Beating Taxes When Selling Your Business: What Benjamin Franklin Didn't Know Can Help You
By Eric Bardwell, Esq. and Jeremy Huish JD, CPA1
When Benjamin Franklin famously proclaimed that "in this world nothing can be said to be certain, except death and taxes," he did not contemplate the availability of Employee Stock Ownership Plans and Qualified Small Business Stock.
While it is true that when a business owner sells a company over one-third of the proceeds from the sale may never make it to his bank account, for many business owners this tax can be avoided with proper planning. There are two often overlooked Internal Revenue Code provisions that could defer and potentially eliminate the owner’s long-term capital gain tax on the sales proceeds. Structuring a business to take advantage of these provisions often takes some advanced planning, but the extra effort is typically well worth the taxpayer’s time. Those two tax provisions are the Section2 1042 election for companies selling to an Employee Stock Ownership Plan ("ESOP"), and Qualified Small Business Stock under Section 1202.
I. Employee Stock Ownership Plans and Section 1042
A Section 1042 transaction is similar at a high level to the popular Section 1031 exchange available to defer income taxation on real estate gain. The Section 1042 election allows a business owner to sell the stock of the business and defer the federal and state capital gains tax if the proceeds are rolled over to other stocks and bonds of another U.S. company, and certain other requirements are satisfied. At a high level, those requirements are: 1. At least 30 percent of the company’s stock is sold to an ESOP;3 2. The seller has owned stock in the company for at least three years prior to the sale;4 3. The company is a C corporation, or can convert to a C corporation, at the time of the sale, and the stock is not publicly traded;5 4. The seller "rolls over" the proceeds of the sale by reinvesting them in qualified replacement property ("QRP") during a period that ends 12-months after the date of the sale.6 Mutual funds and government securities do not qualify as replacement property;7 5. The seller, the seller’s children and certain other relatives, and shareholders who own 25 percent or more of the outstanding shares of the company are prohibited from receiving allocations of the stock acquired by the ESOP in the Section 1042 transaction;8 and 6. The rollover must be elected in writing on the seller’s income tax return.9 If these and other requirements are met, then federal and state income taxes are deferred until the QRP is subsequently liquidated.10 If the seller is still holding QRP at his or her death, then the QRP will receive a step-up in basis and the taxation on the gain will be avoided entirely. Other ways the Section 1042 deferral can be continued is under a Section 368 transaction, a gift or another Section 1042 transaction.11 QRP generally includes securities (debt or equity) issued by a domestic operating corporation that does not have passive investment income in excess of 25 percent of the gross receipts of the corporation, more than 50 percent of the assets are used in the active conduct of a trade or business, and is not in the same controlled group of companies as the business being sold.12 For example, assume a taxpayer sold his or her business to an ESOP and then purchased stock in one or more publicly traded companies and satisfied all the requirements of Section 1042. The taxpayer would not pay tax on the gain from the sale unless the deferral is terminated by a subsequent disposition of the QRP. Most sellers today choose as their QRP certain financial investments that may provide more flexibility than investing in specific stocks and bonds. Such investments may allow the seller to borrow 80 to 90 percent of those proceeds on a non-recourse, no restriction basis for the remainder of the seller’s life, and keep the deferral of Section 1042 in place. The details of QRP are beyond the scope of this article, but the reader should know that there are options.
II. Does An ESPOP Make Sense if the Section 1042 Tax Election is Not Made?
There are reasons for a business owner to sell to an ESOP, even if the Section 1042 tax deferral transaction is not available. Such reasons include: 1. The owner can sell the company at full fair market value to a ready and willing buyer (i.e., the ESOP trust); 2. The owner avoids selling the business to an outside 3rd party and becoming an employee; 3. The ESOP generally provides a greater benefit to long-term employees; 4. ESOP owned companies generally have fewer layoffs during a downturn in the economy; 5. The ESOP may assist in transferring ownership to key management or children; 6. The company can operate completely income-tax free if it is structured as an S corporation that is 100% owned by an ESOP.13 Reasons for not making the Section 1042 election include scenarios where the business is organized as an S corporation or a limited liability company and the owner does not want to make the C corporation election, the owner wants to be allocated shares of stock from the ESOP and such allocation is prohibited if the Section 1042 election is made, or the stock in the company qualifies as Qualified Small Business Stock under Section 1202 such that there is no need to make a Section 1042 election to defer income taxation.
III. Qualified Small Business Stock
Section 1202 allows taxpayers to exclude up to 100 percent of the federal capital gains they realize on the sale of "qualified small business stock" ("QSBS") held for at least five years.14 This provision of the tax code was added in 1993, but it originally allowed only 50 percent of eligible capital gains to be excluded. In 2009, the percentage of capital gains eligible for exclusion was increased to 75 percent, and in 2010, this percentage was increased to 100 percent and the QSBS incentive was made permanent.15 Many entrepreneurs and investors, as well as their tax advisors, are still not aware that they may be eligible for this benefit. For stock to qualify as QSBS, the following requirements must be satisfied: 1. The stock must be issued by a U.S. "C corporation" any time after August 9, 1993;16 2. The stock is issued by a corporation whose aggregate gross assets must not exceed $50 million at any time from August 9, 1993, through the date of issuance of the QSBS;17 3. The stock is issued by a corporation in which at least 80 percent of its assets are used in an "active business" for "substantially all" of the shareholder’s holding period of the QSBS;18 4. The stock is held by the shareholder for more than 5 years (although if a shareholder holds the eligible stock for more than 6 months there is an option for a rollover);19 and 5. The stock is acquired by the shareholder directly from the corporation 20, but- a. QSBS can be gifted during life or transferred at death by the original shareholder and still be eligible QSBS (in which case the date of acquisition by the donor/decedent is the acquisition date);21 b. QSBS can be acquired by a partnership and distributed to its partners if they were partners on the date the partnership acquired the QSBS and they receive a pro rata share of the QSBS equal to the percentage of the partnership they owned when the QSBS was acquired (in which case the date of acquisition by the partnership is the date of acquisition by the partners);22 c. QSBS can also be held by a partnership or S corporation, and the partners or shareholders may exclude their share of any capital gain the partnership or S corporation recognizes on the sale of the QSBS if the partners or shareholders held their interests on the date the QSBS was acquired by the partnership or S corporation;23 d. QSBS can be acquired if an entity formed and taxed as a partnership later converts to a C corporation in a section 351 nonrecognition transaction; e. QSBS can also be acquired by exercise of an option, exercise or a warrant or conversion of a convertible note, in which case the exercise or conversion is treated as the acquisition date of the QSBS.24 Assuming the stock qualifies as QSBS, the amount of eligible capital gain which may be excluded from federal income tax is equal to the greater of: i. $10,000,000, reduced by the aggregate amount of eligible gain realized by the taxpayer in prior tax years for sales of QSBS in the same corporation; or, ii. 10 times the aggregate adjusted basis of QSBS that the taxpayer sold during the current tax year.25 The percentage of eligible capital gain which may be excluded from federal income tax depends on when the shareholder acquired the QSBS. For stock acquired after August 9, 1993, but before February 18, 2009, 50 percent of the eligible capital gain is excluded from federal income tax.26 For stock acquired on or after February 18, 2009 and through September 27, 2010, 75 percent of the eligible capital gain is excluded from federal income tax.27 For stock acquired on or after September 28, 2010, 100 percent of the eligible capital gain is excluded from federal income tax.28 The 10-times aggregate adjusted basis limitation can be used to greatly increase the amount of eligible capital gain. To illustrate, if an entity formed as an LLC later converts to a C corporation in a section 351 nonrecognition transaction, the C corporation stock will be considered "issued" as of the date of the conversion, and the basis in the stock for QSBS gain exclusion purposes will be the fair market value of the LLC interests at the time of conversion, as contrasted with the tax basis of the LLC interests.29 To further illustrate, assume partners "A" and "B" form a new LLC in 2015 and that each partner has a basis of $100,000. In 2018, "A" and "B" convert the LLC to a C corporation when its fair market value was $8 million. "A" and "B" later sell their shares in the C corporation in 2024 for $60 million. At the time of conversion, "A" and "B" each had an aggregate adjusted basis in the LLC equal to $4 million, so that they each may exclude up to $40 million of gain under Section 1202. When the C corporation sells in 2024, the first $3.9 million of gain attributable to each of "A" and "B" is subject to long term capital gains tax and the remaining $26.1 million of gain is excluded under Section 1202 due to the 10-times aggregate adjusted basis rule. Through tax planning in advance of an acquisition or sale of QSBS, the capital gains exclusion can be multiplied as the maximum amount of the exclusion applies on a per shareholder basis. In addition, taxpayers residing in high income tax states have an opportunity to reduce their exposure to state income taxes using non-grantor trusts. Examples of how a shareholder may take advantage of the ability to multiply the QSBS exclusion include: 1. Gifting QSBS to one or more family members such that each of the parties receiving a gift of QSBS would qualify for the capital gains exclusion up to the maximum amount allowed per taxpayer; 2. Gifting, including the possibility of an incomplete gift, QSBS to one or more non-grantor irrevocable trusts such that each trust would qualify for the maximum amount of the capital gains exclusion;30 3. A non-grantor irrevocable trust could make a distribution of QSBS to one or more beneficiaries, each of which, along with the trust, would qualify for the capital gains exclusion up to the maximum amount allowed per taxpayer; 4. An existing non-grantor irrevocable pot trust could split into separate trusts for each beneficiary, each of which, along with the original pot trust, would qualify for the capital gains exclusion up to the maximum amount allowed per taxpayer; and 5. A taxpayer can gift QSBS to one or more charitable remainder unitrusts, and each trust would qualify for the maximum amount of the capital gains exclusion. Some of the planning concepts described above allow shareholders the ability to minimize both federal and state income taxes on a sale of QSBS such as the use of non-grantor trusts established in jurisdictions where additional state income tax benefits are available. The list of techniques described above includes some of the more common methods of multiplying the QSBS exclusion, but in no way is it exhaustive. Other creative planning techniques are available to accomplish the same result using lapsing Crummey withdrawal rights, exercises of powers of appointment, decanting of QSBS from a grantor trust to a non-grantor trust and, in extreme cases of tax aversion, even divorce. Eligibility for the benefits afforded to those selling QSBS requires the stock be held for a period of at least five years, but if QSBS is sold before this five-year holding period requirement is satisfied a taxpayer (other than a corporation) can still retain the potential for the capital gains exclusion. Under Section 1045, if the taxpayer has held the QSBS for more than six months before selling it and the taxpayer rolls the amount realized from the early sale of the original QSBS into new QSBS within 60 days of the sale, the taxpayer will recognize capital gains only to the extent that the amount realized on the sale of QSBS exceeds the cost of the replacement QSBS.31 This may seem unattractive for one selling a business which comprises their primary source of income, but for the venture capitalist who invests in numerous start-ups, the ability to roll the QSBS holding period into future investments until the five-year holding period is met can result in significant tax savings.
IV. Can An ESOP Transaction Be Combined with QSBS?
There are similar requirements in both an ESOP Section 1042 election and a QSBS transaction such that qualification for one may also result in eligibility for the other. Both transactions require a holding period and the selling entity must be a C corporation. In the situation where a business was originally formed as a C corporation and the shareholder is selling 100 percent of the company to the ESOP for a price of $10,000,000 or less, both the Section 1042 election and QSBS eligibility allow the taxpayer to avoid, in the case of QSBS, or defer, in the case of a Section 1042 election, paying federal capital gains taxes. However, as most ESOP transactions do not fit within this fact pattern, the analysis must consider a multitude of factors. Planning is especially useful in a partial ESOP transaction where the taxpayer sells a portion of the business to the ESOP today and later decides to sell his remaining interest to the ESOP or a third-party buyer. The following two examples illustrate how QSBS eligibility can be combined with Section 1042 in a partial ESOP transaction. FIRST EXAMPLE: Assume Dan is the founder and original shareholder of ABC Corporation, a C corporation started in 2014. In 2020, the business is worth $10,000,000 and Dan’s basis in the original stock of ABC Corporation is zero. Dan decides to sell 30 percent of the business to an ESOP for $3,000,000. Dan’s stock in ABC Corporation further qualifies as a QSBS, such that the entire sale escapes federal capital gains taxes. Several years pass and ABC Corporation is now worth $50,000,000. Dan decides to sell the remaining 70 percent of the company to the ESOP for $35,000,000. Dan could use the remaining $7,000,000 of QSBS exclusion, but that would leave $28,000,000 still subject to tax. Dan can avoid paying capital gains tax on the $35,000,000 gain (and potentially defer it indefinitely) by making the Section 1042 election and satisfying the requirements discussed above. Alternatively, if Dan structures the sale in three separate transactions he could maximize the value of the QSBS exclusion and take advantage of Section 1042.32 At the point that the business is worth $50,000,000 and Dan’s 70 percent interest is worth $35,000,000, Dan could sell just 14 percent of the stock for $7,000,000 and take the remaining QSBS benefit to exclude the gain from federal tax. Later, Dan makes a third sale to the ESOP of his remaining 56 percent interest in ABC Corporation for $28,000,000. At this point, as the QSBS exclusion has been exhausted, Dan could make a Section 1042 election to defer (and potentially eliminate) the federal and state capital gains tax on this third sale. SECOND EXAMPLE: Assume Bob and Bill are the founders and only owners of XYZ, LLC, a partnership started in 2016. In 2020, the business is worth $10,000,000 and Bob’s and Bill’s basis in XYZ, LLC is zero. Bob and Bill decide to sell 30 percent of the business to an ESOP for $3,000,000. Prior to the ESOP sale, the owners convert the LLC into a C corporation in a Section 351 tax-free reorganization and XYZ, Inc. issues new shares of stock to its shareholders. The aggregate adjusted basis in the stock for QSBS purposes is $10,000,000. The holding period for QSBS purposes begins in 2020. Bob and Bill make a Section 1042 election with respect to the $3,000,000 sale proceeds and follow the requirements to defer the capital gain on that sale. Six years later, Bob and Bill wish to sell the remaining 70 percent of the company to the ESOP. Let’s examine various scenarios depending on the value of XYZ, Inc.: a. At a $10,000,000 valuation, Bob’s and Bill’s 70 percent ownership interest is worth $7,000,000. With a tax basis of $0, that creates a $7,000,000 gain for Bob and Bill. The Section 1042 election could defer or potentially avoid capital gains on the entire amount. The QSBS treatment would not provide any benefit since they have no eligible gain above their $7,000,000 aggregate adjusted basis. b. At a $150,000,000 valuation, Bob’s and Bill’s 70 percent ownership interest is worth $105,000,000, all of which would be taxable at the time of sale. Bob and Bill could choose either a Section 1042 election or QSBS to defer or potentially avoid capital gains. Section 1042 covers the entire gain for Bob and Bill but comes with the obligations imposed with that election. The QSBS option allows for an exclusion of $70,000,000 of gain due to the greater of $10,000,000 or 10 times the aggregate adjusted basis rule. With QSBS, Bob and Bill would incur tax on the gain from $0 to $7,000,000, benefit from an exclusion from federal tax on the next $70,000,000 of gain, and would incur tax on the gain above $77,000,000 up to $105,000,000. Further, if Bob and Bill decide, along with the ESOP trustee, to sell the business to an outside third party, Section 1042 is not available as this is not a sale of stock to an ESOP. From an employee perspective, the ESOP’s 30 percent interest in XYZ, Inc. appreciates to $45,000,000 at the time of the sale. These proceeds will be held in qualified retirement accounts for the employees and will not be subject to income tax on the liquidity event, much like a traditional retirement account. Depending on the facts of a particular transaction, long term employees can receive a significant windfall from an ESOP transaction in addition to the tax deferral. For business owners and investors contemplating the sale of a company, a variety of tools exist that may reduce, defer or altogether eliminate their income tax exposure. Thus, when it comes to taxes, one should always keep in mind that what you don’t know can’t help you (and may even end up hurting you).
Endnotes: 1. Eric Bardwell is a Partner in the Taxation, Trusts & Estates Group at Jeffer Mangels Butler & Mitchell LLP. He advises individuals, families and their businesses in wealth-transfer strategies that efficiently minimize taxes. Contact him at EBardwell@jmbm.com. Jeremy Huish has experience as an attorney and a Certified Public Accountant. He is a Director with Business Transition Advisors, the ESOP advisory group of Capstone Headwaters. He advises businesses looking to make an ownership transition in the future and not of the California Lawyers Association Taxation Section. Contact him at jhuish@ capstoneheadwaters.com. The opinions expressed herein are those of the authors and not of the Taxation Section. 2. All references to "Section" are to the applicable section of the Internal Revenue Code of 1986, as amended. 3. IRC § 1042(b)(1)&(2). Note the 30% is in aggregate and not required for each individual stockholder. 4. IRC § 1042(b)(4). 5. IRC § 1042(c)(1)(A). 6. IRC § 1042(c)(3). 7. IRC § 1042(c)(4)(D). 8. IRC § 409(n). 9. IRC § 1042(b)(3). 10. Most states’ income tax laws follow the federal deferral for Section 1042. Some states do not and the Section 1042 deferral would not apply to state income taxes of a seller in those states. 11. IRC § 1042(e)(3). 12. IRC § 1042(c)(4). 13. IRC § 1361(c)(6) and The Small Business Job Protection Act of 1996 amended the S corporation law to permit an ESOP as an eligible shareholders of an S corporation) 14. IRC § 1202(a). 15. IRC § 1202(a)(3) and (4). 16. IRC § 1202(c)(1). 17. IRC § 1202(d). 18. IRC §§ 1202(c)(2) and (e). The following types of businesses are not eligible under Section 1202 of the Internal Revenue Code: service businesses such as health, law, engineering, architecture, accounting, consulting, athletics, financial services and brokerage services; banking, insurance, finance, leasing, real property rentals, and investing; farming; natural resources such as oil and gas; and hotels and restaurants. 19. IRC § 1202(a)(1). 20. IRC § 1202(c)(1)(B). 21. IRC § 1202(h). 22. Id. 23. IRC § 1202(g). 24. IRC § 1202(f). 25. IRC § 1202(b). 26. IRC § 1202(a)(1). 27. IRC § 1202(a)(3). 28. IRC § 1202(a)(4). 29. IRC § 1202(i). 30. A taxpayer could make "incomplete gifts" to one or more non-grantor irrevocable trusts (i.e., INGs) which might qualify for continued QSBS treatment of the transferred stock as well as benefit from the elimination or deferral of state income taxes. 31. IRC § 1045. 32. Practically speaking, if a single transaction is eligible for both Section 1042 and QSBS treatment, a seller would likely choose one or the other as Section 1042 is applied proportionally on the transaction proceeds and cannot be itemized to a particular block of proceeds.