Episode #288: Best Idea Show – Doug Pugliese, Alpha Architect, “Why Not Elect A 1042 Sale And Control When You Pay Those Taxes?”
Guest: Doug Pugliese is Head of 1042 QRP Solutions at Alpha Architect, where he manages the firm’s qualified replacement property investment strategies practice. In this role, Doug and his team provide business sellers electing 1042 stock sales with customized, passive equity index investment strategies that align the appropriate QRP asset with clients’ unique, long-term needs. Previously, he was a Managing Director in the Investment Banking Division at Bear, Stearns & Co. Inc., where he developed and executed strategic M&A and financing transactions, worth more than $12 billion, based in the Firm’s New York and London offices.
Date Recorded: 1/27/2021 | Run-Time: 54:41
Summary: In today’s episode, we’re covering Doug’s best idea: employee stock ownership plans. ESOP’s are a niche but incredibly attractive way for a business owner to sell their business for both themselves and the long-term viability of the company. The episode starts with a broad overview and then dives into the inner workings of an ESOP sale. Doug explains how the tax benefits of a 1042 election allow the owner to defer capital gains tax and even invest the proceeds into a portfolio of blue chip stocks.
As the conversation winds down, Doug shares why ESOP’s may be an ideal way for middle market private equity companies to exit investments.
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Links from the Episode:
- 0:39 – Intro
- 1:43 – Welcome to our guest, Doug Pugliese
- 3:59 – Doug’s introduction to employee stock ownership plans (ESOPs)
- 5:51 – ESOPs as an exit strategy
- 7:27 – Advantages of exiting through an ESOP
- 8:17 – Capital gains tax deferral
- 9:22 – How an ESOP trust can finance a buyout
- 11:03 – ESOP ownership structure
- 12:37 – Case study: New Belgium
- 14:43 – Why exiting via ESOP is relevant to you
- 15:58 – Rolling sale proceeds into a growth portfolio
- 18:55 – The traditional 1042 election strategy for sellers to ESOPs
- 22:05 – The problem with the traditional strategy
- 23:19 – How Alpha Architects developed their 1042 QRP (Qualified Replacement Property) Strategies
- 26:10 – Tax implications of Alpha Architect’s 1042 QRP strategies
- 28:05 – Buying the rollover
- 30:18 – Who can utilize Alpha Architect’s 1042 QRP strategies
- 31:54 – The types of companies that are well-suited for ESOPs
- 32:53 – S Corporation ESOPs
- 34:43 – Restrictions on small company ESOPs
- 36:21 – C Corporation ESOPs
- 38:18 – How Alpha Architect works with sellers
- 41:18 – Alpha Architect’s timeframe and fee considerations
- 44:15 – The added complexity of the 1042 sale election
- 46:35 – Why middle-market private equity firms should consider 1042 QRP strategies
- 48:47 – 1042 QRP strategies for individual investors
- 51:26 – How you can learn more about 1042 QRP strategies
- 53:10 – Doug’s most memorable investment
- 54:02 – How you can contact Doug and Alpha Architect: alphaarchitect.com; email@example.com
Transcript of Episode 288:
Welcome Message: Welcome to the “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: What’s up, friends? Today we have another installment of our Best Ideas series. Our guest is the head of 1042 QRP Solutions at Alpha Architect — that’s a mouthful — where he manages the firm’s qualified replacement property, investment strategies practice. In today’s episode, we’re covering our guest’s best idea, employee stock ownership plans, otherwise known as ESOPs. They’re a niche, but incredibly attractive way for a business owner to sell their business for both themselves and the long-term viability of the company. We start the episode with the basics and then dive into the inner workings of an ESOP sale. Our guest explains how the tax benefits of a 1042 election allow the owner to defer capital gains tax and even invest the proceeds into a portfolio of blue-chip stocks. We hear how different companies have utilized this, including one of my favorite breweries. As we wind down, our guest explains why ESOPs may be an ideal way for middle-market private equity companies to exit investments. Please enjoy this special best ideas episode with Alpha Architects, Doug Pugliese. Doug, welcome to the show.
Doug: Thanks for having me, Meb. I appreciate the chance to be here.
Meb: Where in the world do we find you?
Doug: I’m just outside Philadelphia in the mainline, the town of Wynnewood.
Meb: I see the giant Alpha Architect logo in the background, for listeners on the podcast that aren’t watching this on YouTube. How have you connected with a crazy crew?
Doug: Oh, it’s been a long while, a long and enjoyable ride. We first connected back in 2012, I think, when I met Wes. I generated this background just for you, actually, Meb.
Meb: Good. And your immediate reaction wasn’t, “Run away. This is a crazy man”?
Doug: I knew he was a crazy man. Key to working with the crazy man to riding a tiger is to figure out how to get on his back. It took a little while for us to figure out how to work together, but eventually, we made it work.
Meb: Today is going to be a fun and wonky topic. And for probably the first time in about 300 episodes, I did almost no preparation for this podcast. And the reason being is that I wanted to understand it straight from your mouth and because it’s a pretty different topic that I’ve actually never heard covered on a podcast, I thought we would try to start at the one-on-one level before we full PhD. So in our thread of best ideas, what’s the topic we’re talking about today?
Doug: We’re talking about how business owners can exit their companies by forming employee stock ownership plans and selling their stock to the employee stock ownership plan essentially to the employees and creating a win-win situation for both the community and the employees and themselves by capitalizing on advantages and the tax code that were created for this.
Meb: Give us the overview. You can either start with what’s the history. Do people say ESOPs? Is that an acronym that people actually use?
Doug: Yes, indeed. That’s how it’s pronounced. ESOPs.
Meb: When did you get introduced to ESOPs? What are they, the history, let’s start at the very beginning and let’s start at the elementary school level and we’ll go up from there.
Doug: An employee stock ownership plan is a pretty simple concept. It’s like a 401k plan. And I first became familiar with them when I had among my managerial responsibilities at a prior employer, the job of overseeing our business advising in the formation of ESOPs. This wasn’t at Alpha Architect, it was at a prior firm. And I observed first-hand that there was this whole universe of companies, particularly private companies and kind of the $10 million value to $100 value range that was forming ESOPs and business owners were selling their companies to those ESOPs that they formed. And they were our clients and seemed to be pretty interesting ways for business owners to exit. And certainly, they were companies that had strong cultures and a positive vibe going on and the employees all seemed pretty happy, so my interest was piqued. I didn’t pay a whole lot of attention as it was only one of my collateral duties, but at the time that was back in the 2009 timeframe. But I’ve since become obviously involved in them and I work in the space now full time. And so I have taken an appreciation for ESOPs and how they are this wonderful tool. There are about 7,000 or 8,000 companies, more like 7,000 today that have taken advantage of employee stock ownership plans and formed them and exist in this country. They’re employing at least 10 million employees, if not more, across the United States.
Meb: So give me the broad overview. Let’s say we got a company, Faber Enterprises. We’ll do a riff on Bruce Wayne. Faber Enterprises, let’s say, I think it’s worth 50 million bucks. We’ll do 100 million just to do round numbers. Is the main gist of this that the owner wants out or the owners, you can explain it to me. And then I assume that the business has to continue. You’re essentially selling it to the company. How does it work? Give me the 201 level description.
Doug: The typical company is a manufacturing company, although there are professional services companies, insurance, financials, a wide range of companies form ESOPs. And what happens is the business owner typically in a certain stage in life contemplates exit opportunities and among them tend to be the big three. I’ve sold to an acquirer like a strategic trade partner that I know in the industry. I sell to a financial sponsor, private equity firm in other terms, or I sell to my employees. Now, selling to your employees is not a typical option, at least not one that’s typically presented by the usual M&A advisor or investment banker. It’s typically something that is in the margins, in the wings, and only emerges when an ESOP…somebody who’s familiar ESOPs, someone on the advisory team raises the question. But it’s a pretty interesting opportunity.
So a business owner will examine the opportunities for exiting via any of these three choices and upon a deeper inspection, might learn that the culture that an ESOP creates is better for the firm. Might learn that his or her after-tax proceeds are more attractive. There are any number of hooks that draw business owners into ESOPs, but by and large, they’re a way for a business owner to ensure his legacy with the firm, do good for his employees who helped them build the firm and that tends to be the usual initial draw. And the more you learn about ESOPs, I mean, you kind of get hooked. They’re very interesting, as you’ll learn more about them. And I think that’s what ultimately draws business owners in.
Meb: I see some challenges, and some problems, and some benefit. What’s the big benefit to the owner? If you sell it to PE, you merge, you sell it to another company, you get the cash money, you got to pay a big tax bill, right? Does the ESOP somewhat avoid that or does it improve upon that?
Doug: It does. I used to be an M&A advisor in a prior life. I was an investment banker for a dozen years at Bear Stearns before it went through the financial crisis and got taken over. ESOPs were never talked about when we gave advice to business owners or boards or CEOs contemplating selling their businesses, probably because there was no payday in it typically for the banker. But there are really attractive advantages for private companies, not so much for public companies, but for private companies contemplating a sale, there are a whole slew of advantages, both to the company in terms of its taxability as an entity and also in terms of the proceeds of the business owner. A business owner who sells more than 30% of his stock can, in some instances, defer the capital gains tax on the sale of those shares. So favor industries, you might find that not only in addition to selling the business to your employees and thereby making them owner-operators, that there is an attraction to being able to defer the capital gains taxes on the sale, and you can do that through an ESOP with a little bit of structuring.
Meb: And how long is the traditional deferment?
Doug: You can defer taxes indefinitely. And, in fact, one of the important strategies that makes these so attractive is the ability to defer your capital gains taxes through the date of your demise and thereby passing your wealth along from the sale capital gains tax-Free with a step-up in basis. Obviously, that’s being questioned now in the Biden agenda, but it hasn’t changed yet.
Meb: So an obvious question is if you’ve got $100 million company, most employees don’t have $50 million sitting around. Is it the company buying it? Are you taking on debt? Is it some sort of offering, how does that actually progress?
Doug: When you sell your business to an ESOP, ESOP, employee stock ownership plan that you’ve set up, you’re essentially selling it along the same lines of selling to a financial sponsor in that the ability of the company to raise borrowings, raise debt in the capital markets will determine how much of the sale price you take away in cash proceeds versus how much you might have to take away in a similar note, an IOU from the company. That’s seller financing, that’s called a leverage leveraged ESOP, potentially, if you sell all your stock. But if you sell a stake, let’s say you want to sell 40%, Meb, you can do that and typically the company has the ability to borrow from its banks at a senior level adequately to provide you with the bulk of that sales stake proceeds in cash.
So you’re effectively carrying out a financial sponsor buyout of the company based upon the way you’re borrowing and using the company’s own borrowing capability to do the financing for you. And so what we find is that companies will either undergo 100% sales, that’s a typical structure, or partial sales where the business owner eases his way or her way out of the company gradually over time in stakes like that. But by crossing that 30% threshold, in other words, if the ESOP trust has 30% or more of your stock or your shareholder’s stock after the transaction, you qualify, in addition to a couple other hurdles you have to cross, you qualify for that capital gains tax deferral.
Meb: And how does the ownership change? The ESOP acronym implies that there is an employee aspect of this. Are the employees somehow getting a percentage stake? Is it flow through? What does the actual structure look like?
Doug: It’s interesting, the employees don’t actually own the stock in the company, what they own or are entitled to is an economic stake in stock in the company. The employee is a participant in a plan with a trust. That’s what the employee stock ownership plan is built around, a trust, and that trust owns the stock and the trustee controls those shares. Now, the trustee will vote in the best interest of the shareholders, those employee participants, but it doesn’t act in a manner that is inconsistent with the best strategy for the company as well. So you will often find, for example, in terms of strategic opportunities, that the trustee will typically align itself with the best interest of the company and not act necessarily in the short term interest of employees. It will always act in the best long-term interest of employees, but you might find that the trustee, for example, will agree to strategic transactions to acquire or even potentially divest certain masses of the business if it’s in the better interest of the firm.
Meb: I wonder if you know of any case studies that you could kind of just give us an example of. One of my favorite beers as a native Colorado guy was Fat Tire back in the day. My preference leans a little more Hoppy Pilsner, but that old school Fat Tire, used to love. Didn’t they do a big ESOP at some point? If you’re not familiar, I would love to hear any general examples of companies that have been through the process.
Doug: Breweries are interesting because they tend to have a pretty cool employee-centric vibe. And while I’m not familiar with Fat Tire, per se, or maybe I do recall it going through that process. I do know that a number of breweries have gone through ESOP formation process and are employee-owned, for example, there’s a Colorado-based brewer called New Belgium.
Meb: That’s the owner of Fat Tire, New Belgium.
Doug: Well, there you go.
Meb: I was talking about the beer, and now the company. I actually have a funny story. Once I was in San Francisco at a classic Irish/Indian restaurant bar. Listeners, if you are familiar with the bar in North Beach, I hope it’s still there. Kennedys, I believe, was the name. Anyway, I remember chatting with a girl, says, “I have…one of my favorite beers. It’s a Belgian beer.” And she brought over a Fat Tire. And I said, “Well, you know, that’s actually from Colorado.” And she says, “What are you talking about? See, it says New Belgium right here.” And I just let it lie. I said, “Okay. This is delicious. Thank you.” Anyway, New Belgium, parent company. But keep going.
Doug: So New Belgium is indeed an ESOP company. And I think that’s a very common process for becoming an ESOP. You form the trust, you start directing your share of profits into the trust to start pre-funding that stock purchase over time, and then at a certain date and time the owner sells his shares. There’s all cash in the trust available to buy those shares. And that’s how a lot of ESOPs get going. In other words, they don’t need to go out and borrow. Those are unleveraged ESOPs where over timeshare of those profits are peeled off and are used to fund the trust that buys the stock from the owner. That is a very successful ESOP.
Meb: So why are we even talking about this today? This is something that seems a little abstract and interesting, but for a lot of people who are listening, would love to hear how you partnered up with the crazies in Pennsylvania, because it’s actually something that you guys have built out as an offering. Is that right?
Doug: That’s correct. And that’s a great question. Why the hell are we talking about it? And I guess the answer is, to go back to Faber Industries, I mean, if you could sell your business that you’ve owned kind of and managed and nurtured privately over many years, what arguably from third-party’s perspective is a fairly risky asset from a wealth-creation perspective. If you could sell that cap against tax-free and roll the proceeds into a diversified portfolio of U.S. companies, that would be a pretty attractive way to exit a business. And if you could do that at a valuation level that was competitive with the valuations that you see now in the markets, in the capital markets, why that would be really kind of an exciting way to go. And so what we’ve done at Alpha Architect is we’ve developed a way to do that that breaks with 35 years of tradition and goes a new route, essentially plowing that wealth into a diversified portfolio of U.S. large-cap stocks.
Meb: Is that a requirement of this concept that you somehow have to invest in other companies for the tax deferral or is that something you guys offer as a benefit? What’s that sort of tangent?
Doug: So that’s called a 1042 election, meaning that under section 1042 of the IRS code, there was a provision that Congress put in place when ESOPs were still fairly young. This was back in the ’80s. ESOPs were initially started in the ’70s with legislation from, I think it was Senator Kelso down in Louisiana. But anyways, in the ’80s and a new way of adding to the ESOP options was created by a section 1042 sale election. And a business owner could elect a 1042 sale, had to be a C corporation that was forming the ESOP, S corporations can convert prior to the transaction to create that benefit. And if you are a C corporation and a business owner elects 1042 sale, the business owner can roll his or her proceeds into a portfolio of operating company stocks or bonds. That is a requirement of section 1042. And the traditional qualified replacement property, which is the definition, the term used to define what you can roll your proceeds into or buy a rollover like a 1031 rollover, the section defines those stocks or bonds as being the securities of operating companies, domestic operating companies.
Now, traditionally there was an interesting bond created that allowed investors to buy qualified replacement property, satisfying that criteria and that bond is a very low-yielding floating rate note. And then I can get into the details around it. And what we’ve done is we’ve created an alternative to that that is more flexible, we believe, and that allows one to buy a growth portfolio as opposed to buying a bond at par that’s designed to remain at par.
Meb: So anytime you hear accountants and CPAs talking about blazing new paths, I imagine people get a little nervous. What is the reasoning behind? And maybe they do. You mentioned kind of why Bear and others weren’t going down this path. But if this is something that there’s nothing that entrepreneurs and business owners like more than avoiding taxes, particularly big taxes of something like a sale of a business, is this something the banks are offering? Is it something where you guys are like the only ones out there? Kind of give me an overview of the actual setup, how it works, and what the status is of the rest of the competitors.
Doug: There’s a lot of risk around choosing that portfolio of securities because it requires judgments to be made about selecting securities that cannot be 100% made with publicly available information. In other words, you’d need to have, for example, I think the tax returns and other kinds of typically non-public information about a company in order to determine whether or not it qualifies for what we call QRP status, qualified replacement property status. So for that reason, a pretty slick solution was developed in the late ’80s between a guy named William Simon who was treasury secretary under Nixon briefly and Goldman Sachs at the time. That was in the late ’80s. I learned about this really because I was an investment banker working on the IPO of Avis Rent a Car and spent a lot of time with Avis management. Avis was at one time owned by its employee stock ownership plan.
And it was a company that was a portfolio company of West Rate Capital. West Rate Capital was William Simon’s private equity firm back in the ’70s and ’80s. And when Bill Simon came time to sell to exhibit portfolio company, Avis Rent a Car, which had bought for a few $100 million back in the ’80s, it took advantage of this new 1042 sale election to defer capital gains taxes when it sold. And the way it did that was Bill Simon, probably a pretty clever man on many levels, approached his investment back at the time, Goldman Sachs and asked them to devise a security that would qualify for qualified replacement property compliance. He wanted it to be a security that he could borrow against. And so Goldman came up with what is in and of itself, a fairly atrocious investment asset, but which solves the problems of the QRP investor.
And it was a bond, specially designed for the business owner. And, you know, you’re in trouble if your investment bank is designing a specialist security to sell just to you, because it’s probably got you between a rock and a hard place, but this is a bond that has a maturity of some 30, 40, even 50 years, but it has a floating rate coupon. And so it’s designed never to change value in the phase of shifting market interest rates. And guess one of the ways that Goldman Sachs enticed the earliest issuers of that bond, and there are names like Proctor and Gamble, they tend to be not dominated by the financials, but at the time there are more consumer goods companies, General Electric, for example. They entice them by making these bonds very low costs. In other words, the coupons were below market. So these bonds pay three months liable or minus something like a spread of 30, 40 basis points or so.
Goldman approached its best clients had got someone to issue bonds to Bill Simon and essentially Bill Simon bought these bonds. He bought a billion dollars’ worth of bonds and then gave them to Goldman to hold as collateral. And he borrowed against them. He borrowed something like 90% loan to value and was able to walk away with the proceeds and use those proceeds any way he wanted. So he was complying with QRP blinds, which require that he buy qualified replacement property, but in a sense, he was buying those bonds so that he could essentially borrow against them and monetize them by getting a loan from Goldman against those bonds and going off into the sunset tax-deferred.
Meb: That’s a handful.
Doug: Exactly. The idea was that Simon would buy these bonds that would extend beyond his life expectancy and be able to defer those taxes indefinitely. What is implicit in that is that you’re going to pay the Piper for that privilege. You’re going to borrow 90%, maybe a little less these days on your bonds and that remaining 10% or 15% of collateral is going to kind of sit there as collateral cushion, earning whatever that coupon is. Well, today that coupon is zero. And the loan on those bonds, and this is typical in a low-interest-rate environment, the loan in those bonds is a spread today of 100, 125, 150 basis points. And so you are writing a check for the privilege of that loan every quarter, every month. And that’s a very expensive way to get access to your money. And God forbid the bond should mature before you can meet your demise. God forbid that issuer should call those bonds. And now they’re typically call protected for 20, 30 years, but there is called ability allowed in the bond structure eventually. And so, anyways, you’ve got a series of issues that could rear their heads over time. But that’s been the default. That asset’s been a default qualified replacement property now for 30 to 35 years since we developed our strategy, really.
Meb: When did you guys start offering this as an offering? What is it you guys actually do? I’ve read through kind of the posts on the website, but maybe give us an example of how this has worked in practice in the last few years.
Doug: One of our own partners, I won’t name him because his family probably doesn’t want to be broadcast as a client of the firm in this case. But one of our firms on partners is part of an ESOP company, owning family ownership stake. And so he came to the office one day and said, “We’re going to be converting to a C corporation at our company and I’m going to get a chance to sell stock before we convert.” He and his family were going to sell some stock and we had to figure this out. And, you know, we have an equity orientation toward investing like you do. Buying those bonds didn’t sit well with him when he and his family learned about this strategy for floating rate notes and having to monetize those bonds and so forth. And this was a wealth that was in a trust, and so it was going to be sitting around for a while.
So what they wanted to do was buy something that had a longer life span, a longer investment horizon, potentially. What he said and what his family said was, “What would you guys build if it were your wealth? I mean, what equity prospects could we have for finding a solution to this issue?” I guess the first thing that the crew did was they called around, you know, if you call Vanguard, say, “Do you have a 1042 QRP ETF?” They look at you like you’ve got marbles in your head. And, of course, no, there’s no such thing because this is not a very big market. There aren’t that many buyers potentially of this solution. And so it’s not really worth the time and the effort to go through the process of trying to make such an investment product. But more importantly, it’s not permitted under the rules. One can’t buy a passive entity vehicle like an ETF to satisfy this.
So we were then faced with having to come up with our own solution. So what we developed was effectively an S&P 500-oriented, index-style strategy. We don’t actually use the S&P 500 because we don’t want S&P knocking on our door, asking for a royalty. But we use the universe of large-cap equities. And in that manner, we draw from the securities that predominate that kind of universe. And we filter out the securities that are not qualified replacement property-compliant. It took us about, I would say 1,000 man-hours to figure out how to do that. Every client needs that filtering process done because those names change. They come in and out of favor or new securities, emerging securities and retired. And so we filter those securities, we come up with some subset that’s a little less than 80% of the investible universe that we’re looking at and then we create an index strategy out of that market gateway it. And that is what we created the idea being that why own something for 40 years that’s not going to grow and that’s not going to yield any income when you can buy what is arguably one of the more attractive growth asset classes in investing history.
Meb: Can you take distributions from that? Is it just taxable if you were to take money out of? When does Uncle Sam get his pound of flesh?
Doug: The rule under section 1042 States that if you rolled over your proceeds into qualified replacement property, you then roll into that qualified replacement property, the tax basis of your stock that you sold at the ESOP as well as the holding period. So suddenly you now have an asset that you’ve essentially owned since you first created your company and has that long-term holdings inherited by the stock as well. The idea is that if you dispose or generate something that qualifies as a taxable disposition of those rollover stocks, those qualified replacement stocks, you then have to pay the capital gains tax that you would avoid at the time you sold your stock to the ESOP. In other words, when you sold your company. And so you’ve moved that capital gains tax recognition down the road and so a business, somebody that owns this asset now, can enjoy both the dividends, which are taxed as dividends, currently 20% plus 3.8% for VAC a surcharge.
So that’s a reasonably low tax stream of income. And if the owner wants to boost that with additional liquidity, what we do is we algorithmically trim on a pro-rata basis, small capital gains sales across each of the shareholdings in that index. And we can do that. We develop algorithms to help us do that so that any business owner can generate, say, a 4% yield out of the stocks that they own versus maybe 1-1/2% or 2% yield from the dividends. And it’s still taxed because capital gains are taxed, like dividends is still taxed in a very attractive manner for a business owner or for someone trying to support a lifestyle.
Meb: Are there any just kind of generalizations you can make about the companies you guys have worked with thus far? Are they all doing sort of a template model? Is it highly customizable? They tend to all do the same thing, or how has it kind of worked in practice?
Doug: What we find is that most business owners come to us with a very similar set of circumstances. “I’ve just sold between 40% to 100% of my company and I’ve got these proceeds and now I need to buy this rollover.” And the process for buying that rollover is almost uniformly the same. Usually, they’ll come to us with a reasonably significant proportion of cash, but some of them don’t, some of them come to us with 25% down. And so we financially engineer the leverage, the borrowing that they need in order to buy the entire index. But it’s a pretty consistent process for doing that. The real question revolves around how much cash investment they’re bringing to bear to buy their rollover. Because the rules of qualified replacement property require that a business owner by the entire intended rollover within one year of selling the stock to the ESOP trust.
So in Faber Industries, if you sold your company for $100 million dollars, you’ve got a year to identify your qualified replacement property. Now, if you’re a floating rate note strategy pursuer, you will need that year because floating rate notes are issued every couple of months and you don’t want to own just one floating rate note, you’d like to own three or four or five more if you could. But typically, they come out every couple of months. And so you’ve got to buy your bonds in those trenches and hope that you can get what you need within that one-year period. We’re, of course, buying from the most liquid capital markets in the world and we’re buying the most liquid asset in the world, presumably, outside of the U.S. dollar. We’re buying the largest capitalized stocks in the U.S. Those tend to be fairly liquid. We can buy as much or as little as we want. So a business owner can decide if he or she wants to buy initially the whole bunch or wants to spread that purchase out over time.
Meb: Who kind of shouldn’t be doing this? Is there any use cases? We’re going to have a lot of listeners that are business owners on this podcast that I imagine will think this is, you know, an interesting possibility. Any people we should be screening out or any people that we should be considering more appropriate for this sort of thing?
Doug: Our client base covers probably the entire gamut. We had, alas, one client who passed away shortly after she sold her stock within about a month. And it worked as advertised. We helped her to document her purchase so that she was able to go through…her estate was able to go through the procedure to document that they complied with QRP and her step-up in basis was apparently completed. And last I heard her estate was sadly doing well, given the totality of the circumstances. I guess I would say to you that if you are in-firm and very elderly, floating rate notes might make a lot of sense for you because, as we all know it, equities are a longer-term investment asset. Equities are not for everybody. And so if you’re probably looking at less than 10 years of actuary, a lifespan ahead of you, you might want to consider floating rate notes.
They’re just as flexible as our equities and some would argue they’re even more flexible. We’re not sure that that’s the case, but at least it’s an asset that is appropriate to the condition of that age, or that demographic of the business center. A younger investor might want to have a more growth-oriented asset, but 10 years is probably the minimum horizon you want to have ahead of you if you’re considering an equity portfolio. So the elderly and the infirm would certainly want to consider flooding right notes. We encourage all investors to look at all the strategies out there, predominantly floating rate notes in our strategy. We don’t want to try to railroad anybody into the strategy, but we think that our strategy has a number of benefits that are kind of unique.
But as far as companies, you didn’t ask that question, and that’s an interesting question. Like what kinds of companies do ESOPs and what kinds of companies are well-suited to ESOPs? And I’d suggest to you that the company that’s growing 30% a year, maybe an interesting emerging technology would not be an ideal candidate for an ESOP, for example, because that creates certain obligations for buying shares for future employees that might be very expensive, very costly in a fast appreciating equity-based business like that. A slower industrial business or a business with growth, maybe between 5% and 10% per year would probably be ideal to have the full flexibility of considering an ESOP.
Meb: Give you the mic for a little bit, take over the conversation. What haven’t we talked about this that is an interesting discussion, or is there any areas we didn’t dive in deep, or you think we didn’t talk about, things I didn’t ask? What else about this whole ESOP concept is useful to discuss?
Doug: ESOPS are really fascinating. There are two predominant forms of ESOPs that one can pursue, employee stock ownership plans. One is an S-corporation ESOP, meaning that the company that is able to use this ESOP is taxed as an S-corporation currently. Public companies can’t really do ESOPs for these benefits. They have other interesting benefits that accrue to them. And so you’ll find a number of public companies have very small employee stock ownership plans. They check a box and are able to derive certain benefits, but they’re largely divorced from what we’ve been talking about, which is the benefit of an employee stock ownership plan in these kinds of interesting taxable ways. So an S-corporation whose owner elects an ESOP can, in theory, become a 100% tax-free entity. So if a business owner sells 30% of her stock to an employee stock ownership plan trust that she forms for the benefit of the company buying those hairs on behalf of its employees, the 30% of stock then receives distributions tax-free because a qualified plan pays no income taxes. And, again, an ESOP trust is just like a 401k trust in that it is a qualified investment plan, so as such, it’s a non-taxable entity.
So when an ESOP owns the shares of an S-corporation, all of the shares, all of those distributions then become tax-free. And, of course, any Antony that owns 100% of the stock of a company is a non-taxpayer if it’s a qualified plan like that. So it’s really interesting when you think about it. In fact, it brings up a funny story. There are laws in place to prevent small companies with just a handful of employees from taking advantage of these rules to make their companies entirely tax-free. And that’s because, according to those that I’ve heard, Jerry Seinfeld and his production company was a one-man ESOP, and he owned a company that elected an ESOP sale, and he became the one participant in his plan.
And so Jerry Seinfeld pays no taxes on his business’s earnings, which is pretty interesting, but that’s not the reason why Congress put in place these interesting benefits. Congress is encouraging ESOPs because they create wonderful benefits for employees, for their families, their communities, and, of course, for the legacy of the company itself and the business owner. And they don’t want that being abused by small groups of wealthy individuals who are seeking to create a tax-free entity. And so they’ve developed a series of rules to prevent abuses, but that doesn’t mean though that a 20-person firm or larger that is an S corporation can’t undertake to bank an ESOP like this. And all distributions, as I said, from the shares, then are distributed tax-free.
In a less than 100% owned S-corporation ESOP, the distributions are taxed outside of that ESOP. And so typically what happens is the company will distribute funds so that the shareholders can pay their taxes. And so there’s not quite as much efficiency then in those more minority ownership structures. On the other hand, a C-Corp is the entity, the tax structure that permits a business center selling their stock to defer capital gains taxes. There’ve been rumors around that Congress is going to consider potentially allowing that deferred tax benefit for business owners of S-corporations who sell their stock to enjoy that same capital gains tax deferral. But that’s currently now purely the remit of C-corporation owners. Interestingly enough, though, both companies can deduct the debt payments to the trust that are made to repay any debt taken on board to finance the purchase for the business center.
Perhaps I’ve gone a layer too deep here, but suffice it to say that if a business owner sells 100% of their company and the company doesn’t have the cash in place to buy that equity or the trust that is formed, can’t buy that equity with the company’s cash infusions, then again, the company has to go and borrow. And so any distributions that are made to the ESOP trust designed to repay that debt and thereby allocate the shares to the employees as a function of that repayment, those payments are tax-deductible to the company. So there are a real tax benefits to forming an ESOP along the lines of distributions made or payments made to the trusts to fund that plan, essentially. Consider that to be like the way a 401k plan is funded. So those payments, and in the case of a C-corporation, the debt service costs can be deducted up to certain limits, which makes them very attractive from a tech savings vehicle for the entire company, not just the business owner who’s selling the stock.
Meb: And so what do you guys actually do? Alpha Architect. Somebody comes to you and they’re going to email you after the show, say, “Meb referred me. He gets a case of New Belgium beer for every referral.” What do you guys then do? What’s the timeline? Walk me through of what something like this may look like.
Doug: We’ll work with the business owner to understand the circumstances around their transaction and understand what kind of use they have for the proceeds just so we understand really what kind of investment horizon they might have. But typically, that business owner will have thought through their reasons for electing a 1042 sale transaction. And so that is often because the business owner wants to try to sock away as much money as possible for future generations. And so, as a result of that, we will, first of all, help them to determine what kind of structure their portfolio requires, meaning how much cash they bring into the table because, as I mentioned, for business owners who don’t have adequate proceeds to purchase the entire rollover with cash, an amount of borrowing has to be done. That amount of borrowing typically parallels how much seller financing they’re undertaking to finance the sale of the stock.
Just to step back, as I mentioned, if a business owner sells stock to the ESOP trust above and beyond the ability of the company’s financing capability, the business owner typically takes back an IOU from the company, a seller note. And that seller note, while typically more attractive as a subordinated piece of borrowing, pays a better interest rate. That seller note prevents them from buying the entire portfolio outright with cash. And so that … note has to be financed in and of itself on our side of the transaction when it comes time to purchase the rollover. And so what we’ve done is we’ve developed a way to financial engineer that borrowing for the business owner to buy the entire rollover. Obviously, that’s risky when it comes to buying equities, and so we’ve had to develop ways to get around that risk. But it enables the business owner to purchase the entire rollover.
It’s a pretty straightforward process. They are, by definition, typically accredited investors, given the size of their proceeds, given the dollar values that they’re seeking to roll over in this strategy, and so as a result, we have to give them a pretty deep education into what we’re doing for them and what some of the risks are that are entailed in the strategy. But making it through an educational process of several presentations and then they make the determination as to how they tactically want to implement that portfolio. And as I said, that can be a lump sum investment, which tends to align more with the evidence of dollar-cost averaging versus lump-sum investing. Or we can undertake a dollar-cost averaging process. And frankly, we encourage dollar-cost averaging because when you consider the buyer’s remorse that could occur if the market drops 20% or 30% the day after they buy their portfolio, people typically come around to that crutch has been a valuable approach to invest in the process.
Meb: What’s the timeframe? So someone emails you tonight, what’s all this take? How long?
Doug: We can get it done in typically about two weeks if a stock is titled in the individual’s name that they sold to the ESOP, meaning that what we have to do is open an account for them, we have to get them to sign an investment management agreement with us, and more importantly, we have to educate them about the strategy and about the risks that it poses and so forth and work with them. But if they’re in a hurry, we can get it done very quickly. As I’ve said, we’ve gotten these investments done for some clients in a matter of a couple of days, but that’s usually a painful process for everyone involved. More likely a client will come to us after they’ve finished their…completed their ESOP sale and they’ll opt for a longer process that entails a more measured entrance into the market typically over three or four tranches. We call it dollar-cost averaging, but it really is one, two, three, four quarters for equal investment amounts.
Meb: How do you guys work with companies? Is it fee-based? Is it project-based? Is it hourly-based? What do you guys do?
Doug: It’s advice fee-based. So our advice fee is on our ADV disclosures, but the advice fee is charged on amount of the assets that the client is investing. And so that’s tiered, depending upon the total value of those assets. We work with other RIAs who might bring clients to us, because, again, we want… You know, our culture, it’s win-win, right? Win, win, win, as many wins as there are part of constituents. And so Wes is very keen, as am I, to be able to work with other RIAs because the alternative is potentially that the RIA who’s been nursing this client along for many years is going to get edged out of advising the client if the client ops to work with one of the investment banks. And so what we’ll often do is work with those RIAs to educate them about the process. We’ll typically work under a solicitor’s arrangement with them and share with them a piece of our advice fee. As I said, that advice fee is all disclosed in our ADV. We’re happy to talk to people about it one on one.
Meb: Nice thing about podcasts like this is we’ve chatted with a few. I mean, I think most investors are familiar with the old school real estate exchange. What is that? 1031? We’ve talked a lot about the QS BS, which I think is 1202. I’ve never heard of this. Not surprisingly, Wes had sent me his blog posts you guys did a while back. This was a couple years ago, I think. And I just, like many, just eyes rolled back in my head. So we did a poll the other day, asking investors about QS BS and it was, I think 95% or 99% said they never heard of it. And so I imagine on this one, it may be straight up 99.9%. We got a bunch of Alpha Architect followers. So those would be the only ones that have heard of it. So I love that there’s something new we’re unraveling and like many things with accounting and estates and taxes, it’s a double dose of frustration, complexity, and just pain in the ass-ness.
Doug: Exactly. You’ve nailed it. To add to the challenge, often the advisors around an ESOP won’t get to the topic of 1042 in detail until the end of the transaction. So the business owner doesn’t really appreciate the complexity that she’s in for or he’s in for and at the end of the transaction was like, “Wow. So I got to jump through these hoops to do this.” And it’s not like a 1031 rollover in the sense that a temporary one rollover can be rolled over again and again when there’s no practical limitation, I guess, other than lifespan to rolling over those tax deferrals. Well, this is like a one-shot kill. You only get one chance to choose your qualified replacement property and so you really have to understand what it is you’re getting into. And we often get phone calls from business owners who have sold their companies through these ESOPs and opted for the floating rate note strategy.
And I’ll just quote one client who came to us who’s now a client and said, you know, “I woke up one day and realized these bonds were never going to go up in value by design. They don’t really pay anything, at least in these market conditions, don’t really have much coupon, and so my only choice forever and ever is to borrow against these bonds. And I woke up and thank goodness, I still had a few months left in my year.” And that’s when the investor called us. And we were able to find a buyer for his bonds. First of all, because the banks don’t want to buy them back at par. They want to…occasionally they’ll buy them back at a 99.5 or so. But what we were able to do was find a competing bidder on the bonds to make his original bank behave and make them a nice offer to buy back the bonds and then get them into our strategy relatively quickly. That investor is presumably much happier now that he’s got two and a half or three years of growth. Past performance is no guarantee, obviously.
Meb: So as we look to the horizon, it’s 2021, which feels weird saying. We’re recording this in January. I think the assumption of most participants is that taxes probably aren’t going down. If anything, they may be going up. What do you guys see as you talk to people? Is this something that you’d expect an uptick in deal flow, an interest in this sort of concept based on policy? Give us just your general thoughts on the outlook of future. Anything else on your mind?
Doug: I guess there are two important things on my mind that are raised by this question. One is who else besides a business owner would find this strategy appealing. And I think that this is a missed opportunity or at least has been. And I’m keen to see a change. A middle-market private equity firm that seeks among its fund investors, typically large private individuals who are tax-sensitive, that private equity investor is an ideal 1042 sail elector. Why? Because I’m certain that any number of companies exist in their portfolios that have not generated, contrary to what they might be advertising, that have not generated the kinds of offers by acquirers that would satisfy their investment objectives. When you consider that, a middle-market private equity firm that is largely tax-sensitive and its investors can sell to an ESOP and thereby deferred capital gains taxes potentially indefinitely, it becomes a really interesting opportunity, or can a roll those proceeds into another business investment.
Well, how interesting is that? I mean, we have a client, the first I’d heard of it, who is a private…in fact, runs on middle-market private equity firm based here in Southeastern Pennsylvania. And these two partners exited one of their businesses to an employee stock ownership plan. And so they were able to capitalize on this structure to exit their business and roll those proceeds into a large-cap equity index universe and deferred capital gains taxes, it felt to me like the ideal solution for a middle-market private equity firm whose investors, and there were about 8 or 10 of them sitting around the table, were all seeking 1042 rollover opportunities. I mean, how cool is that? So private equity has a real interesting opportunity and I’m keen to get the word out there. I was going to start getting on that Dog and Pony show, but it got kind of busy with business as it developed.
So that’s one universe. But then you’ve got the tax law changes that you’ve talked about now and how it applies to individuals. So just by way of refreshing, if you don’t sell your company to an employee stock ownership plan and you sell it through other means and get your proceeds over time, you are typically going to have installment sale tax treatment on the sale proceeds, meaning you’ll pay your taxes as those installments are made to you. Well, that is an installment sale of a tax-deferred nature and it’s on the schedule of the government. Why not elect a 1042 sale and control when you pay those taxes? Because by electing 1042 and rolling all of this over, you now have the choice as to when you want to pay those taxes. And so it just makes sense from the standpoint of taking control of your tax liabilities and your cash flows, that you would want to have that control in your own power. And with an increase in tax rates, it seems to me to be only more attractive to selling shareholders to have that in very important control. I mean, when you think about it, right now, California state and local taxes plus federal taxes, I mean, you’re looking at upwards of 33% of a capital gains tax on the sale of your proceeds. These are big dollar numbers. If that’s going to go up, it’s already going up in Oregon, in Portland, Oregon. If those are going to go up, those kinds of dollar numbers now are just too big to ignore and too big to ignore without considering other alternatives.
Similarly, we wrestle with this question on the step-up in basis. Most business owners think that assigned to an ESOP is less attractive because there’s a no step-up in basis potentially under the tax law changes envisioned under the Biden agenda. But when you consider that 1042 can be gifted without creating a tax disposition, it stands to reason that it can be inherited without a taxable disposition until that generation then disposes of those equities or those bonds, if there’s still maturity left in them. So perhaps it’s a vehicle for transcending that veil upon demise of in the estate. I’m not a tax attorney, I don’t know, but I believe that since it can be gifted without creating a taxable gain, there’s no reason why it cannot be inherited as, so I show where else the owner could simply gifted upon just prior to demise if we wanted to.
Meb: Talk about resources, we’ll add these to our show note links. This is a pretty esoteric topic. What’s the best place for people to go if they want to learn more? Is it just email you guys? I know you’ve done a post. I’ll add to the show note links. Anything else comes to mind?
Doug: The best most objective answer I can give is to simply ask curious parties to Google the terms 1042 QRP. And if you do that, you will come up with the organic search rankings that give you a pretty good indication of what’s out there. Among those posts will be ours. Hopefully, an investor can determine, but if a business owner wants to contact us directly, we’re delighted to speak with them and share what we know. We’ll provide examples of how we believe our strategy compares to flooding rate notes strategy. We appreciate that we’re biased in the sense that we are selling an alternative to floating rate notes, but we also work with providers of floating rate notes and believe that there’s a place for those securities investor portfolios. And so we’re happy to try to start that education process and even refer clients to floating rate note providers if they want a second opinion.
Meb: Doug, I love it. Looking back on your career, I mean, it’s mentioning spots. What’s been your most… I imagine you still got some Bear Stearns’ gear?
Doug: Yeah. I got a bunch of stuff from Bear. I recently wore Bear Stearns’ sweatshirt that I had gotten… This was at a poker tournament, and people were trying to buy it off of my back. I had the benefit of surfing in the military like Wes. I was in the Navy. At the Navy, I joined Bear Stearns and spent about 11-1/2 years there. Unfortunately, the financial crisis changed the course of my career, but I’m delighted to have wound up where I am, working with this wonderful crew. And as you know, Wes is a lot of fun to work with, one of the smarter guys that you’re liable to encounter. And so he and this wonderful team he’s assembled, they just made what I do so much fun, managing the strategy with them is just so enjoyable.
Meb: Great crew, for sure. What’s been your most memorable investment on your side as you look back in your history? Anything positive, negative, in between coming to mind?
Doug: Do what I do and you’ll be a good poster child for what not to do. I was an early investor in Telmex early because I’m older than you guys are. We’re talking about the mid-’90s. And, of course, not early enough to have bought it when there was any profit left in it. So I realized that chasing returns was a terrible way to invest early on. And so I’ve never done that since. And so I stand back and watch what’s going on in Tesla and which was going on in GameStop and so forth. And I have to just marvel. And you got to love the capital markets for these kinds of things, but boy, it’s like jumping into a bull ring, getting in there to try to play that game.
Meb: Well, by the time this publishes, those will be anywhere between $10,000 and $1 per share. Who knows which? I also have been a shareholder of Telmex back in the day, so I can sympathize. Doug, it’s been so much fun. Where do people go? They want to find out more, they want to email you, you guys, chat a little bit about ESOPs, what’s the best spot?
Doug: Best place is www.alphaarchitect.com. You can follow the links to our strategies, or you can reach me simply at firstname.lastname@example.org. And we appreciate any interest.
Meb: Perfect, Doug. Thanks so much for joining us today.
Doug: You’re very kind to have me on. Thank you very much. Real pleasure.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us a message at email@example.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.