The Fallacy of the December 31 Closing for ESOP Transactions

The Fallacy of the December 31 Closing for ESOP Transactions

While many businesses and their owners wish to close an Employee Stock Ownership Plan (ESOP) transaction by or on December 31, the importance of doing so can be overstated.
Many businesses and business owners contemplating a sale, merger or other liquidity event, oftentimes view closing a transaction before the end of the calendar year as important for a variety of tax and non-tax reasons, and ESOP transactions are no exception. As more and more companies discover the advantages of employee ownership, the number of new ESOP transactions closing on or just before December 31 continues to grow.

Why do year-end closings seem like a good choice for ESOP transactions?

There are a handful of factors that make a year-end close popular. The first, and perhaps most common, is that closing an ESOP transaction at the end of the year starts off the new year with a “clean slate” as an ESOP-owned company and seems tidier from a bookkeeping perspective. Second, closing an ESOP transaction before year-end may permit a company to make a contribution to the ESOP in that fiscal year, allowing for some shares to begin to flow into participants’ accounts, and in most cases, providing the company with a beneficial income tax deduction. However, these advantages should not be the determining factor in deciding when to close the transaction.

While a year-end close may seem tidy from an accounting perspective, it also is very common for transactions to close on a month-end, which can make for a convenient cut-off date as with a year-end close. As always, from a business perspective, the decision to sell a business should be strategic in nature first and foremost, with the accounting of the transaction playing an important, but secondary, role.

What happens if an ESOP sale occurs on a day other than year-end?

If a sale occurs on a day other than year-end, the structure of the transaction will determine whether multiple tax returns need to be filed.  Even if multiple tax returns are required, the time and cost of doing so are minimal compared to the results of a successful and well-planned transaction. 

For the acquisition of C or S corporation stock by an ESOP, a change in ownership could limit the availability of tax attributes that might otherwise exist (i.e., net operating losses and tax credit carryforwards) but it should not result in a closing of the tax year for income tax purposes. If an S election is desired following the sale to an ESOP, there is a five-year restriction under Section 1362(g) that prevents a reelection to Subchapter S status if such status was terminated to take advantage of Section 1042 to allow for a tax-free shareholder rollover of proceeds into qualified replacement securities. However, if the company was a C corporation from inception, or for at least the last five years, and the sale occurs on December 31, then an S election could be made on January 1 following the year of the sale. If the company was always an S corporation and the shareholders revoked Subchapter S status to allow for a Section 1042 rollover at the end of any month other than December 31, then it will become a C corporation. Its termination year would consist of two separate tax years (an S short year and a C short year). Items of income, gain, loss, deduction and credit will need to be allocated between the short years in one of the manners permitted. A revocation would result in a final S corporation return from the beginning of the day preceding the day of the sale (e.g., January 1 through June 30 for a termination effective on July 1), and a C corporation return from the date of revocation through the end of the year (e.g., from July 1 through December 31 for a July 1 revocation date). In either scenario, filing requirements can be managed properly by an experienced tax compliance team and should not be a deciding factor when choosing to sell a business in a certain month.

Are there disadvantages of closing an ESOP sale around December 31?

The popularity of ESOP closings around December 31 can in fact be a disadvantage to closing a transaction at that time. For these types of deals, having a service provider’s full attention and capacity can prove to be instrumental in completing a smooth transition. Service providers are likely to be overburdened at the end of the year, especially legal teams, and like many people during the holidays, professionals may be traveling and/or hosting family and friends and the service team may not have as much capacity as usual. As such, service providers may charge more for year-end transactions because they know schedules will be busy. There are also many instances where transactions are unnecessarily rushed in order to close before year-end, when a closing date in the first quarter would make just as much sense. When pursuing an ESOP transaction, as with any other sale or exchange transaction, providing enough lead time is critically important to avoid potentially costly errors.

What are some advantages to closing an ESOP sale after year-end?

Businesses can take advantage of a full year, deductible ESOP contribution no matter what the actual closing date is. For example, if a company closes a transaction on December 31, 2021, it may still have the option to establish the employee stock ownership retirement plan with an effective date of January 1, 2021. This would allow the company to use a full year’s worth of eligible payroll to accrue a tax-deductible contribution in 2021, decreasing 2021 taxable income. 

Further, the Setting Every Community Up for Retirement Enhancement Act of 2019, or SECURE Act, passed in December 2019 provided even more flexibility for companies looking to preserve their eligibility to take a tax deduction for the current year by amending IRC Section 401(b)(2) to allow an employer that adopts a stock bonus, pension, profit-sharing or annuity plan after the close of a taxable year but before the tax return is due (including extensions) to elect to treat the plan as having been adopted as of the last day of the taxable year. This change should further alleviate the rush to adopt plan documents by calendar or fiscal year-end by permitting employers to close a transaction after year-end and still take a tax deduction for the previous year. 

While the year-end close can seem attractive to business owners, the importance of completing the transaction by December 31 is often overstated, and transactions can become more expensive and rushed to close “on time.” The benefits of an ESOP transaction can be taken advantage of any time of the year, without the rush to meet an arbitrary deadline.