Selling your company to an ESOP is a significant decision — one that impacts your employees, the community, and the legacy you’re leaving. While there are many planning considerations — both pre-transaction and post-transaction — to optimize after-tax proceeds for both you and the beneficiaries of your estate, two important provisions of the Internal Revenue Code (IRC) require special attention.
Planning for IRC 453A installment sale deferred tax liability
As part of a financing deal you may agree to receive a portion of the sale proceeds via an installment note. If so, be careful on how much of the sale proceeds will be represented by the installment note: If you choose to take installment sale recognition on the sale to defer the gain, you’ll be subject to an additional interest charge on the deferred tax liability under IRC 453A if the note exceeds $5 million. To reduce the interest charge associated with IRS 453A, a pre-transaction planning opportunity for married couples is to ensure each spouse has enough ownership in the company before the sale so that each of them can separately take advantage of the $5 million threshold. Considering the higher interest rate environment we’re in today, this can be significant permanent savings relative to the size of the transaction.
It’s also important to note that, while not common, you can choose to elect out of an installment sale to avoid IRS 453A interest charge. Electing out of the installment sale method accelerates the income tax due on the entire transaction into the year of the transaction even though you haven’t received all of the proceeds yet. While electing out can have its advantages such as paying income taxes at today’s relatively lower rates compared to unknown tax rates in the future, other equally important considerations include what impact that would have on your cash flow, the opportunity cost on the accelerated income tax payment, and the very real risk of the ESOP defaulting on the seller-financed debt.
If the ESOP defaults on the note but you’ve already paid taxes on the entire gain, you’ll be able to claim a capital loss related to the default. Capital losses can be used to offset future capital gains, or in a year where no capital gains are realized, only $3,000/year can offset ordinary income and the remainder is carried forward the rest of your life. In the event of a large enough default, you might never generate enough capital gains to fully offset the loss from prepaying your taxes.
IRC 1042 capital gains tax deferral opportunities
Beyond planning for IRC 453A, the most impactful tax planning opportunity for sellers is provided by IRC Section 1042. If properly structured, this provision allows you to defer the capital gain from your transaction by investing the proceeds in qualified replacement property (QRP). (In a related article we review the requirements of an ESOP sale to qualify under IRC Section 1042.) If you hold the QRP in your estate until death, you can avoid capital gain altogether because the assets will receive a step-up in basis upon your passing.
What is eligible QRP?
IRC 1042(c)(4) defines eligible QRP as securities from a domestic operating corporation that: 1) must use more than 50% of its assets in the active conduct of the trade or business, and 2) can’t have more than 25% of the gross receipts for the preceding taxable year be generated from passive income. Eligible QRP can include corporate bonds, corporate floating rate notes (FRNs), or domestic stocks that meet these criteria.
Each security needs to be examined closely to determine eligibility. For example, McDonald’s Corporation stock wouldn’t be eligible. Why? Even though it’s a domestic stock, it’s not eligible QRP because more than 25% of its gross receipts is sourced from franchise fees, which are considered passive. Other non-eligible QRP include bank certificates of deposit (CDs), municipal bonds, US government bonds, mutual funds, and real estate investment trusts (REITs).
As a seller, you have a 15-month window — three months before the transaction and up to 12 months after the transaction — to purchase eligible QRP. Once purchased, your attributable tax basis in the company carries over to the QRP, thereby deferring your gain until you dispose of the QRP. If only part of the proceeds are invested in QRP, any basis you had in the transaction is allocated to the QRP first.
It’s crucial to collaborate with a financial advisor and accountant to model out various scenarios to determine what fits best for your overall wealth management and estate plan. Scenarios could include foregoing the Section 1042 opportunity completely which presumably comes with an income tax bill. Other scenarios can include investing a part, or all, of your proceeds into eligible QRP. Considerations include post-transaction liquidity needs, time horizon, risk tolerance, and charitable desires.
Domestic stock QRP
As many investors already allocate, or plan to allocate, their liquid investment portfolio to domestic stocks, using transaction proceeds to purchase domestic stock QRP presents an attractive opportunity. It affords you the ability to carry over your basis thereby increasing your control over when and if these gains are ever realized. Ideally, your long-term goal would be to hold until death so your estate beneficiaries receive a step-up in basis. At a minimum, you can spread your gain over future years or if there’s a capital gains income tax rate increase on the horizon, you can choose to dispose of your QRP ahead of the rate increase being implemented.
If philanthropy is part of your income tax planning strategy, domestic stock QRP can become your charitable set-aside as gifting appreciated stock is generally more tax advantageous than gifting cash to charities. For example, if you plan to give $1M to charity over the remainder of your lifetime, investing at least $1M of your ESOP-sale proceeds into domestic stock QRP allows for permanent deferral of the capital gains associated with that $1M of proceeds assuming it’s later contributed to qualified charities (including donor-advised funds).
Corporate bonds and floating rate notes
When purchasing corporate bonds as QRP, it’s important to keep the maturity of the bond in mind; the bond maturing is considered a disposition of the property and results in gain recognition at that time. For this reason, it’s worth considering the few large corporations with high credit ratings that issue very long-term (30-50 year) corporate bonds with floating rates, commonly referred to as floating rate notes (FRNs).
One of the benefits of FRNs is the ability to borrow against (leverage) these generally safely-regarded securities, creating an opportunity to acquire more QRP with less cash up front. Similarly, investors can borrow against their stock portfolio, but the systematic risk of doing so would be considerably greater than utilizing FRNs. The amount of portfolio leverage and associated carrying costs should be modeled out as part of the planning process with your financial advisor and accountant.
While utilizing leverage on a FRN portfolio can be an appealing solution for seller-financed ESOPs, there are a host of additional factors to consider. Since there are only a handful of corporations with the ability to make these long-dated notes, your FRN portfolio could end up being very concentrated. FRNs are subject to the underlying credit quality of the corporation and they’re generally callable. In the event of a call, you’d have to recognize the deferred gain at that point. If the goal is to hold until death for a step-up, you’ll want to ensure the maturity date of the FRN extends past your life expectancy. If you outlive the maturity, you’ll have received a nice deferral; however, you didn’t accomplish the goal of permanent avoidance. For this reason, FRNs may be more appropriate for older sellers with shorter life expectancies.
Finally, for sellers who purchase and lever FRNs due to receiving very little cash up front, you must remember that the FRNs are your QRP so as you receive additional proceeds from the transaction, you are faced with a difficult decision. In one scenario, you can use the proceeds to pay down the loan that was initially deployed to purchase the QRP. This will result in you reducing your debt obligation while keeping your portfolio meaningfully concentrated in a select few FRNs, which represents an opportunity cost that can compound for decades. In the other scenario, you can use the proceeds to acquire more securities to build out a diversified portfolio thereby retaining the leverage on the FRNs. This means you must continue paying interest on the loan indefinitely. In most interest rate environments, the interest expense you incur on the loan will exceed the interest earned from the FRN portfolio, meaning you must be comfortable carrying negative arbitrage until you pay down the loan. This negative arbitrage can be quite significant depending on the transaction size and portion of the proceeds that were deferred.
In summary, selling to an ESOP can present you with numerous tax, charitable, and estate planning opportunities that range from deferral to avoidance. Each ESOP sale is unique and your ability to maximize your after-tax proceeds requires intentional pre-transaction planning and continuous monitoring post-transaction.
It’s important to be aware of external risks such as income tax law change (i.e. potentially higher rates in the future), estate tax law change (i.e. a possible loss of step-up in basis), and general business risk (i.e. the ESOP’s ability to service any outstanding debt obligations to you).
Having a holistic team that understands the ins-and-outs of the various investment, income tax, and estate tax planning opportunities is pivotal to successfully implementing any of the strategies laid out above.
