ESOP - Purchase stock from corp. Corp pays debt to SH

Technical topics regarding tax preparation.
#1
Wiles  
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I have a client that is currently a MMLLC. The owners have basis of $3M in their capital accounts. They are working with an ESOP advisor who is proposing the following:

1. Convert the $3M capital accounts to debt
2. Convert to C-Corporation and form an ESOP
3. Have the ESOP purchase approx 25% of the stock from the corporation for $3M.
4. Going forward, the corp will make contributions of approx $500K/yr to the ESOP. The ESOP will turn around and pay the corp $500K/yr towards the stock purchase. The corp will then pay $500K/yr to the owners towards their loan to the corp.

As you can see, the owners will get their $3M paid out to them tax free and the business effectively gets tax deductions for servicing that debt.

Is there a problem here?
 

#2
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There are pitfalls, but the basic idea is solid. If practical, consider a SESOP. Once a SESOP owns 100%, the corporation effectively becomes exempt.

Don't be overly impressed with tax-free repayment of the $3M via moving the money around. The corporation could contribute stock and use its cash to directly pay the debt.

Besides the deferral, the tax savings with an ESOP is in the ease in which OI is converted to LTCG. The ESOP could buy stock from the stockholders who can use their $3M basis to offset the gain.

The overriding question is whether the ESOP makes sense if there were no $3M basis.
Steve
 

#3
Wiles  
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Thank you, Steve. I appreciate you sharing your knowledge.

After the initial sale, they will continue to sell to the ESOP and will want to take advantage of the tax deferral available by exchanging into QRP. Thus, the plan to remain a C-Corp for a period of time.

At some point when the ESOP owns a significant %, they will convert to an S and gain the tax free earnings. In the meantime, they will use the dividend deduction to accomplish a bit of the same.

Regarding whether it makes sense, the two owners are 10-15 years away from retirement. They are looking for a way to transfer this business internally to a core group of key personnel. None of which have the resources to buy them out. They believe this ESOP will help facilitate this process.
 

#4
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Consider an LBO instead. It converts OI to LTCG with flexibility in structure, but without the administrative hassle and expense of an ESOP and without all employees being interested parties.

For example, the $500k annual contribution deduction could be replaced via amortizing a $7.5M allocation to goodwill.

The LBO structure can allow the inside group to maintain control (e.g., via a trust or nonvoting stock.)
Steve
 

#5
Pitch78  
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Wiles, who owns the other 75%? How many employees does the company have?
 

#6
Wiles  
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It is currently owned by 2 individuals. They will be diluted to 75% after the corporation sells 25% to the ESOP.

Approx 100 employees
 

#7
Pitch78  
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ESOP will work with 100 employees. ESOPs administrative costs are high (annual audits, paperwork, trustee, etc.). Fewer than 20 employees and the costs are excessive compared to the gain.

The plan proposed is doable.
 

#8
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I don't like this plan. To begin with the clients were presumably not intending to increase compensation by an average of $5k/per employee per year.

They should have a transition plan which maximizes their net worth and which incentivizes the core group to stay.

The ESOP plan gets them $12M with $9M of that taxed at LTCG rates, all of which is paid via deductible dollars. There are two major problems with that. First, the core group does not have an incentive to stay. Second, the clients end up with less money than they would get with an LBO.

There are two primary ways for the clients to end up with more money. The first takes advantage of the fact that the present value of a long-term, low-interest note would be much less than its face value. So if they were to sell to an outsider on those terms the price would be, say, $20M.

But even if they don't want to play the valuation game, they can form an S to be the buyer with themselves owning up to 49% and the rest owned by the core group. That means they would get to sell twice.

An allocation of $15M to goodwill would get them $1M annual deductions. Not all assets have to be sold. The structure can be designed to avoid triggering OI on the sale.

The trick is to structure the LBO with golden handcuffs via 83(b) elections.
Steve
 

#9
Pitch78  
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gatortaxguy wrote:
The ESOP plan gets them $12M with $9M of that taxed at LTCG rates, all of which is paid via deductible dollars.


How did you come up with that?
 

#10
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gatortaxguy wrote:If practical, consider a SESOP. Once a SESOP owns 100%, the corporation effectively becomes exempt.


Update - The client has decided to sell 100% to the ESOP and elect S-Corp immediately. The owners are comfortable locking in the current value as their redemption price and the 100% tax exempt earnings will accelerate the payout to them.

Corporation will redeem their shares on a 10-year payment term. ESOP will purchase stock from the corporation on 20-year term.
 

#11
Pitch78  
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Dont forget 1042 - there are ways to get the money now if that is what the client wants.
 

#12
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I assumed their basis was $3M. The $12M is effectively paid via contributions to the SESOP.

I realize they are comfortable with getting $12M or they would not be considering the plan. I was merely pointing out that there is an alternative which gets them more money and provides more flexibility and confidence in their transition planning.
Steve
 

#13
Wiles  
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Pitch78 wrote:Dont forget 1042 - there are ways to get the money now if that is what the client wants.

Pitch, can they still do this on the installment sale basis?

For example, elect C-Corp status for the LLC. Sell all shares to the ESOP for $12M. The gross profit % on the sale will be 75%. Each year, as they receive principal payments, each SH to decide to either keep the cash or do 1042 rollover.

The disadvantage is the C-Corp is subject to corporate tax. They can elect S in year 2, but now will have potential BIG Tax.
 

#14
Pitch78  
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Wiles wrote:
Pitch78 wrote:Dont forget 1042 - there are ways to get the money now if that is what the client wants.

Pitch, can they still do this on the installment sale basis?

For example, elect C-Corp status for the LLC. Sell all shares to the ESOP for $12M. The gross profit % on the sale will be 75%. Each year, as they receive principal payments, each SH to decide to either keep the cash or do 1042 rollover.

The disadvantage is the C-Corp is subject to corporate tax. They can elect S in year 2, but now will have potential BIG Tax.


You really need to talk with the folks setting this up. There are many options.

One thing though is 1042 only applies for a year. The seller has to purchase qualified replacement property ("QRP") within 12 months after the sale to completely avoid current taxation. There is no requirement that the seller use the actual proceeds received from the ESOP. If the seller does not have other assets available for purchasing QRP, the seller may borrow the necessary funds - the notes from the ESOP can be pledged. If the payout is cash, there are companies that have the borrower buy long-term high quality bonds (the QRP) and then borrow against those bonds and provide the money to the seller. The bond term will be longer than the life expectancy of the seller. The seller can also do part 1042 and part installment sale. There should be a good ESOP advisor involved to tailor to the clients situation.

As for S corp, dont forget you lose NOLs too. Dont know if that is an issue.
 


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