In order to really grasp this “be all, and end all” ESOP attribute you must open your mind, be willing to at least temporarily sublimate preconceived notions, and hone in on the bottom line. This is because courses of action that initially may seem repugnant can quite often have a very “silver lining.” With this backdrop, I will delve into concepts that can be quite lucrative, and should be analyzed and explored far more than they are since they may enable you to achieve results you probably never thought possible.
To reiterate—when an ESOP owns stock in an S corporation, its share of that company’s earnings are not taxed. Again, this is the only instance within our whole tax ensemble where such a result can be attained. Let’s delve further into this precept—within our tax system, with very few exceptions, all active income is currently taxed. This includes even active income generated by otherwise tax-exempt entities that is not incident to their tax-exempt purpose. This applies across the board— for instance, to churches, trade associations and labor unions. As applied to otherwise tax-exempt entities, this tax is denominated as the Unrelated Business Income Tax and was enacted to prevent tax exempt entities from engaging in active businesses that are not related to their tax-exempt purpose and competing with other active taxable businesses. There is only one exception to this rule, to wit—ESOPs. ESOPs are exempted from the Unrelated Business Income Tax. This means that where an ESOP owns stock in an S corporation (which it now can) the ESOP’s share of that income is not taxed. And, when an ESOP owns all of the stock of that S corporation, it is simply not taxed at all. This paves the way for earnings that remain in the company because tax was not paid upon them to, first, be used to pay “stock acquisition debt,” to wit, debt that was incurred by the ESOP to buy the S corporation’s stock. Then, after that has been accomplished, retain them to finance growth.
With proper planning, this course of action can enable the owners of closely held C corporations to sell their stock to an ESOP and be paid on a tax-free (1042) basis with money that would otherwise have been consumed by taxes paid to governments (federal and state) and then elect S status effective as of the beginning of the following taxable year. Or, where the corporation involved is already S, (1) terminate that status and revert to C, (2) sell stock to the ESOP under 1042, (3) wait for five taxable years during which the company involved makes expanded deductible contributions that can serve to offset otherwise taxable income, then (4) re-elect S and regain its tax-exempt status. Or, once again, forego 1042, pay LTCG (15%) tax (on the installment method where the sale includes take-back debt) and, in their capacity as participants, share in the allocation of the stock they sold to the ESOP.
But, frequently, when I inform stockholders of the potential inherent in a 100% ESOP-owned S corporation, they retort—“but I don’t want to sell my company. It’s a good company, and I want to participate in its future growth.” Well, within clearly delineated parameters, successful business owners can “get the best of both worlds.” This can be accomplished through the use of something known as “Synthetic Equity.” Synthetic Equity is a contractual entitlement that falls short of actual stock ownership, but is, in context, still equity—thus the official name (as used in the Internal Revenue Code) —“Synthetic Equity.” Included in this category are stock options, warrants, and appreciation rights, and phantom stock. The aggregation of rights that inure to this category of entitlement is not deemed to be “stock,” as such, and, accordingly, is not allocated any of the S corporation’s income and therefore does not trigger a current income tax. Congress recognized that the existence of synthetic equity in ESOP-owned S corporations could, if not constrained, result in abuse, and insightfully placed limits upon that status. These limits are embodied in Internal Revenue Code Section 409(p), which imposes dire penalties when fifty percent, or more, of the ESOP’s S corporation stock is owned by “disqualified persons” (i.e. persons who own (or, including synthetic equity, are “deemed to own”) a ten percent or more interest in the ESOP).
As you can, no doubt, surmise, this is quite complicated. It is, nevertheless, manageable, and, fortunately, the Treasury Department and the Internal Revenue Service in Regulations and rulings have provided us with “safe harbors” that enable us to plan our way through this maze. But, as I see it, this penalty—though severe—is actually a benefit in that it delineates what we can and cannot do. And, so as long as persons, including existing and former stockholders, who constitute “disqualified persons,” do not, in the aggregate, own, or are deemed to own, 50% or more of the ESOP’s actual or deemed owned stock, they can still maintain a very significant continuing equity interest in the company.
Now, to carry this line of reasoning to its logical end, you must keep in mind that this ESOP-owned S corporation is, or can be, completely tax-exempt. This is crucial. To better understand the concept here at hand, consider the following—a continuing 42% equity interest in a tax-exempt company is equivalent to a 70% interest in a taxable one (a 70% interest reduced by a 40% income tax burden equals a net 42%), while a 48% (still less than the 50% limit) equity interest in a tax-exempt company is equivalent to an 80% interest in a taxable one. Appendix 5 illustrates that an annual realization of $1,000,000 of net income per year by a tax-exempt ESOP-owned corporation compounded at a before tax 15% for 15 years will grow to $8,137,000, while that same income production by a taxable C corporation produces, after tax, only a 9% (15% less a 40% tax) yield and will accumulate to less than $2,185,000 over that same 15 period.
Similarly, let’s now assess an ESOP-related stock sale for $10,000,000 consisting of cash of $2,000,000 and a take-back note of $8,000,000 that is secured only by the unpaid portion of the purchased stock, subordinate to banks, cannot be accelerated upon default, and carries less than the going rate of interest for that type of loan. Assume further that a qualified appraiser calculates that note to be worth sixty cents on the dollar. This means that the seller would then be behind by forty percent of that $8,000,000, or $3,200,000. The appraiser is then asked “how many warrants to purchase authorized but unissued company stock at its then fair market value should the seller get in order to bring him up to equipoise.” Assume that the appraiser’s answer is 42%, so that, having received $2,000,000 in cash, an $8,000,000 note worth $4,800,000 and warrants worth $3,200,000, this seller will have been paid in full, and still have a major equity interest in that tax-exempt company. So at that point this seller will be in the position to ultimately collect $10,000,000 in cash and still own the equivalent of a 70% income interest in a company that can be expected to continue its exponential growth taking into account the fact that it will not be burdened by ongoing taxation.