EP2 - Meet Joe Black - Death and Taxes - 453a Tax Issue Related to Seller Note and Capital Gains Tax

This episode takes advantage of the classic film “Meet Joe Black” starring Brad Pitt and Anthony Hopkins. The podcast uses the movie to demonstrate the two guarantees in life - Death and Taxes.  The nuances of taxes can catch individuals by surprise.  As it relates to an ESOP transaction - most of the time there is a resulting seller note established.  Relative to an S-corp sale - there will be capital gains taxes that need to be estimated.  We usually look to installment sale method but if a company’s transaction is large enough to create a seller note greater than $5 million there will be an additional IRS interest cost known as 453a.  We detail this issue so that listeners do not underestimate the additional cash outflow to the sellers.   This is a very important step in your personal  Journey to an ESOP!

Transcript

[0:09] Hey everyone this is the journey to an ESOP and Beyond podcast all about Employee Stock ownership plans if you're tuning in today for the first time this is a podcast dedicated to being a.

[0:21] Resource to provide information about. How an employee stock ownership plan works and its journey to an ESOP and Beyond meaning that it's really trying to help determine is this the right fruit is it is this an ESOP right for you or, you know if you're in the middle of a transaction or if you're already an ESOP what what are the things that you should be thinking about so we're we're covering all kinds of topics and as we go we're going to start with this this topic to kind of Kick It Off.

[0:47] Stepped away for so long this is a friend of mine I asked to talk by. Stuff andhe's going to join us for dinner.

[1:01] So they're like wondering who is this guy how nice to meet youis this guy's name how nice to meet you.

[1:13] Yeah I'm sorry this is my daughter Allison and her husbandname.

[1:23] Oh I don't understand something excuse me this is uh this is uh.

[1:28] This is um come on suspense is killing me I'm sorry it's uhthis is I'm sorry this is.

[1:36] Joe Joe Joe.

[1:40] So Meet Joe Black of course if you've seen this movie you know exactly what I'm going to say if you haven't you may not. Meet death so this movie is all about um death and we're going to use it because what is certain in life.

[1:57] Death and taxes so we're going to get to talk about tax today it's going to be super exciting um the topic today is 4:53. Which is a IRS code section we're going to break it down for you and talk about how important and relevant it is in your ESOP transaction. So as I said before uh the podcast really is here to provide a resource and go into topics that hopefully will be helping you. Um whether you're an existing ESOP or you're just thinking about becoming an ESOP and if you go and if you're interested and you go to our website you're going to see that we have a lot of topic. Uh a lot of things to learn about esops and so you're welcome to uh jump in it's completely free resource. Um if you do like the podcast please refer it to a friend because you might know somebody that say thinking hey I might do an ESOP and there's a lot of information out there but this information is hopefully very helpful um to provide very. Good clean understanding of topics without McKing them up with all kinds of of um legal speak or PhD type ESOP so this is all about on just really understanding it so again thank you for joining today. Um and as we start the topic I wanted to kind of start off with is is this idea behind um.

[3:16] This this certainty that you know of course we're all going to die and we're all going to pay taxes and when you get down to it the first thing that people think about when I say taxes as it relates to ESOP for the most part if you've done any research at all. Is that esops are completely favorable and a very friendly thing and honestly 1 of the only vehicles to utilize in the in the Internal Revenue Service from a perspective of. Of getting your company not to pay income tax whether it's federal income tax state income tax in a quart of course incorporating the idea that it's an S corporation. So you may already know that and that's really a helpful or you're shifting over to the other side of things and saying hey, I'd love to you know I'm a C Corp or like a convert to a c in order to not pay capital gains tax or at least defer my capital gains tax using the 1042 so when I talk about tax these are the 2 primary things that people are going to going to get to so, what we're going to talk about today is a little bit more of a a deeper. Um level of analysis that I think is very important to be aware of and I think it's something that you should at least um, if you are planning to do an ESOP you should be um and really understanding um what this what this really means for your future. Potential tax soobviously what we're talking about is um the structure like when we talk about the structure of an ESOP. Um the first thing I wanted to kind of say is that when you structure an ESOP transaction generally what's happening is is that there there there could be.

[4:46] And possibly should be some initial senior debt financing.

[4:51] What that means is that the bank comes along into the transaction and then they they will provide financing for some level of, what we would call the turn on your historical cash flow so, let's just say that's 2 times your historical cash flow they come in we have that much senior debt and then the rest of the of the amount evaluation that gets negotiated in the ESOP is going to be is going to be um financed by the shareholders. In seller notesand so what we're going to talk about with 453a is what what happens with those seller notes from a future standpoint.

[5:28] Now, the the way that we're and this is all about like capital gains so kind of keep in mind that what we're what we're talking about is not a 1042 transaction we're talking about you're staying an S corporation and the individual sellers are taking back a shareholder note section 4 53a. Is what it does is it imposes an interest charge on installment obligations where your property exceeds $150,000 um and your in excess of 5 million so anything above 5 million in the seller note under 453a would be subject to an additional interest and we could call it a penalty but it's really just tax right when you get down to it they're they're basically wanting um the IRS is wanting, their pound of flesh out of the deal right and so clearly when you start to analyze this issue what you're what you're looking at is, um how much when you look at the the senior debt versus the seller note and you start kind of doing all the math around it. As part of feasibility what should happen is that there should be.

[6:39] Some calculation for the shareholders around the taxability of their. Seller notes and primarily the first part is of course as they receive interest payments, those are going to be taxed at ordinary income rates they're interest income that's just part of the uh individuals 1040 and then they're going to pick up taxes there so of course as you build seller notes and you start looking at the structure of the seller notes um you have to start picking up that tax and when you go back to the structure I just talked about where you have the senior debt piece, generally speaking for the most part you're going to have a subordinatedseller note meaning that the principal portion of that seller note is not going to be paid um until the company satisfies the obligation with the bank first and so once the obligation for the senior debt is paid.

[7:35] Then the individual um seller notes that are there on the books of the company's records can start to be advertised or we can have the bank then look at that and say all right well will either take another round or another tunche of financing and start paying that down. So at the very beginning when you start looking at this the first thing to to start analyzing is is the.

[7:58] And again an S corporation we've got to deal with the the the capital gains tax so in the first year. The seller is going to pick up capital gains tax on the principal. Um liquidity of the senior debt that the companies borrowing that's so that's the liquidity event and so they're going to pay paying taxes on it now, when you're looking at that and doing the tax analysis around the and again around the feasibility which is just going backwards a little bit that should be happening really really super early in the process for you. Um to do an ESOP and so um I'm saying that because if you're in that. If you're in a boat where you're like oh wow we're we're just doing tax planning now and we're ready to close before the end of the year then that's not a good feeling because you're like oh now I got I've got to really think about, the best tax structure right so in that we're again we're we're an S corporation so 1 of the things that that, S corporation shareholders will have is some level, of AAA which stands for accumulated adjustment accountand the AAA really is the accumulated tax basis that the shareholders, have accumulated I keep using that word over all the years that they've owned the stock and so they can.

[9:16] They can do that and then basically say all right well we're not pay you know like there's some companies that are like we're not taking anything but tax distributions every year as an S corp and so what they do is they just keep building up a stronger and stronger balance sheet all of that's going to be fine we'll we can talk about that on another episode but essentially you'll you'll end up adding the excess working capital back into the equation. And so it's not a problem having the AAA whatever the AAA is though it will offset the total of the capital gains because the company shareholders has have already paid. Capital gains tax on are not capital gains tax they've already paid income tax on that they just are leaving it in the company like they're leaving it in the bank account and so they're just sitting there so part of the analysis when you're looking at the net taxes that U and, the shareholder of an S corporation is going to have is you're going to want to understand and and isolate the AAA portion of it but he is too honorable of a man to have done that.

[10:13] Is me he's lost his work his company his reputation.

[10:19] Music.

[10:28] The time has come to tell you who I am uh-oh.

[10:34] Who are youso tell me tell me I'm peeing in my pants and you're going to be some more you're going to be some do this. It's okay Bill it's time to put this person in this place it's not necessary Joe Joe's going to step aside not stepping anywhere I appreciate your gentlemen this but what we need to do here is Drive the dagger home the dagger, I told you just shut up prepare yourself Drew.

[10:58] I to please Bill kindly let me take it from here and don'tI am.

[11:08] An agent for the Internal Revenue Service uh ohdude.

[11:14] An agent with the Internal Revenue Service so as I started death and taxes here we are on the tax part so real quick on the movie part like he's, um who, Joe Black is basically death played by Brad Pitt right and he's and and Anthony Hopkins is is the main character who's dying um are going to die right but the point of this is that finally um he reveals himself right, and, the guy's like the guy the bad guy basically has no leg to stand on at this point and eventually B basically is is kicked aside because he does some a lot of underhanded stuff, so don't do underhanded stuff whether or not you're going to get found out by the IRS and that's what this is all about with 453a is because you just can't get around it and it's, just the way it is so it's it's really knowing that you have done the analysis correctly and what I wanted to say about the calculation is just I'll give you kind of an overview of of How It's calculated but of course you're not you're going to want your CPA to do this or, whoever you're trusting on the advisory side. So as I talked about 443 the first thing it's going to happen is the taxpayer needs to determine the applicable percentage of the Deferred gain that's outstanding at the end of the year.

[12:29] So that means like the amount that the um is left over, from the payments that are being made each of the years so the pay down that the amount of the total um loan obligation on the seller note and so once that's done the applicable percentage is is is calculated and the amount that um installment obligation is is out there. Um for whatever is in excess of the 5 million so whatever is in excess of the 5 million is going to create um. You know the amount that's going to have to be paid tax so this is going to be referred to as the Deferred gain portion. And that will be again calculated at the end of the year by your CPA but you do want to calculate the potential for what that should be in the analysis so you can properly assess, what the taxes are so with when you have that then you're going to multiply the that percentage. By the Deferred gain and that's going to give you um an overall uh potential tax that's additional. Interests do for that tax year and so it needs to happen is that needs to be calculated in a sense for each of those years going forward, um all the way through the maturity now what 1 of the aspects of this that's important once you understand how it is calculated, is the way that the structure of an ESOP have is basically structured or happens to be structured this way.

[13:56] In that as I mentioned the a lot of the common structure is in from a a leverage standpoint is the company um is going to borrow the money. From to to buy out the shares of stock for the shareholder or shareholders. And as it does that it's going to um the company is going to be obligated to the bank. Under the senior debt portion as a preferred payment and what that means is that we're going to subordinate the seller note and the seller note balances are going to be you know static in terms of because we're not paying anything on the seller note except for the interest payment so it's an interest-only obligation by the company as long as the senior debt is out there so so part of the analysis is going to be to to know the the in the feasibility the structure.

[14:49] Of the the percentage of the senior debt or the amount the the amount of the senior debt versus the seller note with a of course that AAA portion that we talked about. That's going to the the the downside in that is that because the seller note portion is static and not being paid until the senior debts um paid off the downside is is that going that is going to kind of yield this um this differential on the Deferred obligation. Um for the Deferred um portion of tax liabilityum so, so that's going to be um calculated each year going out into that into the future and it just needs to be done of you know of course um correctly in order for the proper amount of taxes to be um, evaluate it and so that the net cash flows to the shareholders back to feasibility um are actually accurate so if you want to do the analysis here or don't consider 453a then the problem is of course you might think you're getting more each year out of the deal than you are actually getting um so that's that's kind of the the overall the very beginning of it as we go through it that's kind of what 453 is a is, that's what that's where the problem lies and now kind of thinking about this. From a solution standpoint 1 and this is part of just thinking about conceptually how. This can be managed the best way it possibly can be managed and.

[16:18] 1 of the 1 of the things that we have to be careful with is when we you know say all this I got to say that Internal Revenue Service, has to um you got to just make sure your your advisor really is following, the the rules accordingly and that if there was an issue that you're you're doing all this correctly so everything I've mentioned is is pretty much the way it is it is, going to be done correctly Now 1 solution or option as you start thinking about this that kind of recently came up in some conversations that we've been having. Um is if you have the um this the structure this is probably best done this way but if you have if you're going to sell your stock as an ESOP. And you're going to you're going to know what that seller know it's going to look like after the fact. Then you might have a situation where um either right now you you and your spouse already own the stock in the company. Um and or they could be um partly. You know giving that stock before the transaction what you could do is is say let's just keep it hypothetical and somewhat simple there's 1 selling shareholder and they they are 100% owner of the stock.

[17:30] And that person is married and so their spouse could basically become um owner of the stock like 50% of the stock and you could actually split the stock. Because you can change property between spouses without any tax issue. Um it's not a gifting it's just we're we're transition we're transferring the property over to my spouse's name so there's not a taxable event there. So what you could do is is change the ownership there before closing, and then that would yield a a smaller seller note for each of the individual, um stockholders which of course is are both spouses so husband and wife they go husband owns it, they change out the um the the the ownership or the wife owns the stock 100% And then she changes it out and and gets 50% to her husband they close the deal and then um now they have 2 seller notes the seller notes have been reduced it's because if they're both going to get the 5 million dollar exemption that were referring to under 453a so now instead of having 5 million we've actually by doing it that way we actually have 10 million of an exemption and now what we've done is mitigated or reduced the overall tax, that's going to be coming back that the taxpayer now that's pre-planning if it's going to be done prior to the closing.

[18:45] We are looking at this as a potential to go back and say oh well we didn't do that um what would it look like for me as a spouse to transfer the property I have um quote unquote the property that I have is a seller note what would it look for like for me to transfer 50% of that property, as a as a transfer to my spouse now, and now I take the 5 million exemption and then um the spouse gets the 5 million dollar exemption so in combination of that we're getting back up to the million dollar exemption so so that's another thing to think about now all I've said is um and I've said this kind of as we go through that process, definitely a a a CPA uh Tax Advisor or tax attorney thing to look at um don't. You know don't just take this podcast and say I just I'm I'm going to do all that just an idea as you think about it the first thing in the podcast that we wanted to do.

[19:40] Like everything with ESOP is understand this as an as a part of. Understanding your structure what you should be thinking about what you should be asking your advisor so that's the first part of what we're trying to accomplish. The second part is giving you some um exposure to the Nuance of this specific tax issue. Um and then kind of thirdly to follow up like these are things that were really dealing with and how does that actually happen in the real world from an advisory standpoint so hopefully that might help you to kind of think about a potential solution but ultimately as you go through your ESOP plan.

[20:17] And it's just good to know basically that this is there and this is going to affect, um pretty much any ESOP except for any ESOP that's going to be under that 5 million threshold for the shareholder then it really won't won't be an issue at all so so that's 4538 installment sale method of income tax um thank you for listening today appreciate um uh just going through this whole process together and please check us out on our next episode and enjoy your next step on your journey to an ESOP.