EP39 - 1042 - set hike - tax play for an ESOP

The question I have this morning is, will I have time to get this podcast recorded and uploaded with everything else going on on a Monday morning. Thank you so much for listening. I'm the ESOP guy and this is Journey to an ESOP. If you have been continuing on this journey with us, I just wanted to say thank you so much. For those that are joining for the very first time today, I wanted to say welcome. If you have an interest in this podcast or this episode or other episodes, please go to our website at journey to an ESOP.com. There are multiple episodes with different types of, of topics that we cover and as well as interviews with different ESOP professionals. Today's episode is going to be topical, it's not an interview. And the title of this episode is 1042, set, hike, Touchdown, tax deferral. All right, sounds like a football play, but it's not. Is it complicated? Yes, it is. Are there multiple steps in the process? Yes, there are. Pulling off a 1042 like kind exchange in an ESOP transaction is a bit complicated and it has multiple steps. Today, what I want to do is give, give the listener a good overview of what the 1042 is. What are the benefits to the selling shareholder? Where are the limitations and the, and the conditions that you should be looking for? This will equip you for the questions you might want to ask your advisor and at least give you kind of a good general overview of what this is all about. And as you go through this episode, I just wanted to say again, please subscribe to the podcast if you like it, if you think it might help someone, please share it with a friend. So going into this podcast, I wanted to start with this bit of sports history that I read in a recent article. Head coach Dan Quinn, his staff, and players have no one to blame but themselves. While there are times when a team builds a lead before running into a buzz saw, this isn't one of those cases. The Atlanta Falcons were the team to beat, but they didn't look like that same squad during the second half or overtime of Super Bowl 51. Everything started to fall apart with an 8 minute and 31 2nd lead remaining in the fourth quarter. At the Atlanta Falcons still held a 28-12 lead and possessed the ball on third and one from the Atlanta Falcons 36 yard line, offensive coordinator and future San Francisco 49ers head coach Kyle Shanahan called a pass play. Running back Devonta Freeman didn't recognize linebacker Donta Hightower as he blitzed off the edge until it was too late, and the defender got a clean shot on quarterback Matt Ryan. Now, there's no other way to describe this, the team Super Bowl 51 loss to the New England Patriots at the NRG Stadium in Houston, except for absolutely disappointing. After leading by 25 points and with an 1818 minutes left to play, Atlanta allowed the biggest comeback in Super Bowl history as the Patriots roared back with 31 unanswered points to emerge with a 34-28 overtime victory. You got to remember this Super Bowl. It has to stand out in your mind. The question, as we get started, is this, who should have won this game between the Atlanta Falcons and the New England Patriots? You know, if you go back and look at the game, and you remember it, it's like they're the Atlanta Falcons should have one. They were, they absolutely blew an incredible lead over the Patriots. What did Atlanta need? A better coach, a better team? I don't know, but It wouldn't have hurt them to have a touchdown play or a winning play. And so what we're going to do is talk about the ESOP touchdown tax play. So in this game, whether you were a New England fan or one of the millions of folks, maybe billions. Who wanted Atlanta to beat New England. It doesn't matter because ultimately, the winning play was made by Tom Brady and not Matt Ryan. Everyone knows that the touchdown play wins the Super Bowl. So for the ESOP community, uh, this really is pretty exciting and it's, it's fun to talk about 1042 because it's interesting and when you see it work on a transaction, and the selling shareholder wins big time. So what that, what does that mean to win? Winning here means that either the selling shareholder has deferred capital gains on the sale. Of their business for say an extensive period of time, or in fact, they've even eliminated the the capital gains tax entirely. Now, given certain conditions, uh, capital gains tax can be deferred, allowing the full transaction proceeds to be invested in a qualified replacement property or a QRP. Under the Internal Revenue Code Section 1042, we are really exploring as part of this journey to an ESOP, the beneficial tax treatment on shareholder gains when we sell our stock to an ESOP. Now, let me just hit the pause button. So as soon as I mention 1042 tax codes, I, I do think that we all tend, most of us tend to be wired to a, I don't want to listen to tax codes. I have people that I pay for that to tell me what the tax codes are. And if that's what you're thinking, I think that you really do need to listen to this podcast because there's, there's a great deal of benefit for you behind this particular tax section. And so, We have to reference tax code sections, but as we do, we're going to just get into some practical aspects of that. So, long term capital gains are recognized upon the liquidation of QRP securities at a future date, after required minimum holding period. So if we take that QRP and we, and we actually exchange our private stock for this other qualified replacement property, and we liquidate that at any point in time, we're going to then recognize the long-term capital gains. If the QRP is not liquidated and becomes an asset of the seller's estate, this is really kind of an important point. And this is where I, I think you got to listen in. what happens is the asset. Of the QRP goes into a stepped up basis and what happens is that when it's passed on to this, to the uh into the estate, into the uh it's inheritance, what happens is you're avoiding capital gains tax completely because we're stepping up the basis on the cost of that asset. So it goes in at the new cost of when it went into the QRP. So, Let me just say that is a touchdown. I mean, you know, everyone, everybody should pay their taxes. That's just true. It came from a movie called Madman, Mad, Mad World if you ever watched it, but everybody should pay their taxes. But listen, if there's a legal way to not pay your taxes, and it works into your business strategy, then I'm gonna just say hello. Why not, why aren't we doing that? So this is why it's so important to, to think about the, the 1042 in your transaction. So let's go into the game rules. What does it take to, to accomplish this? So we're gonna start when we start looking at the game rules of understanding the playing field. First thing we got to do is we just have to address the again, the difference between an S corporation and a C corporation. So an S corporation is a pass through entity. A C corporation pays taxes at its corporate level. On S S Corporation going into an ESOP, the exciting part about an S corporation is that you get this tax exemption on whatever the ESOP owns of the S corporation stock. The S corporation, however, doesn't have the 1042 like kind exchange option available to its shareholders. So that's one distinct difference. Now, when we go into deductibility of contributions, and I just want to make a quick, quick note on this, that S corporations have a 25% limit on the tax deductibility of their contributions um made by employers to ESOPs. On a C corporation, what happens is there is a 25% limit, but they don't count interest payments on the ESOP contributions. So, S corporations do, ESOPs don't, so SC corporations have a little more room on the limits. So as we start thinking again about the difference between SNC, it's really important to understand the, the, the ground rules, the game rules behind using 1042 and the options that it creates because there's going to be a decision-making process that says, do I convert my business from an S to a C to then elect to become a C corporation. To, to elect the 1042 uh like kind exchange. If I do that, generally speaking, you're going to have under the current tax law, you're going to have a five-year waiting period to convert the company back to an S corporation to enjoy the tax benefits of Being an an S corporation tax exempt entity, but there may be enough information in here to say, well, let's talk about that as a as a strategy, but that's part of the, the ground rules of the game rules of looking at the possibility of a 1042 when it comes to your current entity type. Now, one thing I will say is if your entity type is an LLC. You are going to have to convert your company to either a C or an S anyways, and there is an opportunity, a planning opportunity to convert an LLC into a C corporation, elect a 1042. And then elect S corp status immediately following that. So that would be where we would not have to deal with the five-year waiting period. So that's a part of, part of the rules of, of looking at entity, entity structures. So right off the get-go, we have a very big planning item that we have to deal with as advisors is what is the best entity that we want to transact this ESOP for. And obviously, it has, it has a lot of significance when it comes to the selling shareholders. Tax treatment. So, more rules that we're going to consider in order for the sale of the stock to qualify for a 1042 rollover, several requirements must be met. Number one, the seller must have held the stock for at least 3 years. Number 2, the ESOP must own at least 30% of the total stock immediately following the sale. And then number 3, the seller must reinvest the proceeds into the qualified replacement property that I mentioned above. Within a 12 month period. After the ESOP transaction or 3 months prior to the transaction. So they have an entirety of 15 months to transfer their stock into this qualified or to transfer or reinvest the proceeds of their stock into the qualified replacement properties. Now, as I go through this, I just wanted to kind of put a uh a plug in here. We are going to do more on the 1042. Uh some of the information I just recently, um, you know, received to just really better understand the 1042 or do a podcast on it came from investment groups, investment companies that do this all the time. That's what they do. So part of the plan of the podcast episodes coming for going forward are going to be an interview. To discuss more deeply some of these things. So some of this information that I'm going to go through is just directly from their information they submitted to me. Um, but the, I think it's important to understand the general overview and then the benefits so that you, you kind of know what this is all about before you jump into an interview. So with that, I'm gonna talk a little bit about, again, we're still within the game rules. What is qualified replacement property? And it's going to be simply defined as stocks and bonds of United States operating companies. And that's gonna include common stock, preferred stock, convertible bonds, corporate fixed rate bonds, and corporate floating rate notes. So those are all eligible qualified replacement property or QRP. On the ineligible side, we're gonna have first off, any government securities that they are not going to be replacements for ESOPs. We're gonna have bank CDs, US government bonds, municipal bonds, foreign securities, exchange traded funds. Mutual funds, real estate investment trusts, master limited partnerships. So those are all lists I got from, from the investment company, but um very important to know what you can invest in to make sure that this is something that you're comfortable with because again, those eligible securities are all you can put the, uh, reinvest your stock into on the qualified replacement property. Now, the money that is invested can come from sources other than the sale, as long as that amount does not exceed the proceeds. However, not all of the proceeds have to be reinvested. If the seller chooses to invest less than the sales price, then he or she will have to pay the taxes on the amount not invested in the QRP. One interesting aspect is that the two or more sellers, we talked about the 30% rule. Two or more sellers may combine their sales to reach the 30%, provided that the sales are part of a single transaction. The shares sold to the ESOP cannot be allocated to the ESOP account of the seller and the relatives of the seller, except for linear descendants receiving 5% of the stock, and who are not treated as more than 25% shareholders by attribution, or any more than 25% shareholders. So the limitations related to how relatives are considered in this uh calculation. Now, as we go through the process of looking at more of the the rules and the things that have to be required, there are three statements that must be filed with the IRS to successfully complete the 1042 election. That is a statement of consent. A statement of election and a statement of purchase. So the statement of consent just requires the company to consent to the selling shareholders election to defer taxes. The statement of election confirms the intention of selling shareholders to elect non-recognition treatment with respect to the stale, the stock sale under section code 1042. And the statement of purchase really just completes the tax advantage sale of of qualified securities to the ESOP and declares those specific securities that represent the QRP with respect to the stocks sold to the ESOP. So those are all required as part of uh successfully completing the 1042 election. So a disposition of QRP will trigger capital gains tax, which I mentioned, um based on the taxpayers's basis and the original shares sold to the ESOP. Now, one, the exceptions to this, if the dispositions happen either through a gift of the QRP. A transfer upon the death of the QRP holder. Transfer the QRP in connection with a divorce. And certain tax-free transactions between the QRP issuer and other companies. So let's talk briefly again about, like, I'm just touching on the surface of some of these things that we'll need to go into deeper, but briefly, what I would call this next section is just the 1042 places. What are the options? What are the strategies behind using the 1042. Now, clearly these, let me just say this as a, as a strong caveat, these need to be addressed by an investment advisor. And again, I'm only touching on them and that's the purpose of having a 1042 interview later on. So, clearly, all these, all these, when I talk about these basic strategies, these are gonna have to be worked through with, with an investment advisor. So sellers often use all or part of the replacement property as collateral for loans used to finance ESOP purchases. And so, um, leveraging the sale of stock to the ESOP can provide further financial benefit to the company and its shareholders, but it really kind of depends on, on the strategy you move into and there's two basic strategies that I'll touch on. As we go through this, there's the passive hold strategy where I reinvent, just basically holding my investment. This is going to include, you know, creating a, a portfolio of qualifying stocks or bonds that are designed to really remain constant over the selling shareholders' lifetime. And so the idea here is that I'm a shareholder that I'm selling into the ESOP and I just don't want to mess. With this, I just want to put it away and not worry about it. I don't want to be thinking about it. I'm not that concerned about trying to use the liquidity or have any flexibility. So if that's you, then this strategy might be really um where you might want to go into more discussion with the investment advisor. This is going to, you're gonna be able to use that if you want to on margin loans. You're gonna be able to, um, uh, if you, if you wanna go in and take some of the, the liquidity out of the QRP you're gonna be paying whatever capital gains tax is on that. And just kind of in general, just, it has a constancy to it. So it's just gonna be that type of strategy where you're just not gonna wanna deal with a lot of changes or, or a lot of different types of um approaches to it. Now, the other side is more of an active strategy where the, uh, this selling shareholder maybe is going to be more interested in, in liquidity, um, a lot of flexibility. So this is where they're going to invest a portion of the proceeds at closing, say, say 10% of the total and enter into a monetization loan for the remaining amount. And the way they do that is they purchase floating rate notes that satisfy the 1042 requirements. So In this active strategy, selling shareholders can reinvest the remaining proceeds from the sale and other investments that may or may not qualify as QRP but that can be traded freely without triggering capital gains taxation. Again, all this is coming from information I got from an investment advisor group. Um, but what that does is it allows the selling shareholder to leverage the floating rate notes for investment options, having greater liquidity and flexibility. And Although they might use this leverage um to do different things, I just wanted to say that it does increase the complexity and there will be an uh an increase in expenses in using this type of strategy. Um, when I look at this, uh, you have to ask, you know, from a planning standpoint, you know, will the additional cost of the, the strategy of getting more liquidity, will that be more than um worth it when you look at the tax benefits that you're receiving, um, to go down this road, or would you be, you know, better off as a passive, more of a passive investor in this kind of, um, this kind of com kind of the combination of looking at both of those in comparison? Um, some of it has to do with your risk tolerance of the selling shareholder as well and what they wanted to do with it. So, the nice thing about this is it gives some, some people options, um, as to how they want to go about in reinvesting that QRP and it doesn't have to be as much in the box as, um, you know, as you might think. So going into this, I wanted to finish this episode with just kind of a quick overview of what would it look like on a potential transaction. So in this, we're just gonna assume we have an ESOP transaction where we've sold the company for $20 million. So, uh, in this case, what we're gonna have is a taxable ESOP transaction versus a 1042 ESOP transaction. So, in a 1042, as we talked about the benefit at the very beginning, what we're going to get out of that is we're not going to be paying uh capital gains tax. We're not gonna be paying um the additional 3.8% tax, um. We're not going to be, which is the surcharge. We're not going to be paying state, uh, any kind of state tax. So if you live in a state where you have state tax, so in this example, we're just going to assume $20 million was taxed at the current federal income tax or the capital gains tax rates, and that $20 million was taxed at $4 million. Plus the 3.8% tax of $760,000 plus a state rate tax at this point of this state being at 4%. So, all in, you have a, a transaction where it costs the selling shareholder $5.56 million. So that's $5.56 million in additional um money that went uh instead of being paid in capital gains is gonna go back into the estate. So clearly, as I, as I finish with that example, um, There's uh such a significant difference. This has to be, this has to be explored when you start thinking about your ESOP transaction. And so I'm excited when we get to the next um episode, it won't be, I don't know if it'll be the next one we have, but, but be looking for it when we have the next episode on the interviews because I want to, we're gonna go deeper into that 1042 topic. And I think that would be very helpful um to, for you to round out your better understanding of it and and really just to be prepared to ask the questions of your advisors. Um, of what this is and how this can be used to enhance your transaction. As always, please subscribe and rate and review the podcast, share it with a friend if you think it will help them. And with that, I will look forward to the next episode on this journey to Anisa.