LLC ESOPs? The Facts, Risks, and Possibilities

This episode of Owners at Work podcast is sponsored by Prairie Capital Advisors. Prairie Capital Advisors, itself an ESOP company provides a full suite of services to middle market companies with a focus on ESOPs. Services include ESOP Seide and Trust Side advisory Services, ESOP valuations, M&A, sustainability, and Mature ESOP Consultant. Hey there listeners, jumping in here, uh, before the intro with a little correction for this episode. When the interview and editing for it took place, our guest Mike Currie was working at Walter Haverfield. Since then, Mike's began working at the law firm Benish. While we still refer to Walter Haverfield in the actual episode, we made sure to update the contact details for Mike Cerrie, which you can find in the show notes and on our web page where this episode is found. OK, that was it, on with the show. Welcome back to another episode of Owners at Work. I'm Mike Palmieri, research associate at the Ohio Employee Ownership Center. In this episode, we get a bit technical again. Uh, Chris sits down with Mike Currie, an attorney with Walter Haverfield, and talks about how employee stock ownership plans can be sponsored by businesses that do not adopt the C or S Corporation, specifically LLCs. For the uninitiated, this is quite a big statement. It's a common understanding in practice that businesses must be either a C corporation or S corporation to sponsor an ESOP. However, as Mike Cerisse outlines, there indeed is nothing ruling out the possibility of a business organized as an LLC to do the same. Granted that certain specific elections and choices are made in how the LLC is taxed and how it sets up its shares and ownership interests. So why does this even matter? Well, for one, LLCs have been and still are one of the most common forms of businesses in the US, second to only sole proprietorships. Typically, when a company that is an LLC wants to sponsor an ESOP, it has two options. Again, because the assumption was that only C and S Corps could sponsor ESOPs. The first option is to restructure as either a Corp or S Corp. The other option is to set up a separate entity that's either a C or Scorp, that would then act as a holding company for the LLC and at the same time sponsor the ESOP. As Mike lays out in this conversation, there is a viable third option that includes making changes to how the LLC is taxed and how its ownership interests are organized. In this formulation, the company begins and ends the process of sponsoring an ESOP as an LLC. While Mike is clear that this option may not be a silver bullet that will drastically increase the number of ESOP companies, he still sees it as yet another tool in the toolbox that can work well in certain situations. Now, it must be said, and Mike makes this clear that there is a level of risk in pursuing this option. While there's no regulation or rules prohibiting an LLC from sponsoring an ESOP, the law does not explicitly state that it can. Chris and Mike talk about a recent ruling from the IRS that makes Mike more confident. That this practice is allowed, but it's mentioned numerous times, and I'll do it again here. There is a level of risk still associated with an LLC sponsoring an ESOP, and there is not clear guidance or a law on the books that speaks directly to the situation of LLCs sponsoring ESOPs. As you can probably tell from this introduction, the episode is indeed technical. Still, Mike makes this complex topic understandable and is clear-eyed about the facts and risks associated with setting up LLC ESOP companies. OK, let's hop into the interview with Mike Currie, an attorney at Walter Haverfield's Business Services Group. Well, welcome back to the pod. We're talking today with Mike Currie, an attorney with Walter Haverfeld, a law firm based out of Columbus, and we're gonna be talking about LLC ESOPs. Mike, welcome. How are you doing? I'm doing great, Chris. How are you? Doing good. It's a little humid out today as we were talking before we got started today, but otherwise not too bad. Good, good to hear. Great. So, uh, you know, before we get started with the technical stuff, we're gonna be talking about LLC ESOPs and so that can get technical really quick. But one of the things I always like to do with all the guests on our uh pod. I ask you to tell us a little bit about yourself. Uh, one of the things I've noticed over the years is, is most people don't necessarily start out like thinking in, you know, in high school that they're gonna be working with ESOPs and employee owned companies as they're thinking about what they're gonna do with their. Life. So I always ask folks, how did you get started working in the world of ESOPs and employee ownership? Sure. Um, so, so I'll, I'll say, um, I, I grew up in Youngstown, Ohio, as a, as a child of immigrants, Italian immigrants, and that sort of immigrant work ethic really, uh, informs a lot about who I am and, and what I believe. And so from that perspective, I, I knew that I wanted to be an attorney. I knew that I wanted to go to law school. Um, and so I ended up going to law school at Ohio State, and from Ohio State, I ended up taking a lot of, uh, more business-oriented coursework, more tax-oriented coursework, fell in love with tax, and, and then I discovered, uh, the world of ESOPs, and I discovered, um, You know, not, not only how great of a retirement plan that that an ESOP can be, but also, um, the way that an ESOP sort of democratizes the ownership of companies, um, the way that it sort of expands and ownership culture out to employees, um, and the way that, uh, an ESOP can. be beneficial for the company as a, as a whole, because it, it makes people feel, it makes the employees feel as though they're part of something bigger and, and they work a little harder, and they, uh, go that extra mile. And so I just, uh, fell in love with the idea of ESOPs as a concept. And then, uh, I ended up, uh, going to work with Tim Yoakam, who's the sort of the godfather of ESOPs in Ohio. And I've, I've been in this space ever since. Yeah, and, and I think that's something that happens to a lot of folks that end up in the community is in some way, shape, or form, we fall in love with the idea of employee ownership in ESOPs. Yes, and, and, and that's exactly what happened to me, and I think that's what happened with Tim, um, back in, well, I think back, uh, he's, he's been around since ESOPs were invented. Right, I, I always called Tim one of the deans of employee ownership, uh, uh, not, not just in Ohio, right, nationally as well, right? Great, great. So as I mentioned at the outset today, uh, we're going to be talking about LLCs and ESOPs. Now, uh, one of the things I'll preface all of my comments with is I am not an attorney. I am not, I don't play one on TV. I don't pretend to. To have that in-depth, you know, legal knowledge of, uh, that you're gonna have. So if anything that I say here doesn't quite make the grade, feel free to let me know. But you know, traditionally it's been assumed and, and it's been the law that only S Corps and Corps can sponsor ESOPs or become employee owned through an ESOP and that LLCs could not, but as we know, um, a lot of companies are LLCs nowadays. And there's a lot of reasons why and so can you briefly explain the basics around the differences between corporations. And LLCs and why it's been understood that LLCs cannot have ESA. Sure, um, so I'll start, uh, with a sort of a summary of the similarities and the differences between, uh, limited liability companies and corporations and then move into sort of the reasons why the conventional wisdom has been um that LLCs cannot sponsor. Uh, and ESOP. So limited liability companies and corporations are both forms of business entities, um, that have a separate legal existence from their owners, which means that limited liability companies and corporation corporations can sue and be sued. They can enter into contracts, they can own property all in the name of the company, not in the name of the business owner. Uh, and that's important for, for a couple of reasons, um, but, but really important for sort of separating the liability out. It's, it's sort of in the name of the company, right? Limited liability company, but it limits your liability as a business owner to what you have invested in the company or in the corporation. And that's, that's distinct from partnerships and sole proprietorships where, uh, your liability is really unlimited as a business owner. Um, so that's how limited liability companies and corporations are similar, uh, but there are also some really important differences. Corporations, uh, as a concept have been around for hundreds of years. They go back to ye old England, um, and so as a result, as a result of of that history, the structure and the management and the governance and the organization of corporations is very rigid. Owners of corporations. Are called uh shareholders. Ownership in a corporation is represented by shares of stock. The powers of a corporation are uh vested in a board of directors, um, and that board of directors is elected by the shareholders. Uh, the board of directors delegates its powers and authority to corporation officers like a CEO, a president, secretary, treasurer, um, and those officers manage the day to day operations of a corporation. On the other hand, limited liability companies are much more flexible. Company owners are called members. Company ownership can be represented by shares. But it also cannot be um it's really up to when, when I say limited liability companies are flexible, I, I mean that their organization and structure and management and governance are sort of up to uh the founders and the owners and, and what they need, how they need to structure the business for their ongoing business. And so with a, with a couple of exceptions related to sort of minimum standards in state law, limited liability companies can be made in whatever image you want them to be made in as a business owner. So when I say that company ownership can be represented by, you know, unit shares or unit. Certificates, that's one of many options that a business owner has. Similarly, company powers may or may not be vested in a board of managers or in a single manager, um, or they may be managed by, uh, just the members as in their capacity as owners. OK. Um, a limited liability company may or may not have officers and with some exceptions, um, the, so with some exceptions, the structure and management of an LLC is up to, um, the founders and the owners of the limited liability company. So one of the things that that is interesting about LLCs is that they can choose. Uh, how they're taxed, right? So they can be taxed as a similarly to an S corp or similarly to a Corp. Can you briefly explain the uh difference in taxation with SNC Corps and how an LLC can choose one or the other? Sure. So for federal income tax purposes, there are two types of taxable corporation. There's a C corporation and an S corporation. The Corp is the default form of a corporation. Uh, so when you form a corporation under state law, unless you make an election, that corporation is going to be taxed as a C Corp. Um, and the Sea Corp is treated as distinct from its shareholders, which means that the Corp is subject to a separate tax rate, which currently is 21%. And then Sea Corp owners also pay taxes on any. dividends that they receive. And that's where we get this idea that Corps are subject to double taxation because they're taxed at the corporate level. And then when the shareholders receive a dividend, the shareholders are taxed at that dividend level. OK. Shareholders can elect as corporation treatment if they meet certain statutory requirements, which include having fewer than 100 shareholders, having, um, with a few exceptions, only natural people as shareholders and only US citizens as shareholders. Um, and that election to be an S corporation removes the corporate level of taxation. So instead of being taxed at the corporate level, um, an S corp is taxed at the shareholder level. So all of the income and loss and gain and expenses. Um, are attributed to the shareholders who then pay tax on that income or, or loss in their capacity as individual shareholders. And the rate at which they pay tax is essentially at what whatever their personal income tax rate would be, correct? That's exactly right. OK. And so, so the whole idea as to why LLCs have um been considered no go land for ESOPs is because the law regarding ESOPs specifically says corporations, am I misunderstanding that? So, so the law regarding uh ESOPs says employer. Securities, right, so an ESOP is designed to invest in primarily in employer securities, and the definition of employer securities is common stock of the employer. Now that has traditionally been interpreted to mean common stock of the employer has traditionally been interpreted to mean common stock of a corporation that is the employer. OK. But there's no mention of corporation in that definition in uh the code section that defines what employer securities are and what qualifies as an employee stock ownership. Plan that has been sort of, uh, I would say just a cautious and narrow interpretation by practitioners who who see common stock and think corporation, not any other uh form of business entity. OK, perfect. So the idea that an LLC can sponsor an ESOP comes from, if I'm not mistaken, again, not an attorney, right, uh, a private letter ruling from the IRS in 2015. Before we kind of go through that, can you explain what a private letter ruling from the IRS is? Sure. So a private letter ruling abbreviated as PLR is a written statement issued by the IRS to a taxpayer, and that PLR interprets and applies the tax laws to a taxpayer's particular facts and circumstances. So they're issued in response to a written request that the taxpayer submits and where the taxpayer has described and laid out all of the facts and circumstances that the taxpayer is facing. Importantly, PLRs can't be relied on as precedent by other taxpayers or by IRS personnel. Um, and, and that means that there is some risk involved, uh, when we're looking at private letter ruling for guidance because it can mean that, uh, the IRS doesn't have to follow the reasoning it's laid out in that private letter ruling if it changes its mind. But PLRs are a good resource um to understand the, the IRS reasoning on particular issues, uh, but again there is that risk that if the IRS challenges a taxpayer's categorization of uh transaction or certain facts, um, that the IRS and maybe the courts are not bound by that reasoning and can come to different conclusions. They can change their mind, in other words, right? Exactly. They can change their mind. And so and and I'm not saying that to scare any of our listeners. I just, I think I have an obligation, right, to ensure that our listeners understand that there are risks involved. And so they need to understand those risks so that they can make informed decisions about which path they want to go down um based on their own personal risk tolerance. Right, right, and that's important, that's important because we want uh their eyes to be uh wide open as they go through this process. Exactly. Right, right. OK, so, so did I have the sense of the LLC ESOP coming from this private letter ruling in 2015? Is that a correct reading of what's happened? Yes, so that's, that's generally, yes, generally correct. So the, the IRS issued the private letter ruling in 2015. And once we had that sort of guidance of understanding, this is the IRS's thinking on the issue, it became more, more possible for attorneys to recommend it as a course of action, um, because the, the risk reduced a little bit from what it was when there was no guidance on the issue. Right, OK, so what does this, this specific private letter ruling uh say about LLC sponsoring ESOPs that our listeners need to know? So the, this private letter ruling addressed whether an ownership interest in an LLC qualifies as employer securities for purposes of the requirement that an employee stock ownership plan invest primarily in employer securities. OK. So remember that the conventional understanding narrowly interpreted employer securities to mean only the common stock of a state law corporation, and that would preclude LLC ownership interests from being treated as qualified employer securities. The private letter ruling looked To several Internal Revenue Code provisions to determine that employer securities includes the ownership interest in a limited liability company, provided that the LLC has elected to be taxed as a C Corp or an S corp and that the LLC's operating agreement. ownership interests as unit shares that have the same voting and dividend rights as all other ownership interests of the limited liability company. You know, again, you know, not a lawyer, this sounds a little complicated for someone like me. Uh, can you provide maybe some additional details or maybe some understanding. About what are some of the key issues around or maybe complexities is the right way to put it around in an LLC ESOP that someone thinking about this needs to be focused on. Sure. Um, so, so the two most important areas, uh, for an LLC ESOP are that, um, the LLC has elected or will elect at the time it adopts the ESOP to be treated as A S corporation or a C corporation. And so that requirement um comes from the private letter ruling and it comes from the reasoning of the private letter ruling. Um, that basically said stock means stock in a corporation, but the definition of a corporation under the Internal Revenue Code means a state law corporation or an entity that has elected to be treated as a corporation for tax purposes. And that's where LLCs are able to get in if they've elected that corporation treatment. So, so the first requirement is an election of that corporation treatment by the LLC. The second requirement is. Amendment to the operating agreement of the limited liability company, which is sort of the governing document of the limited liability company. It defines the relationships between the owners and the company and it defines the management of the company. And we have to amend the operating agreement or write a new operating agreement that specifies that that the ownership interest of the limited liability company is represented in unit shares, uh, which is analogous to stock in a corporation, and, and that those shares all have the same. Rights to distributions and voting rights. What it really comes down to at the end of the day is making the LLC more like a corporation. And, and because LLCs are so flexible, we have that ability to do that, to make an LLC look and act and feel more like a corporation. And when we do that, that is what allows us to then have the LLC sponsor an ESOP. OK, so I'm assuming that if you're an LLC that decides to put in this ESOP and you say, I've, I'm gonna choose between being taxed as a Corp or, or as an S corp, you know, depending on which one of those they choose, they will get the same tax treatment as your, let's say, you know, for example, your prototypical Scorp ESOP, so some of our listeners may know, uh, others may not, that if you are an S corporation that's 100% owned by the ESOP. The ESOP is a tax exempt entity and the corporation is taxed at the shareholder level, so if the ESOP is the is the only shareholder, that company is 100% income tax free, right? So that that all applies with the uh. Uh, LLC ESOP that chooses either an S corp or a Corp as well. All of those kind of things stay the same in a sense. That's exactly right. So everything that applies to a traditional, traditional state law corporation that sponsors an ESOP should apply with equal force to an LLC that sponsors an ESOP. OK, perfect. And, and again, I appreciate you kind of explaining this to someone who's uh not an attorney. So with all of the complexities involved the kind of maybe a little bit higher level of risk, right, is that private letter ruling gonna hold for, you know, my particular case with all of these kind of things? Why would someone possibly choose to do an LLC ESOP instead of just converting to a C or or an escort? So what it comes down to is that limited liability companies are an increasingly common and popular form of business entity. I think the statistic is that there are more LLCs formed every day than any other kind of business entity other than a sole proprietorship. OK. Um, and so because they're so common, LLCs are so common. There is a very large chance that if you're considering an ESOP as a business owner, your business is structured already as an LLC and if not for the LLC ESOP, the owner would have to either convert to the LLC to a corporation under state law, which has some added complexity of its own right, um. Or form a new corporation um as a holding company for the LLC and then move the LLC into under the umbrella of the holding company, uh which then sponsors the ESOP at the holding company level. OK. Um, but both of those alternatives have their own complexities and requirements. So for example, the conversion of an LLC to a corporation under state law seems like it only requires the filing of one or two forms with the Secretary of State to to make that conversion. But there are, there is a lot more added complexity. Because we have to have a plan of conversion, we have to file the certificate of conversion, uh, and then there are forms that have to be filed with, for example, the Bureau of Workers' Compensation in Ohio, the Department of Jobs and Family Services, you know, various other state and county agencies that have to be notified about the conversion, um, and so that adds some complexity to, to the conversion. OK. Uh, whereas if you're just starting with an LLC EAP, there's some added complexity and and added risk involved, but you don't have to make that conversion and go through that process. And similarly with the creation of a holding company, there's added complexities that uh you just don't have to go through um if you start and end with an LLC. So, you know, we should not assume that just converting from an LLC to a C corp or an S corp as, as you point out, is like a click of the fingers, right? And so regardless of which option you would choose, you do have to cross your T's and dot your I's. Exactly, um, and it really is when, when we consider, um, and when we're advising clients, we operate on really a case by case basis. So an LLC ESOP might be right for one business and one business owner, but it may not be right for another and it really just comes down to the. Specifics of the facts and circumstances of the case, you know, we look at the totality of the circumstances to make any recommendation, and some of those circumstances can include, you know, what, what kind of contracts do you have with suppliers and customers? You know, are you required to be professionally licensed? There are a lot of um. There are a lot of architecture or engineering or um CPA firms that are forming ESOPs now and they're subject to state law licensing requirements and we have to make sure that we're not screwing up their licensing when we're going through the process of choosing the entity form for the ESOP sponsor. All of those things factor in. Yeah, you, you kind of want to make sure that the business can actually do what it's in business to do when it's all said and done, right? That's good. Yeah, right, right. Great. So do you have a sense how many LLC ESOPs there are out there in the universe of ESOPs? So that's, that's really difficult to say. Um, I don't know that there are any reliable, reliable metrics out there. Um, that we could look to, but what I will say is that, uh, in the 3 years that I've been advising clients on ESOPs, we've done 2 LLC ESOPs. It's a, a minority of the, the ESOP transactions that we, that we handle, and I think that comes down to, like I said, the totality of the circumstances um and the. The particular clients sort of flavor for risk and and whether they're willing to take those risks. Yeah, so it's important to kind of make that point, I think, I, and I, and I think that's a great point and you've made it a couple of different times is it's important to understand that this LLC ESOP is not necessarily automatically gonna create a ton more ESOPs. It's just if the circumstances, uh, and the situation uh make it a fit, then it's just another tool in the toolbox. Is that fair? That's fair. That's absolutely fair, and I think, I think the next step in LLC ESOPs and, and something that the advocacy organizations need to look into um is getting sort of more published guidance that that we can rely on more clearly when we're recommending. And LLC EOP to clients, um, because that, that reduces further reduces the risk if we have something we can rely on. Rather than simply relying on and and looking to a private letter ruling. Yeah, it's the difference between good guidance and, and hope. Exactly. I, I think we always want to Look at uh whatever one of these regulatory agencies says something that we can then assume that that's gospel in a sense, right? But we know that, you know, as you mentioned, private letter rulings are not quite that. That exactly they're, um, they can be guidance, um, they can help us understand and they can sort of confirm our reasoning. So when, when I started recommending LLC ESOPs I hadn't uh found that PLR yet. uh I had just been thinking through uh the issues and saying well it says stock of the employer um but stock, you know, means of a corporation pursuant to the tax law and a corporation includes LLCs that have elected to be taxed as a corporation. So you go through that reasoning and then you find the private letter ruling. That sort of confirms that reasoning is is sound and that's really I think where the community is at now is we've confirmed that our reasoning is sound but we would like more clear and reliable guidance um and and the knowledge that we're not risking uh disqualification of a client's ESOP uh because they're an LLC. All right, well, well this has been fantastic, uh. As I've no doubt shown and, and I know I've mentioned it a few times, as a non-attorney, non-practicing attorney, non actor attorney, it's always great to have someone who can kind of uh boil down these complex things into easily understood uh language. So I really appreciate the time you spent with us today, Mike. Absolutely. I'm, I'm happy to have uh been here and, and helped out. All right, perfect. Thank you. Well, that's it for another episode of Owners at Work podcast. I hope you enjoyed the show. 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