock that you sold to the ESOP. And you have to, you have to basically sell at least 30% of your outstanding shares, and the seller must roll over money to um certain securities, which is the qualified replacement property. The rollover must occur between 3 and 12 months after selling the ESOP stock. There's a cost to this tax advantage. ESOP sponsors must have their company um stock valued by an independent appraiser to establish fair market value of the stock. So basically, in an ESOP transaction, that's going to happen anyways. And what happens is, If we take it into numbers, you, if your stock was worth a million dollars and you had to pay $200,000 of capital gains tax on the sale, that $200,000 now gets deferred. And so you keep the whole million dollars in the QRP and $1042 allows certain structures that you can then create these floating rate notes off the million dollars. And, and secure that QRP with a 10% of the total balance and then pull out the $900,000 through floating rate notes. So real quick snapshot on it, on 1042, so with the Corporation, you get to use that. So, but looking at the Corporation, really there are two layers of taxation that exist for C corporation income, one at the corporate level and another at the shareholder level. So for businesses that are not C corporations, an analysis is usually needed to determine whether it makes sense to convert to a C um prior to the sale to enable the owners to save the capital gains tax. So, see corporations sales generally involve a conflict between the objective of the seller and the buyer as to the legal structure of the transaction. Sellers typically want to sell corporate stock to incur only one layer of tax at favorable capital gains rates. On the other hand, buyers want to buy assets directly from the corporation to qualify to allocate the entire purchase price to assets and enhance the step up and the tax basis in the assets which can be deducted by the buyer, increasing its investment return on the acquisition. So the second layer of tax inherent in an asset transaction, however, usually makes it extremely expensive for the seller. If the buyer is willing to buy stock and forego the step up benefit, it usually will do so only after discounting the purchase price at least in the amount of this of the foregone benefit. So the ESOP structure allows to the, the seller to avoid the stock asset conflict. So as it involves a friendly buyer of stock, not assets, so, so as the trustee buys the company, they are buying the stock and not the assets. Now, in addition to that, the shareholder level benefits, the corporation itself will qualify for post-transaction income tax benefits, which vary for C corporations. Um, but so for starters, the tax law allows certain deductions that are exclusive, exclusively available to ESOP owned sea corporations. This includes the ability to deduct ESOP contributions to fund the entire purchase price of the transaction over the life of the ESOP loan. So we'll talk about this in a few minutes, but just basically, Um, that deduction is partly because you can deduct retirement contributions. So we'll, we'll get into that in a second. And then secondly, reasonable dividends paid to the ESOP. So those two can be deducted from their taxes. The limit on Corporation ESOP contributions is generally 25% of payroll for employer contributions. So when we're analyzing the, the actual deductibility of the contribution, one limitation has to be how much payroll the company has. And we're only then allowed to take 25% of that payroll on an annual basis. And so what this does is it helps us to frame out the actual what we call the inside note for the company between the ESOP and the company. And so that then dictates the amount of, of deduction we're gonna have based on the contribution we're gonna have every year. And so, for an ESOP that buys a C corporation, now the, the opposite is true like the concern here for an S corporation is completely different. So if we have a 100% S corporation, it doesn't even matter anymore what's deductible because all of the, all of the income of the entity is exempt. So that's why, um, having a C corporation. As an ESOP is um favorable from the seller side, but from the company side, they're still going to have taxes that are going to be owed. The taxes are going to be um reduced because of these two deductions that we just mentioned, the contribution each year and the dividends that are paid to these uh. So when we, when we go through this, um, the one thing I wanted to point out is that the amount of the annual ESOP contribution, which is found in the note between the ESOP and the company, or the note between the company and the shareholder, this amount is based upon the amortization that's going to be deductible and should be calculated as part of feasibility. So this amortization um is really determined by a couple of different factors. One is how much stock do we want to go into the participant accounts and how soon. Now, this is a negotiated um issue in the with the trustee anyway. So, but what we're concerned about is, is we want to make sure that that loan that dictates the amount of stock that's released every year is long enough to make sure we're not putting too much stock in those accounts so that we can avoid repurchase, you know, high levels of repurchase liability. And secondly, so that we can help to make sure that we've created a long term. strategy behind the employees owning stock over a longer term period so that they don't get too much too soon. And now you have an issue of, of retaining people. So that loan um that we, that we're going to create in the process of creating the ESOP is going to be important. Um, to establish, um, how long that needs to be. So, so as you as you go through that, one of the things that we'll do early on that your advisor should do is you should be putting that into the feasibility study and asking the questions based on the deductibility. If you're a C corporation, what's the deductibility of that contribution? And what would be then the net impact of that deductibility on the cash or then the remaining income of the company? That then is available, um, of course, to then service the acquisition debt, which really the biggest part about planning ESOPs is, is how much cash are we gonna have available based on the valuation that we're going to end up negotiating with the trustee, how much cash flow will we have available to service the debt. And so that's really important when you're doing the analysis and that's why understanding the deduction on that, on the Corporation is really important. So for both C corporations and S corporations, the enhanced cash flow from tax havens can be used, like I said, to repay the acquisition debt. Um, one of the strategies that exist out there, which I did my last podcast, this is season 2, episode 32 of, it's called the A Reorg, basically says that you can take um an existing ass, flip it to a C, and then flip it back to an as immediately. So listen to that podcast because there's all underneath what I'm saying right now, if we could avoid having to be taxable at all, then that would be great. But if we, you know, and, and really the podcast on the reorg is really about, you know, is it very, is it really viable? So listen to that and ask the question, um, you know, if, if you would be comfortable going through that strategy, but it's definitely something that um I think it's important to, to really consider. So, um, and we, we talked about this a little bit, but um what happens is that the, the reason that we can contribute and deduct those, the contributions for the ESOP are really based on the fact that the corporation itself is contributing to all the eligible employees. So this is, this is just kind of to make mention of, of the role of the Department of Labor. So generally, you must contribute into the ESOP accounts of all full-time employees at our age 21 and older and have at least one year of service. Um, or it's 1000 hours. This differs greatly from some employee stock option plans, which favor really just key executives. Um, that the, the contributions are made equitably, plan sponsors make, um, may make contributions either as a percentage of salary or an equal dollar amounts to their employees for ESOP accounts and permitting employees to vest. Federal law guarantee guarantees plan participants assume full ownership of stock in their accounts over time. There are And I've done some episodes on, on plan design, but there are really two vesting strategies. One is you gradually vesting or graded vesting, and the other is what we call cliff vesting, but it's, but basically you have to allow the employees to vest. Um, now, as you know, as we go through that, you need to understand that this is the reason why. Um, and this is something to identify early on that your company is is becoming an ESOP for the first time is going to want a very qualified third party administrator to make sure all of those contributions are done in accordance to the plan document, so that you don't jeopardize any issues with the Department of Labor. So now we're going to finish off the episode with a discussion on a, I don't think it's not, I think it's a not so well known tax code for C corporations, and it's called 1202. And again, if your company is, is a very large company, then this is not going to apply to you. So this is going to be, this is going to apply as a benefit for C corporations now selling to an ESOP or selling to anyone really. Um, and it does not require the use of 1042. So you may look at 1042 as a C corporation selling and say, you know what, it's, I don't necessarily want to do all the um investor type of setup that's gonna, that's gonna be necessary and require extra some costs and everything else to defer or eliminate capital gains. So if that's you, then this 1202 might be something that you want to investigate further. I'm gonna give you kind of an overview of it, but definitely something to talk to your tax um advisors about. If you um look at that, and if you have questions about that, just go to journey to an ESOP.com and, and shoot us an email on the how can we help section? We can always go into it a little bit deeper. So 1202 is applying to a taxpayer who might be able to exclude 50% of the gain from their disposition of what is called qualified small business stock or QSBS. This has to be held in the business for at least 5 years. Now, if the stock was acquired after February 17, 2009 or before September 28, 2010, a 75% exclusion applies. If the stock was acquired after September 27, 2010, the exclusion rate is 100%. So that's um going to increase the actual exclusion of what you can actually get on the normal um 1202. The amount excluded will be capped though at a greater of $10 million in aggregate for all sales. Um, such issuers, all sales of such issuers of the qualified small business stock by the holder, or 10 times the adjusted tax basis of the QSB stock of such issuer disposed by the holder during the tax year. Now, there are 5 requirements that must be met in order for the stock to meet the definition of what we call qualified small business stock, and the first is, The stock must have been originally issued after August 10th, 1993. So this actually happened where I had a client who um had issued their stock, you know, prior to 1993. So again, that's a good long ways away, you know, historically, but um so anything before 1993, that would not be allowed, so to be using 1202. 2nd, the issuing company must be a domestic C corporation that is not a disk. DISC is Um, an international company that uses, um, um, a sale, I said domestic international sales corporation that basically is set up for international exporting back and forth, um, so that is not, they won't qualify. The stock must have been acquired by John, or I'm sorry, by an original issuance in exchange for money, property or certain services performed. So the stock originally issued with a certain window of redemptions or reissuances by the corporation may not qualify and stock received by gift bequest or in a partnership distribution may qualify if the stock was originally issued by the company to the transfer. Um, the company must be a qualified small business. So here's, here's the company's size. The corporation must have an aggregate gross gross assets of $50 million or less at all times, on or after August 10th, 1993 and before the issuance of the stock for which the exclusion is sought. Second, immediately after the issuance of stock, the aggregate gross assets, including amounts received in the issuance of stock, must not exceed 50 million. Third, all corporations which are members of the same parent subsidiary control group are treated as one corporation. Note that a parent need only to own greater than 50% of subsidiary under this code section. OK, the next thing is the company must conduct an active trade or business. So it means um that they actually have to be in business, right? At least 80% of the assets are used by the corporation in active conduct or one or more qualified trades or business. Um. Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or where principal assets of the company business, um, is the reputation or skill of one or more of its employees. So hopefully that, that um allows for you, including the other ones are going to include banking, insurance, financing, leasing or investing, farming, oil and gas related businesses, hotel, motel, restaurant, or similar businesses. No more than 10% of the company's assets by value may consist of real property, which is not used in the active conduct of or qualified trade of the business. So in case they're dealing with a lot of rental properties. So, again, I gave you a good snapshot of the code section of 1202. I want to expose you to that so that you can ask the questions. If you're a C corporation, is that something you would want to use in your sale for your ESOP? So again, if you have questions on that, please email us, email us at journey to an EOP.com and we'd be happy to um get on the phone with you and walk through that. Um, or walk through anything else with you. So, the, um, so this whole section today was gonna be how, how does C Corps work as an ESOP. Um, we briefly touched on the 1042 and we briefly went through, um, the idea of the Department of Labor requirements of, of the deductibility of the contribution and when we went through the idea of actually using a 1202. So, hopefully, that really helps you today in terms of your, on your journey to an ESOP. Um, You know, I would just say at the end of all this, again, I'm really, really um excited to be, you know, part of the ESOP community and thank you so much for listening today. Keep on keeping on. We'll see you next time on this journey.