EP35 - Bill and Ted - Face The Music of 409(p)

Hey everyone, thank you so much for joining on the ESOP Guy. We are on this journey to an ESOP. So this podcast is for those that are thinking they might want to consider an ESOP. And if you've been continuing on this journey to an ESOP with us, I just want to say thank you for those that are just. Very, the very first time listening, I'm just saying, wow, how'd you find this and great that you're here and wanted to explain a little bit about the podcast. It is designed as a resource to help answer questions for folks that are thinking they may want to consider an ESOP um employee stock ownership plan for their business. I have been able to through the podcast interview a lot of different types of professionals, um, that includes independent trustees, ESOP attorneys, banking, uh, lenders, of course, bonding companies, insurance companies, just a lot of different varieties. So there's a lot of interviews that are on the podcast that you might want to check out. You can go to our website at journey to an ESOP.com. And in addition to the interviews, there's a lot of different topical discussions like what we're going to do today, that might be helpful to dig deeper into a certain topic like warrants or uh today's topic is going to be specifically related to the IRS and some section codes. So go into that, that website and check those out if you have an interest and again, thank you for, for joining and listening to this podcast. So today, the title of today's episode is Bill and Ted's Face the Music 409P. This episode is designed to discuss the issues related to 409P questions related to disqualified persons for S Corporation ESOPs. So we're going to answer the questions of what does it mean to be a disqualified person under 409P? and what does it mean to be too small of a company to become an ESOP company. And so these are very helpful, or they should be very helpful questions for you as you're thinking about whether or not your business is a good fit. As always, if you like what you hear, please subscribe to the podcast and please rate and review the podcast as well. It really will help our other listeners or those that are checking out this as a resource to determine whether or not this is something they want to utilize. And also, if you think it's helpful, share it with a friend. So if you recall from episode 19, and you can always go back and look at that one, that was titled, that podcast was titled Bill and Ted's ESOP Adventure. Now, Bill and Ted at that point had combined their two companies and they sold the entire thing to a police stock ownership plan in ESOP. And I have to say it was totally awesome, but now they have an issue because they did not realize that their company violated 409P by having disqualified persons. So here are some of the facts of this situation of the case itself, so we can better understand 409P. The IRS had found that the company, which is named Be Excellent to each other, um, which was an S corporation, sold 100% of their ESOP, or 100% of their stock to an ESOP. At that point, they had 1000 shares and the transaction was done on 1231, 2019 for a $30 share value price. When they sold the company to an ESOP, they had 3 employees. There was Bodie, Bro, and Brenda. And when tested, Bo, Bode's account had 800 shares of the ESOP stock, and it was valued at that time at $24,000 and that was the equivalent of, for him, 80% of the total ESOP shares. Bro's account had 140 of the shares, and it was valued at $4200 and he had a total of 14% of the total ESOP shares. Now, Brenda's account had 60 shares and she had a value of $1800 or and she also had a 6% total of the ESOP shares available. And so there was only 3 employees in the plan. And so the plan year of 2019 is deemed now as a non-allocation year. We're going to get into definitions in a minute and, and there is a prohibited allocation for the company at this point in time. Now, the reason that is, as I go, I'll go into it is because we had. Disqualified persons, which owned more than 50% of the total equity of the company. And we had individuals that owned more than 10% because they each owned more than 10% of the ESOP stock. We had an occurrence of a non-allocation year and a prohibited allocation. What happened in this case is that then there's a consequence of, of that. So we're, we're in this 409P test and they've failed. And the consequence is, is that Brody's income of $24,000 and bro's income of $4200 is going to be taxable. Um, because each of them have 10% of the stock or in excess of 10%. So in this case, Body had 80% of the shares and Bro had 14%, because Brenda didn't have an excess of 10%, she was actually less, um, and didn't have that, the taxable income for what she received. So in addition though to that, be excellent to each other, S Corporation now ceases to be an S corporation and owes 50% excise tax on the prohibited allocation. So, we have a major issue. And one of the things that, that as I bring this up, we know one of the reasons we do ESOPs for S corporations because of the tax exempt status that they get. And so the issue is, Now, once you don't have that tax exempt status, and we don't have that additional tax cash flow, we actually owe the government back the money and it becomes a real big um a big problem. And so now Bill and Ted are faced with this and they are beside themselves and they both are like bogus, dude. So let me start off with this and I, and I gave you the, the case study, we're gonna go into another one, but I wanted to get you a little bit deeper into the concept of what is 409P. And I purposely started off with Bill and Ted because when we start hearing the word, the, the letters or the numbers 409P, we immediately wanted to shut the podcast off and move on. But I, I got to tell you as a listener of this podcast, this is a very important episode for you to listen to. And you're, if you can bear with me for a few minutes, I'm going to give you some explanation of what foreign IP really is, and we're going to go back into um our case study. So beginning in 1980, 1998, Congress allowed S corporations to be owned by an ESOP trust and exempted the S corporation um from unrelated business income tax and it's called UI. Under Internal Revenue Code section 5123, which doesn't matter but just knowing where it comes from. So the intention was for the rank and file for an ESOP to give the rank and file employees a meaningful stake in the S Corporation. So after the 1998 change in this legislation, there was a surge in new ESOPs. However, there was a surge in abusive taxpayers' use of this new provision, because it wasn't, it wasn't affecting what the IRS had wanted to, which is to have a meaningful stake, the rank and file have a meaningful stake in the company. So in 2001, Congress added Section 409P to the IR the Internal Revenue Code. To contain rules that ensure this tax advantage benefit to a broad group of rank and file employees of S corporations. And so it's typically deemed this anti-abuse rule and that's where, that's where this comes from. So the purpose of Section IR Internal Revenue Code Section 409P was anti-abuse compliance test to ensure that an S corporation ESOP is providing broad-based coverage that benefits rank and file employees. It is a very complex test that must be passed every day of the plan year, and penalties are so severe that failing this test is not a practical option, which I kind of got into already with the Bill and Ted episode. The way that 409P works is this. Under the deemed owned shares of the ESOP, there may not be allocated directly or indirectly for the benefit of any disqualified person if at any time during the plan year disqualified persons in aggregate own 50% or more of equity of an S corporation. So what we do is we start looking at definitions at this point and say, OK, what we need to do is understand and identify what disqualified persons are as really the first step of understanding 409P. And the second is to determine whether or not they own at least 50% of the total equity. So one confusing point is, are we talking about the total equity of the company or are we talking about the deemed shares? Of the ESOP. And so, under the second step, we actually are testing 50% of the total equity of the S Corporation. Now, as I alluded to, and we're gonna kind of repeat this so, so we can really understand the concept behind 4019P. What that does is if you do fail this test at any point in time, There is a deemed non-allocation year for your ESOP. A a non-allocation year occurs. And the result of that is that the plan loses its election exemption from taxes, which I said would be very problematic because we built all our models on having S corp cash flow back into the model, so we can pay the debt back and we can also do other things. And so it loses at selection and the disqualified persons are subject to taxes, and the employer is now subject to 50% excise tax on the value of shares allocated in a prohibited calculation. And so, that gives you the detail behind it and so I wanted to make sure you had the, the understanding. So if we go back into our example with Bill and Ted, They are, and I left them off at, hey, this is bogus, dude. They're pretty upset that they're gonna have a problem. So because they have a time machine. They can go back in time to fix the problem. So, in the past, they go back in the past and they restructure the company. Now they have 20 employees instead of 3, and they, they do this by expanding and acquiring other, they acquire other companies, and they expand their revenue and they do things that that actually increase the number, the need for employees in the, in the new business that they've they've restructured. And then they sell to an ESOP to avoid having anyone own more than 10% of the shares. So now in this go around, the S Corporation, still called Be Excellent to each other, has now 900 outstanding shares for our new example, now of which 100 are owned by Bill and Ted respectively, and 700 of these shares are held in an ESOP. So those are the deemed ESOP shares. Bill and Ted also have warrants. We're gonna make, we're gonna make the connection between warrants and the con the concept of synthetic equity at this point because any synthetic equity is going to be considered under 409P as part of additional shares. So they have warrants that have equivalent of 100 shares each. So what that's going to do is going to include for both Bill and Ted, combined ownership of, of be excellent to each other of 200 shares. So, they're going to be tested with both 100 ESOP shares and 100 synthetic equity shares based on the warrants. As we get there, that'll start to make sense because I'm gonna do all of the math, so it's hopefully very straightforward. Now let's turn to the employees of be excellent to each other. So we, now we look at the employees and we have of the employees, of the 20 employees, we have Brenda, who has an ESOP account with 65 shares. And her husband Bro, who has an ESOP account with 65 shares. Now, they also have a son in the business who's named Biff, and he owns 14 shares. So when we look at it, we go back to Bill and Ted, both Bill and Ted own 100 of the 700 ESOP shares, or they have actually 14% of the ESOP shares, which are now going to deem them as disqualified persons. And individually, Brenda Bro and Biff have less than 10% of the total ESOP shares. However, because they are related and we get into disqualified disqualified persons, we're going to have to ask, we're going to have to also answer for their family members. And so the ruling of foreign IP is that related party members or family relationships, we're going to aggregate all of their ownership with the ESOP shares and they are not allowed to have an excess of 20%. So when I do the math, I have 65 shares for Brenda, 65 for Bro, and 60 and 14 for Biff. When I divide that by 700, I get 20.6%, so they're in violation of that and now they are deemed disqualified persons. So, As a result, now I have to test the entire 900 shares of the plan to determine whether or not they have more than 50% ownership. So as a result of the disqualified persons, which are Bill, Ted, Bill has 200, Ted has 200, Brenda has 65, and Bro has 65, and Biff has 14, I'm going to have a combined number of shares of 544. And when I divide that by 900 shares of the total equity of the S Corporation, I'm going to have unfortunately 60.4%. Now, we're back to the same result that we talked about before, which unfortunately is that we're going to have taxes that are owed by each of the disqualified members because we have a non-allocation year. We're gonna have an a revoking of our Scorp election. So we're gonna lose the Scorp election and the company is now gonna owe 50% excise tax on the prohibited allocation. So, Unfortunately, even though they could go back in time, they didn't understand 4409P enough to understand the family member issue that they had. So both Bill and Ted at this point are like so unhappy with the IRS. Now, how many times have we all been unhappy with the IRS? And it is what it is, but they were like, look, this is most heinous. So now, they decide to go in the time machine. And they go into the future to consult with none other than the ESOP guy, and he tells them the following related to the definition of disqualified persons for family members because one question they're like, who is a family member? And the ESOP guy tells them that, hey, a family member is going to be the following. It could be either one, the spouse of the individual that works in the company of both work in the company. 2, an ancestor of lineal descent of the individual or the individual spouse. 3, a brother or sister of the individual or of the individual spouse, and any lineal descent of the brother or sister. And then for the spouse of an individual described in item 2 or 3 above. So, Basically, let's test it, but it's going to cover a lot of different family relationships. And so they realized in this process that obviously, they violated 409P because of the relationship Brenda and Bro had and they had a son named Biff in the company. So the ESOP guy gives them some other advice on 409P and then does some other work for them and they go back in time again to restructure the company, so that they are large enough to do an ESOP and deal with the family relationships. Now, in our fictional example, unfortunately, they accidentally caused Brenda not to marry bro, and then, because then that happens, Biff is actually never born. So, but all that's good because it helps get the ESOP done. And they live happily ever after, and they don't have a 409P violation. So, so with that, um, I hope you better understand the 409P. What I'm going to do is end up with a few things I wanted to comment on, um, as far as suggestions, if you have a 409P um issue or think about it. You know, for us, as we look at this podcast, A lot of it is about planning and so the first steps of planning are really to understand what 40 IP is and make sure that you're asking your adviser how they've looked at it and make sure that there wasn't an issue for your company going into an ESOP. So some of these, some of these points from the NCEO National Center of Employee Ownership are for existing ESOP companies that are dealing with 40 IP issues. So, take it with a grain of salt, there might be information in here that might be helpful for you to better understand it. So one suggestion they have is reducing the level of synthetic equity by canceling or distributing part or all of the syn synthetic equity. And they really note, make sure you talk to your advisor, but basically, if we're going to plan a warrant, we need to be planning it in relationship to how it works with the um With, with 409P specifically. So in that, in the case with the warrant, for instance, or a stock appreciation rights, that's how we would want to make sure we're, we're understanding the impact of that on 409P. The second thing is rebalancing participants' accounts. The use of a plan-wide rebalancing calculation really could result in each participant having the same proportion of the company's stock or other investments. So often for an ESOP that changes from pure share accounting to rebalancing the result, um, this is a reduction in the number of shares in the accounts of long-term employees, which may be beneficial for 409P testing. So that's another um suggestion that NCEO has. There might be an opportunity on uh from another suggestion is to allow for in-service withdrawals from your plan that could reduce the share balance of disqualified persons or potential disqualified persons. So this feature must be offered on a non-discriminatory basis and it um could impact the ESOP's repurchase obligation. So if you're withdrawing from your shares, then the company is going to owe you something. So that's a cash flow issue that the company is going to have to address as well. The other option would be that you would transfer shares from a participants ESOP account to a non-ESOP account, and this alternative is included in section 409P regulations in the Internal Revenue Code, um, with sample document language that might, that might be helpful. So it has to be done though, one of the things to note with this with this suggestion, it has to be done in advance of an event um that would cause 40 IP. It can't be reacting to an issue with 401P. So in, in really in summary, those are a couple of good suggestions as you and I hope they helped to kind of like, think about and frame out what 409P is. Um, as I mentioned earlier, I think the, the major thing to summarize here is that 409P needs to be addressed early on in the feasibility process. And the reason I'm doing a podcast on it is because I think it's really important for you to totally understand how important it is to not only understand it before you get into an ESOP, but also for it to be managed on an ongoing basis because any time in a plan year, if you have an issue with 40 IP. That could violate the plan. And as you saw from the example, the consequences are extremely, really painful, and they kind of void out the benefit of having an ESOP, and they kind of make it worse anyway. So, so definitely wanna think about that. And the other summary point I wanted to make, make, and I hope it was clear, but You know, sometimes I get questions from companies and they're really just too small and, and if your company is less than say 2015 people, I think you really are wanting, you may have an issue with trying to do a an ESOP. And so certainly anything less than 10 people would not work at all because of what we just talked about and Bill and Ted's company are 3 people. So 409P definitely is uh addressing whether or not from a feasibility standpoint, you are. Good fit. So for whatever reason, some companies are really productive and profitable, but they're small. Um, it just may not be the ESOPs may not be a good fit for you. Um, one strategy with that is to acquire some other companies if you want to get larger and do an ESOP, um, grow some revenue streams, just different things like that might help to build a stronger necessary employee population. I wouldn't hire people just to do an ESOP, obviously. So I hope that really helps you with the 4019P. It is, it is um a very specific part of internal revenue code that is very important for you to understand, um, whether, how that works into your organization and your future plan. So as we close, again, I wanted to say thank you for, for listening to this podcast. And if you haven't subscribe to it, subscribe to it, and please rate and review the podcast. It's very, very helpful for us. And I look forward to our, our next podcast with you. Thank you so much. Have a great day.