This episode we get to review what is important about third party administration of an ESOP plan. Scott Freund is an absolute expert at the nuances of how benefit testing as it incorporates IRS limitations related to ESOP Plan design. For instance, IRS code section 404 that generally allows for a contribution to the ESOP plan up to 25 percent of the payroll and IRS code section 409(p) related to S-corporation ESOPs to test related to disqualified persons. This is an essential step to understand for planning your ESOP and for staying on top of an existing ESOP plan.
This episode we get to review what is important about third party administration of an ESOP plan. Scott Freund is an absolute expert at the nuances of how benefit testing as it incorporates IRS limitations related to ESOP Plan design. For instance, IRS code section 404 that generally allows for a contribution to the ESOP plan up to 25 percent of the payroll and IRS code section 409(p) related to S-corporation ESOPs to test related to disqualified persons. This is an essential step to understand for planning your ESOP and for staying on top of an existing ESOP plan.
[0:11] Welcome everyone this is the ESOP guy we are on a journey to an ESOP.
As everybody knows we are right around the corner from the craziest time of the year which is the month of December and I when I say that I'm a basically mean that we have a lot of Christmas shopping to do and, and I feel always guilty every day because I haven't done what I should be doing.
We do also have a lot going on in the ESOP world and so at the end of the year it always kind of gets crazy with esops and the amount of things that have to happen, and so one of the things that gets kind of caught up every year in terms of Aesop's is just kind of the things that happen with allocations companies getting ready to make sure that they've you know done all of the things that they're supposed to do from a compliance perspective.
[0:57] In some cases a lot of Aesop's are trying to close their deal you know and I've got a couple that are closing so so December is crazy but I thought it would be a very good topic for us to talk about today the, idea behind how the payroll affects an ESOP and some of the some of the things that we're going to get into our the structure of how an ESOP works and the payroll itself the way it works within a within a company that's going towards an ESOP or is an existing ESOP is going to influence this the way that the structure of the ESOP is and so navigating the complexities of payroll, and how that affects an ESOP benefit is important it's complicated and because it's complicated I thought it would be best to go to an expert, to have this conversation and today we're going to talk to one of the what I call one of the go-to people in the country because he's somebody that I go to all the time it's named Scott freund.
[1:52] He's the senior managing director with Blue Ridge ESOP Associates Blue Ridge was founded in 1988 that happens to be the year I graduated from high school, so you know it's a long time ago, they provide third-party administrative surfaces for esops also 401K plans and defined benefit plans right now I think they have over 1400 esops has clients so that's a pretty big number, so Scott I want to welcome you to the podcast officially thank you for you know agreeing to do this I know you like a lot of other things going on so I appreciate it.
[2:27] Absolutely thank you for one appreciate you didn't give me the opportunity to be able to talk about the subject with you I'm sure a little bit of knowledge was the community awesome.
So before we get rolling just because I do a lot of movie stuff I wanted to ask you Scott and we're in Christmas season will tell me what your favorite Christmas movie is and why.
[2:47] Oh you know there's so many great Christmas movies out there it's I always find it's hard to pick one but.
If I'm thinking Christmas movie that Christmas story for me is always the one that I go to a it seems like like every year I walked at multiple times I mean it's always on Christmas Day I like all day long and it's something when I was, you know little bit younger.
My kids were younger we would always watch that on on Christmas Eve and Christmas Day and always and just get a kick out of all the different sayings and they're like, don't think the old man opening up his box and one front heel a me laugh all the time seriously is there say I love that little white that for to that everything I think it's funny like Christmas movies are funny because you do watch them over and over and over again, and it's a tradition in our house as well but it's fun and it's nostalgic to I think the Christmas story is is a movie about, you know the Nostalgia of Christmas is long ago and traditions and families and partly how weird every family as a little bit so it's a cool that's a cool one Scott that's great.
All right so as we get started just to go get everybody to kind of know you a little bit better how did you get started and working with Aesop's why would why why did you even get into this whole crazy industry.
[4:01] Well it's kind of.
[4:03] My accident really um so I graduated high school seniors you did um I'll be probably dating myself here but as soon as we're getting into, from the mid 90s I was my first round of college a degree in accounting and I was working at a local bank doing taxes so I did taxes for their trust to Collins and some of their personal trust clients.
I didn't see a future in it it really wasn't going anywhere for me and so at the time they were actual newspaper with actual want ads, and so there's this company in Appleton Wisconsin.
I called benefit Consultants or RBC I group in short that we're looking for people with an accounting background to do record-keeping work for a retirement plans.
[4:45] Sound interesting something I might be interested in so I interviewed got the job and that was back around 95 and that I first started there and.
I've really been in these top industry ever since wow you know I worked at that will be see a group is that grew over time, you learned a lot from folks like Dennis long and people now who are you look pretty much the founders of the company they are prepared by principle and you know work there for a while to before I decided to make the change to come over to Blue Ridge nice I've been in the industry a long time there's always something new to learn and that's one of the interesting things about he stops even though I've been doing this for quite some time and going back to when I had hair on my head, exactly that they're going always some things new things pop up there that and that's why you know doing the podcast is fun because there are new things that pop up, and then there are things like this to their kind of out there that are older that are been around for a long time but I really not as well understood and I know that because people ask me questions about what we're going to talk about today.
[5:43] All the time so and I like that you mentioned One ads and just because some people might not know what that is.
Those are things in the newspaper that told company of companies were advertising for a job placement instead of going on the internet which really didn't exist back then right so really that's how things and we read maps real Maps we didn't have, a phone telling us where to go anyway I'm digressing but so yeah so you've been around a long time and you know Aesop's and so one of the things that, I just as we start out foundationally and fundamentally when you think about a third party administrator, how do you explain the role of what your company does and we can we can make it you know relevant to Aesop's because I know you guys do 401ks as well.
Sure sure so as it as it relates lasted for they Stewie stops I mean really that the big picture thing is as a company we're helping maintain the records of your plan.
So it's a company that identifies who's eligible.
[6:43] To be in the ESOP helps to figure out how many shares are available to be allocated to your employees and determine what that the total compounds is.
Probably employees know we can calculate fasting and then as an ESOP becomes more mature you may have different types of transactions that they happen over a course of time, so we help work through through that with you to ensure that those transactions are out get it right.
To your employees But ultimately at the end of the day the account balance total invested are correct.
Yeah yeah record Keepers going to help create those statements that you hand out to let people know exactly what their benefit is.
[7:20] In addition to that you know what I think is really important when you talk about, the the TPA world is having at EPA who really focuses on himself administration because it is very unique, there are a lot of ppas in the country that do 401K Administration they do a very good job with that but when it comes to e-stops it's really more of a limited market place and since he stops are our unique and different, and have different rules it's really important that you're working with the company not only that leverages technology to be able to Mammy that but, has a foundational understanding of all the ins and outs for esops that they're keeping you abreast of updates and ensuring that your plans are staying in compliance.
[8:02] I think that's a key thing and I think that comes up from time to time with ESOP clients or companies that are going into the ESOP space.
And they have an existing third-party administrator and so the conversation usually is like, yes they do your 401k well but you may want to consider somebody else because the ESOP expertise is very important because the complications you don't want the complications to get you into a position where you have a problem with.
With compliance with the Department of Labor you know that that's the last thing you want to be thinking about and you certainly you know should definitely qualify the TPA that you're working with.
That they have that type of experience and they really know what they're doing so so.
For me my purpose is I know Blue Ridge knows what they're doing and that's why obviously why they're on the podcast.
One of the things I wanted as I set this up kind of correctly is understanding like the ESOP process itself for this is this is really for those companies that are, listening to this and saying hey I'm going to go towards an ESOP over the next year or so.
[9:02] One of the major steps that we have to look at is how does your company fit within an ESOP structure when it comes to the way that the shares are going to be released for your employees and how that's going to set itself up, in the structure of the company itself being the Aesop's going to have you know basically buying be buying this these shares and your company can be either an S corp or a c-corp and so there's really only two, different corporate entities you can have to be an ESOP company so you're you're going to have to be either an s or C so some of the things we're going to talk about are going to be, around the idea of your planning to be an ass or you're planning to be a c or you might be going through and really thinking about I could do either one, and so that's going to be important as we as we think about it and so.
[9:49] So as we as we talk to Scott about this I'm really kind of getting into one of the things that I try to do really early on in the process in what I call feasibility, which is really at the very beginning of the ESOP process is establish how this is all going to work and there's going to be, some specific things that we're going to have to look at and so the first thing that we do when we call Scott's Company and say we have a company that's thinking about an ESOP, as we say we need we need to look at their employee information or their payroll what they called the payroll census.
So with that Scott what sort of information from the payroll do you need to start looking at, because that people always ask me and I'll send them something that you would send me right and it's like 15 different columns and that's usually overwhelming so what sort of things do you need and why do you need to see those things on the payroll senses to get started.
[10:39] Sure Phil it's a it's a great question I mean a lot of those built different columns in our in our request for information or and it is needed for various purposes.
In Auto at the end of the day what we're trying to help identify in of an employee's total employee base.
Who we would expect to be eligible for ESOP purposes and what they're eligible wages line.
In order for us to be able to accurately identify that there are some key pieces of information that leak.
Also some very good basic sentence information for things like dates of birth and a fire there could be age requirements are there could be retirement provisions, where we need to know the age of an employee.
[11:18] Your most plans are designed in a way where employee has to work a certain amount of time if they have to work a year before they become eligible so we need no higher dates to know what you knew employees are versus long term.
Might be eligible for the plan.
If we're receiving a total payroll of all your employees over the course of a year we need termination dates to usually when people leave them out eligible so in order to be accurate we need to know who your current employees are.
Obviously pay and typically, typically in the context of an ESOP it's generally gross wages that are eligible for yourself purposes so at least if you're initially looking at the feasibility you'd want to be looking at your total gross wages.
That that you pay to eat one of your employees and not taxable because you're counting everything and that's important to get on a per employee basis to, and there are some some weight limits as far as what are eligible for you sign purposes so if you're a company that has employees who earn significant salaries.
That there may be limits on how much of their pay you could count all for he stopped purposes and in particular for this year for 2022 that limit is three hundred five thousand dollars.
Even though you may think we have a 10 million dollars worth of payroll if you have folks that are making more than that limit you can't count that and select the part of that analysis.
[12:40] Yes four hours to because usually most plans will have an hour's provision that person have to work 1000 hours or more.
To be eligible for ESOP purposes so it helps to break down between your full-time and part-time employees.
May or may not be eligible for those are the the primary drivers as far as what we would need to help at least do an initial.
Compensation type of projection.
Having some information about other plans that you administer can be helpful to for some other deduction purposes so if you sponsoring a 401k plan for example.
If you have information on how much people contribute to that plan are specifically if you're making the contribution so whether to match or a safe harbor typo.
Contribution of that plan knowing that on a per person basis can be important to because there are limits on how much you as a company can contribute.
I took qualified plan and what you put in your 401k plan part of those overall limits so.
It's helpful to have those details to Hamilton when we request payroll information.
[13:43] Now that I think that's good comprehensive and I think sometimes people are like trying to get the data and sometimes I just tell them you know it's in the file that you send to your payroll company, or send the file that you send to your 401k company and and usually most of the information is going to be on one of those things and, but but we I know Scott can kind of glean a lot from a little, because he has in a lot of the things that I've worked with to try to make sure the conceptually almost all the information is there.
One thing that has come up from time to time is like you'll get people that are union and non-union.
And with an ESOP what are the complexities of a having a union employee in an ESOP plan.
[14:28] There's some some additional testing complex means if you have, you have Union employee that artists are palpable you know a lot of plans are designed in a manner where if you have a union those benefits are collectively bargained in there getting benefits somewhere else obscenities on they may not be salvageable.
[14:47] If they already stopped eligible then it really kind of breaks the plan down into type of many plans when it comes to testing focuses so when we're looking at at things like You're highly compensated employees if you have some of those in Union we have to monitor them a little bit separately from.
Employees that are non-union it's what we call without getting too deep into the weeds here yeah sometimes, guilty of doing that as an ESOP geek here but yeah I would do dumb things called permissive your desegregation or required to segregation where you're required to test a union and non-union employee separately, for various reasons so it just, it's not something that can't be handled or necessary the problem is just a consideration sure that that has to be taken into account when you're doing your annual compliance testing for a plan yeah I mean the big big idea behind me ask you that question is I know some people just don't know whether or not you know if I have a union a union employees can I be still be an ESOP so it's like yes you can there's different tests that you have to do I think our encouragement is to try to do those things early in the process in case there's something that's.
[15:52] You know going to be really restrictive about the type of Visa plan you're going to have, and you want to know you want to know as much of this information early in the process so that you can with your advisor navigate through that and make sure that the structure of your Aesop's going to work for everybody.
Certainly before you spend a bunch of money and everybody's like at the closing table saying oh no that's not exactly what we thought we were going to get you know so that's that's just kind of good advice to make sure you've thought through that, I actually had Scott had somebody call me this week about Union so I was just on the top of my mind you know so I'm like, might as well and he maybe listen to this or not so anyway, so those are the pieces of information that you look at and so we kind of touched on I'll get one out of the way right away but we already touched on it a little bit, and it's when we think about these code sections they're just they help us to kind of like put ourselves in the right lane of thinking so this first one would just be for 15, which is the high compensation limit where if I have an employee as you said they make more than three hundred five thousand dollars.
[16:56] They're not going to be able to get an allocation on those shares that exceeds the 305 thousand dollars that correct.
So they're going to be correct they're going to have a forfeiture of some of those ESOP shares and so and the reason is and that's a retirement rule anyways it's not just Aesop's right it's, anything it could be 40 and yeah all qualified plans are qualified but yeah so it's not like this is not specific to Aesop's but it does, and that's where esops are over time because of the retirement plan they fall under those risks are requirements and they have to you have to follow all of the rules, for the qualified benefit plan as well as other things that we'll get into.
So what one of the reasons we look at 4:15 early on is say you have some key Executives and you're thinking through the plan and that you're going to say well that's going to be your benefit you're going to get this benefit as an ESOP.
And you go through the whole thing and they're like hey I'm not actually getting my entire allocation you're going to want to know that.
And communicate that early in the process for your highly compensated people and be able to plan accordingly with other types of incentives or vehicles to help them you know, should be treated you know at their level or fairly at their level from a compensation standpoint.
[18:07] And the 415 doesn't rule out that you're going to be an ESOP so that's not going to be it's just more of a restriction on the payroll limits anything else on the 415 that think is.
Important.
[18:18] Yeah yeah I think though when you're talking about the 450 annual Edition limits under under 415 that those limits are.
More on a employee basis all right well it's limiting on a per employee basis how much of a benefit they can receive in a hold of plans.
That there are participating in so it's one of those one of those tests that's it combined plan type test where you look at these op and you look at your 401 k plan, and the total benefit our annual Edition that someone can receive is limited to a certain dollar amount 61 thousand dollars.
For the 2022 plan year so as you're looking at feasibility and looking at what type of, ESOP contribution you may be given to employees over time if someone's ready maximizing what they're putting in their 401k plan or maybe getting a match in that plan it's possible that could have a limit on what they can receive in these.
Or or vice versa if if they're getting too much in these up and they may have to receive, refunds out for of what they're contributing the 401K plan if you get the ability to new design that upfront and look at the feasibility that you can structure an ESOP loan that you provide the benefit that's still a reasonable benefit but maybe if them so rich that it's causing people to go over.
[19:35] Well Daniel dish which can be pretty frustrating for some people when they're getting those texts back and they're like Oh I thought that was going in, 24 okay so so planning is always a kind of the the essential part of this every step by step if you have a good plan on the benefit side it'll just be helpful for everybody to communicate the benefits to everybody.
[19:53] But good point it's an individual test as other things are going to be company or corporate tests on the whole balance on the whole payroll as well.
[20:01] So going into the next thing would just be kind of the the 404 which would be the.
Twenty-five percent payroll limit and so what that means is that you can contribute to the ESOP up to 25% of your payroll in conjunction with your match of your 401 k so the combination of those two so when you get down to it I think it's as simple as saying you got, you know 100% of your payroll compensation you take 25% of that, and you can contribute on an annual basis to the ESOP the up to 25% and then if you have 401k that's just kind of gets subtracted from the 25% so that's kind of how the 404 works right Scott.
[20:43] Right yeah that's basically how it works it's that you're worth the 415 limit wasn't on an individual basis, that that 44 limit is on a company basis so you're looking overall it as a company what can I contribute to my plan as a deductible.
[20:59] In the the limits do very little bit whether you're a sea or an S corporation generally you have been that it doesn't have corporations pretty straightforward yeah the limit is 25 percent of your eligible payroll so again you're looking at that payroll that's Limited, I'll surrender 5000 and just looking at Coney people that are getting a benefit in either in the East a 401k plan so what you can contribute as an ESOP contribution or or match another plan is limited to that.
One of the important things about that is if you make contributions that go above that 25% women.
[21:34] Mo not only they not deductible but a non-deductible contribution is subject to an excise tax to you as a company and that excise tax of 10%, of that non-deductible contributions so it's important that you're paying attention just for even if the options aren't to make you yeah penalty usually are for you you want to try to avoid penalties are like raise your hair on your back because it's just like why why have to spend the extra money on, and again planning all this in early as very important to understand it the nuances between the escorpion the C Corp were very very interesting and even when you get to the.
One side of this is when you get to the percentage of the sale that's also Nuance so if it's a hundred percent versus a purse partially ESOP so.
So let's go into that for a second one one of the things like four and four just a straight-up seek let's go escort for so for an s-corporation on 100% basis we can basically contribute and.
[22:31] The total contribution each year so if I had a million dollar payroll.
[22:38] I can I can contribute without a 401k I can contribute 250 thousand dollars a year to my Esau.
[22:47] And the way that works mechanically is it's in the form of an inside note.
[22:53] Amortizes that the amount of shares each year or releases the amount of shares each year based on the amount of the value of that inside note over this inside note amortization schedule.
Which is going to be calculated with a principal and an AF our interest rate and so the principal and interest component of that is what's deductible.
On an s-corporation ESOP from a tax perspective and so for a million dollar payroll that's 250 thousand dollars a year.
And what we would do basically is taken a ation schedule and create a benefit to the employees.
Um of that 250 now what Scott has to do is look at also the percentage of the benefit and making sure that, the benefit to the each employee depending on how number how many numbers of people are and payroll are there what is the percentage there each getting and so's that can vary a lot based on the number of people, in a company so so based on that Scott what are the normal benefit amounts that you would see, and those percentages for employees that you're trying to kind of dial in with the inside note that we just referenced.
[24:02] Charlie may I think we don't think it's important to clarify when you're talking about that that Cheryl Eason happens yes so you know company is making a 250 thousand dollar contribution to their plan to make a payment on that loan which had going to release shares of stock.
So should stock that had been purchased from the song shareholder ultimately what employee sees is going to be that shares of stock times whatever the current fair market value.
Of those shares of our neck that may be less than or greater than.
What that contribution amount is good point so bright and so that that back the level really is if the value of the shares that employee sees every year.
[24:42] You know it generally when we talk about Aesop's you stops tend to hit provide a bigger benefit in general than other types of retirement plans II think in the neighborhood of eight to eight to twelve percent benefit is very common.
For programmed ESOP and sometimes it can be much more than that, I think there's limits if you start going to be on twenty twenty five percent now you're running into some of those compliance limits that we had before yeah and you may not be sustainable you know to have that rich but benefit over a long period of time, but generally speaking an ESOP there are established in a way where it does provide, you know that that type of eight to twelve or fifteen percent type of that effect to employees on a year-by-year basis and as compact as compared to a 401k match which could be like what four to six percent.
[25:30] Spring so so that's when people roll out there Aesop's one of the things I like to talk about with the new employees is hey guess what you know you were getting now sometimes they keep the 401K match another time some companies to spend it.
But in comparison you're getting this benefit of the company was making on your behalf.
And you're not make it you're really not putting any you're not putting any money as an employee end of the ESOP Planet at all so you're basically just getting 8 10 12.
Of your salary into this plan every year and you didn't have to do anything.
[26:02] And then it grows you know any compounds every year of course because you're getting more shares in the value of the business can keep going.
Hopefully upward right you know so your value of your of your retirement portion of your plan gets higher so so that's that's kind of a very important step in its, and it's difficult modeling right Scott because it's like you've got a lot of variables and those can change early in the process into at the end, like I'll get Scott involved six months later we do a transaction so some things have changed so we're going back over that and updating these benefits studies to make sure, nothing major and you could have people leave and come aboard so you have new people you know the dollar amounts that we estimated maybe higher so that could definitely change, a lot of the modeling so but if you get a good overall modeling at the beginning then you can structure the ESOP I think with the right expectations and then going to go and move on from there, so right I think it's important as you're going through the whole modeling process is helping to determine, what the proper term is of that internal own how many how long do you want that internal moan to be spread out make sure that you're providing a benefit to your employee that are that is reasonable, strong but is not unsustainable.
[27:16] Yeah I want to one of the nuances that I thought it would be helpful is in the event that let's just say you have a hypothetical you have a company that has a very high valuation.
In a in a relatively low number of employees.
[27:30] What that's going to do is it's going to put some pressure on that inside loan payment because we can only use 25% a year.
And so an S corp we it's only principle its principal and interest and as we flip that over for a c-corporation you do have the benefit of having you go in excess of the 25% is that correct.
[27:53] That's correct gear for leverage c-corporation ESOP that 25% limited just for the principal just for the principal yellow payment the interest portion of the loan payment is fully deductible regardless of how much it is so typically earlier on in the life of an ESOP you love the larger portion of the payments going to be interested yeah so you do have some.
Probably a little bit of Greater flexibility as far as the deduction limits for a company like that that has a high value to payroll, type of ratio or you may be able to get away with larger payments because you're only looking at a portion of that loan payment for that least for that deduction on it yeah, so when it gets really really tight and then in the hypothetical I'm talking about is we have a high valuation and a lower number of employees what happens you have to stretch out the inside note, for a lot longer period than you would normally and I've heard I've heard some people have 50-year inside notes.
Right I mean sometimes it goes on it's a fifth to basically what that means is that there's a share release of the existing shares over 50 years as opposed to, you know a 30-year or a 20-year which means that's a long time for all those shares to go from the Trust In into the participants account, because a lot can happen over 50 years but but that's the only way you can really structure it if you have that type of situation where where you have a high valuation and a low number of employees.
[29:16] So with a partial let me go into the partial the nuances of a partial escort so if you have an s-corporation and you sell a portion of it not 100%.
And you have the pressure on the 40 for the 25%.
Um what are some options when it comes to the value of the inside note and where I'm getting at is in setting the inside note we have we can use the value of.
[29:45] Basically the value of the day to price basically getting into that in terms of the net Redemption amount versus the the actual amount that we would look on the inside note so so part of that is just trying to make sure we don't have a 404 issue so, relative to the partial S Corp what sort of things do you do to try to work through that issue.
[30:06] Wait I think another complexity factor with a partial s-corporation esab, usually they use of s-corporation distributions or dividends because when you have when you have an s-corporation you stop it doesn't own a hundred percent of the outstanding shares, if you have outside shareholders who still have tax liability on the portion of stock that they own.
Typically a company will make tax distribution so it's outside shareholders you know to help them pay their tax liability well a nice Avi stop gets his piece of that.
I can really for an s-corporation there can only be one class stocks you can't say that the outside shareholders get a tax distribution and preferred dividend yeah yeah they have to distribute all yeah.
[30:51] They have to get their piece yeah so now that's another that's another source of funding now so if you if you're making it and text distribution or S distribution into the ESOP plan, back in the years as well I just service that debt right now so that can be that can be paid towards that internal Lon and since it's not a contribution.
[31:12] Such as earnings, that those that bomb those payments are not subject to the compliance limits that we previously talked about alright so far that her 25 percent of payroll deduction any sort of dividend or S distribution you put in the plan are not subject to those limits.
It's another potential.
Source of cash that can be used to help when you have that type of a shortfall when you're if your payroll unexpectedly goes down and the the amount that you need to fund to the east side, is going to be greater than 25% of your pay but by Declaration of a finesse distribution or dividend to the east up for that difference.
[31:50] So that you're not going above the limit and having to pay an excise tax is a new it that's a planning tool that's available.
Nuts are other considerations which I think probably go beyond the scope of what we're going to talk about today yeah and I think yeah we could get into some major complexities but I think the key is it's just this to kind of explain the.
The way that planning is necessary for these types of things and then, there's things that will be established at the beginning that can change over time like like Scott saying we could lose employees down the road that puts pressure on that 25% limit and then you can adjust accordingly with some other ways to make sure you don't have, any issues and potential excise taxes of being in excess of the 25% and that's and that's really a fundamental reason why, you have to have a third party administrator that has expertise with an ESOP because it's not just I'm putting numbers in a box in though and delivering those we you have to be able to have all of the situations.
That could happen and be able to go through that from a consultancy and advisory standpoint with with firms that know what they're doing so.
[32:57] Now let's jump into because we as we get into the third thing is just the 49p ruling and has it as it affects again Aesop's potentially sup companies, we're going to primarily deal with s-corporations because this is what, This only affects an S corporation so just like the 404 and 415 these rirs sections and the 49p is going to be there to protect the.
The company for a while to protect the government I guess from having an anti abuse situation with an ESOP.
So because an S corporation needs up as people may know is tax-exempt yeah absolutely as you said Phil it's a specific to an S corporation.
And 49p is specifically is called anti-abuse test and so the what it looks at is.
We complete that test to ensure that the share allocation and concentration of ownership within the plan isn't concentrated amongst a small group of people.
The two part really that this test is done it in two pieces that the first part of the test and determine if you have anybody that's concerned disqualified person.
[34:10] That's based off of share ownership so anyone who is concerned disqualified person is going to have ownership in the company of ten percent.
Or more more or if there's a family group or if you have people that are related to you that work for the company that the family group looks at 20%.
[34:28] This looks at allocation within the ESOP and can also look at other forms of equity outside of the ESOP, so if there's if you have things like stock appreciation right so warrants or even form of deferred compensation plans those are considered.
Forms of ownership that we have to take into account for this test so so when we're doing not only working with the plan to help.
Projected out and ongoing Administration purpose and we're going to ask questions about who do you have that are related to each other because the that matters for purposes of this test, and we'll ask about outside Equity type of Arrangements that are in place because we have to take those into consideration, to make sure that you don't have a an equity type structure that that weren't that we're not aware of that could cause an issue with the design of the test.
Through the first part of that test is that anybody own 10% or more of the company between what they have in the E5 or what they might, have an equity Farm outside of the plan if you don't then you're good right if you if you do have any of those them then the second part of the test for anybody that does own 10% or more either within the ESOP or with other forms of equity.
Do those people in total or more than half the company so the second part is do those disqualify people.
[35:45] And worship of fifty percent or more of the company and if they do then that's.
That's where you have a testing failures that Stanley called on El Cajon yeah and that's.
It's a huge problem she's always really really the penalties that come into play when you fail this test are really rather Draconian there are significant penalties from a company perspective.
From a planning perspective it jeopardizing your status as an s-corporation.
It disqualifies your plan you lose all your contribution you have it's just there's a lot of its kind of do bad thing it's nuclear it's the whole thing's nuclear right so that's why we're so big on planning for if it ever happened and I don't have I think I ask you this question have you ever seen a company actually failed to 40 9.
[36:30] Well I mean you really can't you can't yeah me yeah you really can't fail for a 9p usually companies will have language with them their plan that gives you directions on what you do.
[36:43] If a failure could happen right you know part of that would be transferring shares to a different part of the plan that makes those shows taxable mhm.
[36:52] But I you start to lose some of your tax benefits right I'll make it if you have to do that type of transfer so it's just the sum of the luster of having an S corporation used to have yeah it's just knowing that it could go nuclear you have to be on top of this this issue.
And, it's one of the variables with 409 p is again we're thinking just about us corpse is that you know really it's important how many people are in the company so one of the questions you're you're going to likely get asked by an ESOP person and say how many people in your company and they're asking you that question.
Because they want to see if they're potentially could be.
[37:25] For 9p issue so if the answer is I have 15 people or less then probably you're highly possible that you're going to have a 49p issue because when you start thinking about the allocation of stock.
When you add warrant since ours on top of it or you have a deferred comp plan it makes it even worse.
So that's the that's kind of the the easy way to look at it when you think about it when Scott goes through it he's usually going to go through the whole payroll senses and he's going to do an allocation of, ESOP stock for everybody include the Deferred Comp include the warrant include the SARS and then you're going to have these buckets where somebody's over 10% or less.
Or we have the family grouping test as well which is you know in that first test the aggregate has to be less than twenty percent so we'll look at those and see if there's any potential violations.
That way you can you can plan accordingly at that beginning step.
I know so for that definitely can be problematic for small companies like you Sabbath who have yeah you have less than 15 employees it's hard to not have a lot of people get 10% or more it's just yeah that's just a massive way the math works yeah he can't change it, so so in so in some cases people are like oh I'm not I'm not big enough I can't be an ESOP so let's just say we have and I have this going on I have an escort, that's got a 4 and IP problem well I'm going to look at doing just a c-corporation what will happen is we will revoke the S election.
[38:53] Which is fine we end up taking it over to a c-corporation.
Then we get to use which we're not really going to talk about today we get to use the 1042 like-kind exchange on the transaction which is going to be favorable for the selling shareholder, what we're going to do we're going to lose in the end the tax benefit of being an exempt entity as opposed to having to pay C Corp taxes.
So that's that's kind of hot what you have to do write in terms of a small company you still can be an ESOP you just can't be like you know and eventually you could get to a point where you could.
After that five-year period you can go and become an es again assuming you qualify for 49p in that and that tax year.
[39:35] Yeah they that 49p test doesn't apply to a c-corporation definitely there's no there's a limit on how many employees and they have but I've seen that I mean I've seen company that.
And seen one that was an s-corporation around 15 16 employee so they were really pushing the limits they had one of their Founders retire once that happened.
- share started getting redistributed everybody else there's just no way there's no way it was going past them so they provoke their a selection yeah to become a see now is they're getting a little bigger like you know it's been more than five years I've been thinking about maybe.
I'm coming - yeah so it doesn't it doesn't eliminate that option but it is it's something that you definitely want to know and analyze before you get into it and that's probably the main the main thing with 49 p is that's probably what we look at, there are.
Interesting cases where you do have some pretty heavy deferred comps that can be can play a role into some disqualified persons test but so you just want to have all that information ready to go so you can really understand, that those types of limits and keep going towards you know the ESOP planning that you're doing so.
Any so from there we kind of I think what's gotten I did today was we really hit the high level of what I would say are relatively common for every stop company we're going to talk about 40 44 15 and 49, at least consider for an mp4 all s-corporation so anything that you would add to what we talked about today on that Scott.
[40:59] I mean I think the key really did to everything that we're going through is planning no we need ensuring that if you're considering an ESOP that you plant that you look at these types of limits and try to plan accordingly so that you have that the term of the loan that, provide you with a good benefit but doesn't run afoul of of your compliance limits and that you're just buying accordingly and then, not only one City South put into place and then ongoing purposes when you have a good third party administrator who pays attention to these limits and points out when you're potentially, going to run up into issues in the future down you make it true you're working with good advisers who are keeping track of that as you plan becomes one true.
[41:36] Yeah I think that that's a great point and my point would be to just kind of in almost segue into what happens after that everything is set up.
[41:44] Every year matters every everything that goes in the ESOP going forward is going to matter so like down the road you're going to have to be thinking about you know if you do have a change in payroll if you do have, you know some things that that change internally that you have to go through that with your teepee a to make sure it's not going to, have a man issues like they test once it's like these are things that are going to be kind of part of your vocabulary as a maturity sap company, and then what comes later is repurchase liability conversations about hey that's that's going to have to be considered as well, and so it's really important that as the company establishes itself as an ESOP that there are people in place in the company it's HR levels.
Controller cf0 levels they really understand these these types of things.
So that they can be thinking about it on a routine basis and then pull in the advisors as they need to you know as things go on so.
[42:40] But very helpful so so so with all that thank you Scott for your time today I think it's these are these are really good types of topics for people to listen to because, they can become confusing and I think our question and answer part was you know you can get into some nuances and I think we did that a little bit like you got into like something heavy, like okay what about this what about that so, hopefully the important parts we pulled out the important parts of planning early and really identifying some vocabulary and definitions around some of these Concepts that you're gonna and you're going to end up talking about as you go through the saw process.
[43:17] Very welcomed by the label that people take the time and talk through some of these Concepts like I said you can get of the weed pretty quickly on some of the details here but happy too.
Happy to go over there.
Well with that I hope everybody gets their Christmas shopping done on time enjoys their holiday season and we will see you on our next step on this journey to an ESOP.