On this episode - we evaluate the idea of taking the “mask off” - what is actually going on with the new IRS Article related to the IRS commissioner investigating ESOP transactions and how do you build your ESOP plan to not be concerned with an IRS issue? Meanwhile utilizing the available tax benefits. This is a critical part of the feasibility Al that you need to thoroughly review with your advisors for short and long term consequences.
On this episode - we evaluate the idea of taking the “mask off” - what is actually going on with the new IRS Article related to the IRS commissioner investigating ESOP transactions and how do you build your ESOP plan to not be concerned with an IRS issue? Meanwhile utilizing the available tax benefits. This is a critical part of the feasibility Al that you need to thoroughly review with your advisors for short and long term consequences.
[0:10] Hey everyone this is the theesopguy we are on a journey to an ESOP and for season or in summertime and.
For Floridian summer is a long long season in its kind of never-ending almost but anyway it's hot.
So today I want to start off with this as we get into this topic because it's going to be a continuation of what we were doing a few weeks ago on the mission impossible stuff so check this out.
[0:48] Okay so real quick I'm just going to give you the blow-by-blow here the bad guy this is Mission Impossible 2 it's a scene clip that's called stop mumbling.
The bad guy who's really bad is shooting what we think is Ethan Hunt Ethan Hunt is played by Tom Cruise of course because he banks.
15 million Mission Impossible movies but right now he just shot him in the leg.
Stop mumbling Freddie's gonna choice I believe I break his jaw three he's got no choice I believe I broke his jaw.
So they're laughing about that obviously not so funny.
Stamp I'm impressed right we don't have a lot of time hon whatever you got to say say it now.
But that giving us a big smile this guy can't smile like he's been shot and so he's being taunted by this bad guy.
Nope she's doing it.
Point of view of next nah.
But I hate to tell you what's going to happen but he's going to turn around and show him what it's like to unload his gun.
It's what's known as getting your gun off.
[2:17] Music.
[2:24] Okay so while he's shooting at me smiling and okay that's totally evil right so we're watching this guy go down.
Not good if you don't know what's going to happen.
[2:35] It's kind of like oh man Ethan Hunt who's the hero of Mission Impossible 12 and all the other Mission Impossibles is now probably dead except for this.
[2:46] Music.
[2:59] The bad guy notice is something on his finger he realizes something's not right.
[3:07] Music.
[3:15] He thinks to himself let's look a little closer he's kneeling down to Ethan Hunt at this, the music's awesome here by the way oh he just pulled the mask off and guess what.
He just killed his partner and.
[3:42] Ethan Hunt has totally tricked him the whole mask thing if you watch Mission Impossible is like you we're all going to, deal with this all the time they always have like the best possible Mass anybody can look like anybody in mission impossible so he pulls it off and he didn't realize because he was so filled with pride and Evil that he actually killed his own partner so.
That's a great start so the whole the whole scene here is about pulling the mask off and so this topic today is going to be Mission Impossible 2 we're continuing, in the series on ESOP feasibility and one of the things that you're going to just go through in the feasibility is important it's like what are the tax benefits of an ESOP.
[4:25] And some of the things that we'll try to address early on in the in the conversation before we even get started, is what type of entity are you like are you an S corp it existing S Corp or you an LLC we talked about this a little bit in the mission impossible one that we did, but but recently this is why are you know kind of doing this topic literally right now recently the IRS came out with this article and it says, in came out in August 9th IRS cautions plan sponsors to be alert to compliance issues associated with.
So I've gotten a lot of like conversation about this I've had clients to ask me about this I can't even what are you thinking about what are you what are you thinking about this is all over LinkedIn people are posting about it, what's going on so so this really works well with the feasibility conversations that we're going to have because it's going to identify what I believe is is really.
Pulling the mask off of things in the industry that I believe are just cannot right so.
[5:29] In I'm going to go into this a little bit more detail but in 2021 I did a podcast called Tommy Boy, and in Tommy Boy what we did is we went into to what this whole a reorganization thing looks like and so today we're going to go we're going to go back in, deal with some of the things that we dealt with back then and I think it's this whole thing has been kind of interesting for me for the last couple weeks only because it's kind of coming out right now and I think it's just kind of by time by the, bye make it just makes logical sense that the IRS is starting to look at this stuff so in this article this is important so in the article, the IRS commissioner Danny Wuerffel is quoted as looking at spotty or this spotting aggressive tax claims as they emerge in warning taxpayers, the i.r.s. is now taking Swift and aggressive action to close the gap, part of that includes alerting higher-income taxpayers and businesses to compliance issues and aggressive schemes involving complex or questionable transactions including those involving esops.
[6:35] Now what I had said back in 2021 and I'm going to say this like as we go through this one of my biggest.
Awareness items for Isa the ESOP community and let me just stop for a second and just talk a little bit about you know the podcast because, first off the podcast itself that worker that we created in 2020 is really there it's a resource and it's free doesn't cost you anything, I don't get paid for this I don't like I do this because I do like it and I think it's important for people to have this additional resource when I first started doing this.
You know I just felt like it would be another resource to kind of make it you know clear and be helpful as as time has gone on what I realize is that.
Is there is a lot of in unfortunately I believe a lot of, presentations with within the ESOP world and I would say particularly at these conferences that we all go to where you get where I would say the majority of information about ESOP is generated.
[7:34] My problem with it is that they're not giving you the whole story and their bill their able to say things like hey this, this very complicated tax strategy call it a strategy instead of a scheme the IRS is calling this a scheme this complicated tax strategy should cost more because it's saving you so much money, all right so that's the that's the kind of thing I've heard and I've seen and and, I'm not against like just make sure you I'm very clear I'm totally not against the conference's I think there's is so helpful.
When it comes to connecting with your peer ESOP companies and, having a forum to ask direct questions I think that's phenomenal I think it's under Irreplaceable what I am saying is that the problem with the conferences is that the people that speak at the conference's are the ones that are sponsoring, and putting the more the biggest dollars into these associations and the problem is that they're the only ones you're going to hear from and they're the ones are going to coming up with these types of things so they can in my opinion go back and be like all right well it's a, you're saving a lot of money and it's complicated so now as we as we start to take whatever we're going to talk about today is this IRS warning, I'm going to bring some light to that warning just like we did back in 21.
And talk about the reality of 10:42 we're going to talk about the S Corp exemption.
[8:59] And try to just put some sobriety to what this really is because I back in 21 I was like this doesn't make any sense I've never used this I would never I would never, suggest or recommend anybody use this and I think it's it is recommended by people and I you can kind of guess for yourself why.
Deep down I just want people to be aware of it so if the IRS is saying it now and August 2023.
And you're doing a transaction this year or next year or whenever you're going to do it and you're doing this.
Don't forget fair warning so that's what this is going to be about today as it relates to ESOP feasibility so.
[9:39] As we start I wanted to say if you think this podcast is helpful to you please you know subscribe to it.
Would you share it with a friend that you think is you know helpful another somebody that's going through the ESOP and then finally would you would you put a star 5 star rating on our.
Platform that you're listening to so that's always helpful as it kind of validates and creates this credibility that people are looking for again I don't get paid for it so it's just it's more for you guys and it is it is for me.
[10:09] So as we go through this IRS notification so you can go right on in Google that IRS cautions plan sponsors to be alert to compliance issues associated with Aesop's so, you can review the full article, but one of the things in the article that talks about is is for instance as it talks about the the schemes that he that then were full of talked about in the, first part of the the article for instance the IRS is obscene schemes who are business a business creates a management S corporation whose stock is wholly owned by an S corp by an ESOP, for the sole purpose of diverting taxable business income to the ESOP the S Corp reports to provide loans to the business owners in the amount of the business income to avoid taxation of that income, the IRS disagrees in was how taxpayers interpret this transaction and emphasize that these purported loans, should be taxable income to the business owners these transactions also impact whether the ESOP satisfies several, tax law requirements which could result in the management company losing its s-corporation status so that's one of the schemes as we look at it as we think about the this a rework as an as we go through it today it's going to be understanding that you can't let me just say that this like black and white, you can't manipulate the IRS rules just because you want to take advantage of everything that you possibly can Under the Sun and.
[11:29] That is what I believe is happening in the industry as we as we start thinking about it so let me explain the way.
The way I understand the a reorganization so it's as a statutory merger or consolidation these are mergers or consolidations affected pursuant to, and under the State corporate law so a merger really is a union of two or more corporations.
Corporation retains its existence and absorbs others and are on the other side of consolidation occurs when a new Corporation is created to take the place of two or more corporations so.
[12:05] As we think about just doing a reorg just in general there's nothing like some of CPA perspective there's nothing wrong with doing a.
We can we will often identify the entities as we start thinking about an ESOP transaction and feasibility and determine like it's more efficient to be, more when entity right so that's not the problem but I'm talking about is the problem when it comes to, trying to get the 1040 tube because you're trying to be coming from an s-corporation to a c-corporation trying to get the 10:42 and then flipping it back to an S so so what's happening in this type of.
Like I would say scheme is that the company sets up a holding company as a c-corporation.
With all of its shares being sold then the entity then is merged into the holding company but then needs to be there needs to be another entity for this to work, the owner has potentially real estate a real estate company and they conclude that as another subsidiary to the holding company they then take the 1042 at the C Corp level and then.
After the ESOP sale.
Convert the S corporation are the C corporation to an S corporation so so in effect what they've done is they've been able to to convert that to a c-corporation.
[13:20] Pick up the 10:42 benefit and then and then move it to an S corp and then get the benefit of being an S corp exemption.
Let me stop for a second and just go backwards a little bit just so it's clear for people that are brand new to this a 1042.
Is an IRS code section that says in an ESOP transaction as long as you're a c-corp.
[13:41] Then the the stock that they the the owners hold.
Can be in a sense like kind exchanged with eligible Securities so, just like a 1031 exchange in a 10:42 you're going to sell in an ESOP transaction you're going to sell the company stock.
Then you're going to reinvest that into a qualified replacement property with eligible Securities that.
Pretty much done by an investment group working through the transaction are after the transaction to make sure that happens so nothing wrong with it your c-corporation there's certain rules to attend 42, you have to do like a thirty percent transaction you have to have owned the stock for 4 for 3 years so there's certain rules to that type of thing now on an s-corporation side if you are an S corporation and you sell your stock as an ESOP.
Are the ESOP is owning as Corporation stock you whatever the ESOP owns of that S corporation stock the.
[14:41] Income that that entity creates is now exempt because the K-1 goes from the company to the trust and its exempt from taxes.
[14:52] So as we go through this like that's the best those are the benefits right now so it it is the rule in IRS if we if I have revoked my selection.
Then I'm going to to create Wi-Fi revoke the u.s. election I automatically become a c-corporation so that's kind of how the tax rules roll now technically what happens is we would have to be.
55 a c-corp or five at least five years so I revoke the S election I'm a secret for five years I have to wait and then convert it back to an S after the five-year period of time.
[15:27] So what we're talking about is a way that they're there.
That gets pitched because of a private letter ruling that you can take an S to a c and then back to an es again that's what we're that's what we're saying so as we go through that.
Now after like as we gone through this research with different people they reviewed the legal Authority and.
[15:53] The others are using to support this this idea this notion that you can create a newly-formed C corporation that would be the sole shareholder of an s-corporation merge those S corporations into the C Corp sell the C corporation to the ESOP claim 1042, and then immediately after that elect s-corporation status for the.
[16:10] So unfortunately those legal authorities do not stand for the proposition that 1042 treatment would be available in that type of transaction they describe one of the legal authorities cited is known as the, letter ruling which is a ruling that the IRS issues to one party that cannot be relied upon, by anyone else but that generally reflects the position of the Internal Revenue Service so that ruling addresses how to apply the rule that says.
A corporation that revokes it's a selection and becomes a sea must keep its status for at least five years before I can re-lect s status the ruling says that you can merge an s-corporation into an existing, C corporation and immediately thereafter elect a status for the new Corporation the technical holding in that private letter ruling is at the loss of S corporation status for the S corporation that is merged.
Into the C corporation is not treated as a revocation of S corporation status thereby triggering the five-year waiting period for re-electing S Corp status in the context of merging an s-corporation into an existing C corporation, that makes sense but we believe we believe the ruling accurately reflects the irs's position on the issue because of that, private letter ruling if 10 if section 1042 were not an issued they see no reason why an S corporation could be merged into a newly formed C corporation with the surviving Corporation immediately electing S corporation status, so in that situation there is no policy reason suggesting the s-corporation status should not be available to the surviving entity.
[17:36] Now that's kind of the way that people look at it so the the primary concern is that none of the legal Authority cited, involved a 1042 election in fact there is another private letter L letter ruling, 1999 5 2007 to which an s-corporation converted to a c-corporation the S the C corporation stock was sold to an ESOP the selling shareholders claim 1042, and the corporation ask the IRS for special permission to re-elect s-corporation status before the five-year waiting period, in that case the i.r.s. rejected the request to allow a re-election of s status before the expiration of five-year waiting period.
Holding that doing so would circumvent the clear Congressional intent of section 10 42.
[18:20] So when we think about this the intent itself is to Grant tax deferred treatment upon the sale of a C corporation.
[18:29] That's not enough to legitimize that whole scheme so that's allowing a c-corporation to be created out of thin air and used to effectively facilitate the sale of what would otherwise be an s-corporation to an ESOP.
Only in order to obtain the 1042 completely circumvents the purpose of section 1042.
So while other why some have argued in that that having a legitimate business purpose for creating the S the C corporation would adequately address this concern.
What we're saying in this is the research that I come up with.
That a is not accurate statement of law be it would be a real difficult if not impossible to prove it business purpose separate and apart from the real reasoning for establishing the new Seco C corporation.
[19:11] Um which is to obtain of course the section 1042 So based on all of that, the research shows really that if someone were to create a c-corporation merge an existing s-corporation into that.
C corporation sell the stock to a newly-formed ESOP and then reelect s status after the closing the IRS would challenge the section 1042 election or.
The other side of this is alternatively take the position at the company is not really a valley that valid S election so what does this really do it puts in Jeopardy as we talk about it.
It really puts in Jeopardy what actually is available to the shareholder.
You know or to the company right so there's so as we as we start to kind of pull this together and I went through the the research that was kind of saying this is not a solid 100%, strategy for somebody even though it might really look okay and somebody that has a lot of experience that can present this really well so.
And when you get down to this you you do subject yourself to something happening to the 10 for you to or potentially the S Corp so which means that do you know the question mark for us is for from this, tax scheme or whatever where we're going into is it worth it to you to go through this whole process and expect to get all of that out of it now.
[20:34] We've talked about this this year there is new.
Legislation coming down the pike in 20 Billy 2728 were s corporations are going to start to get to 10:42 but they're only going to get like a small piece of it like they might get ten percent I think is the, is that is what we talked about earlier so there is good legislation going on within I think the IRS moving, towards this but I think in general I wanted to kind of step into this the idea and it could be a different type of scheme when it comes down to it I think the question mark is, finding like what is really when somebody puts a present something to you.
What is the what's the reality of that and how much does it hold water with who you what you're going through so.
As you go into the feasibility part of this is to extrapolate what is your what is your IRS plan when you get down to it and what I mean by that is is are we an existing s-corporation are we, an existing C corporation and in the feasibility part when we start thinking about that that will.
Where that matters is first off validate that those those strategies work so that's really the first part of what I wanted to get to the second part of what I wanted to get to.
[21:50] Is whatever that is if you if everybody feels good about it now the now the the advisor can go through, the important part of taking that information and extracting from it the cash flows available from the tax benefits of being an ESOP, so why is that important for feasibility because those specific quantifiable.
Cash flow numbers that are going to be the benefit now for C Corp if we have to be a c-corp we're going to stay a secret.
The benefit is going to be primarily the contribution of the principal and interest.
On the inside note that gets to be deducted from the income that the company is going to.
Create each fiscal period so that's going to be the benefit as a c-corp so we can quantify that benefit.
Add that back into the cash flow so that when we do the debt structure which we talked about in the first part of the series we can then anticipate with that benefit how much cash flow is available to service the debt, pay for the ESOP compliance costs and then net us out at the end some type of cash position that the company has.
[22:59] The other side of it is is that we have now the benefit of if we are going to just wear an S corp we're going to stay in S Corp or not going to do the stuff that we just talked about.
Then okay so now it's a little bit easier in that model because we're just going to be if it's whatever the ownership is of the S Corp stock that's going to be exempt so either way we're going to quantify the cash flow benefit of becoming an ESOP company, for the benefit of underwriting the company's cash flows against the debt that we're creating, and again we started off with this idea that we're creating debt because we're buying out the owners and the owners have certain fair market value of what those Shares are worth the companies perch, B will basically borrowing the money to purchase those shares on behalf of the employees.
So the other part of that is to is to start to work through the the math when it comes to how much if you are not 100% s-corporation Esau, how much this contributions are going to be which then comes back to estimating in feasibility what the potential inside note is going to be so we're going to get we're going to get deeper into that as we go but.
[24:12] The main thing I wanted to kind of just graduate to is this idea that we need that, those numbers and we need to model them out because we need to know do we have what we need to manage through the debt and from a benefit standpoint I think the biggest thing here to is these are the way the tax benefits work.
In an ESOP transaction.
[24:34] So with all of that I wanted to kind of stop and just say thank you for listening today it's a little shorter than what we would do normally I did kind of, borrow content from the 2021 so you know I just wanted to kind of highlight some of those things I wanted to make this very applicable to the most, news out there so I think that's really the value of just trying to re-up this information but I don't feel like there's anything different, that we had back in 2021 then we do now I still think these are, um if it doesn't look right or if it feels like it's too good to be true I think you just have to kind of investigate that a lot of different levels so thank you so much for listening today and we will definitely see you on our next step on this journey to an ESOP.