Many ESOP transactions involve the selling shareholder financing all or a portion of the purchase price with an installment note. With installment treatment, the selling stockholder generally recognizes gain as payments are received on the note, which may defer recognition of a portion of the gain and the related tax liability over the remaining term of the note.
However, it should be noted that there are additional tax consequences that apply to certain large installment notes. Subject to certain exceptions, when the sales price of the property exceeds $150,000 and the face amount of all such notes that arose during the taxable year and are outstanding at the close of the taxable year exceeds $5,000,000, the obligation is subject to Internal Revenue Code (IRC) Section 453A.
Under IRC §453A, interest is charged on the tax liability that is deferred, but only for the portion of the deferred tax liability that relates to the installment note that originally exceeds $5,000,000. It is important to note that once IRC §453A applies to an obligation, it continues to apply to the obligation even after the remaining balance is reduced below $5,000,000.
Computation of Interest under IRC §453A
To compute the interest payable under IRC §453A, the following steps should be taken:
- Determination of the “deferred tax liability.” The deferred tax liability with respect to any given year is the product of the amount of gain with respect to the obligation that has not been recognized at the close of the tax year multiplied by the maximum tax rate in effect for such taxable year. The applicable maximum tax rate is dependent on the type of deferred gain and the tax rate in effect for the applicable taxable year. For many sellers, the maximum tax rate in effect related to their installment note is the long-term capital gain rate.
- Computation of the “applicable percentage.” The applicable percentage is determined by dividing the portion of the aggregate face amount of such obligations outstanding as of the close of the taxable year, in excess of $5,000,000 by the aggregate face amount of such obligations outstanding as of the close of the taxable year.
- Computation of interest. The applicable percentage of the deferred tax liability should be multiplied by the federal underpayment rate in effect under IRC Section 6621(a)(2) for the month within which the taxable year ends.
Illustrative Example
Consider this example when working through computation of interest based on the above. ESOP seller has a $10 million installment note that arose during the tax year. This note remains outstanding at the end of the tax year. ESOP seller’s “applicable percentage” is 50%. This is computed based on $10 million (original face amount of installment note) less the $5,000,000 IRC §453A threshold, which equals $5 million excess above the threshold. The $5 million excess above the threshold divided by $10 million (original face amount of the installment note) equals 50%.
Assume the ESOP seller had $2 million of basis in his stock. There is an unrecognized gain on the installment note of $8 million. Assume this stock qualifies for long-term capital gain treatment, so the applicable maximum tax rate used in this example is 20%. Assume the interest rate under IRC §6621(a)(2) is 7%. The interest on the deferred tax is computed as follows:
| Step | Calculation | Amount |
|---|---|---|
| (1) Deferred tax | $8 million × 20% | $1,600,000 |
| (2) Applicable percentage | Based on the portion of the installment note exceeding the $5,000,000 threshold | 50% |
| (3) Deferred tax subject to interest | (1) × (2) | $800,000 |
| (4) Interest rate | IRC §6621(a)(2) rate | 7% |
| Interest payable on deferred tax | (3) × (4) | $56,000 |
Planning Opportunities
Under Technical Advice Memorandum 9853002, a taxpayer and the taxpayer’s spouse are considered separate taxpayers for purposes of applying IRC §453A. Therefore, there may be an opportunity to significantly reduce, or sometimes eliminate, the interest under IRC §453A by making a marital transfer of shares prior to selling to the ESOP.
If you are considering selling your stock to an ESOP and taking advantage of the tax deferral of installment treatment, it is important to consult with your ESOP and tax advisor to fully understand the implications of IRC §453A and any planning opportunities available before closing the transaction.
For more information on how we can help you explore the potential benefits of ESOPs and whether they’re a good fit for your organization, please reach out to a professional at Forvis Mazars.