By Michael Kouyoumdjian, CPA
From Volume 41, Issue 2 of the ESOP Report
Taxes are never a topic people like to discuss, or if they do, it’s rarely a fun topic. Many sellers choose the ESOP alternative, at least in part, because of the tax benefits the option provides.
One of these benefits the seller can choose on the personal side is the ability to defer the capital fain by electing Section 1042. Although Section 1042 may provide tremendous benefits, it is not always the right fit for each seller. Electing to forgo Section 1042 usually comes with the requirement to pay capital gains tax on the proceeds as they are collected.
Unfortunately, many taxpayers are surprised to learn that the capital gains tax they pay may not be the only tax. Nestled in the tax code under Section 453A is an application of an interest charge for installment sale obligations, referred to as “interest on deferred tax liability” or the very appropriate nickname—the “Sting Tax.” Although this code section applies to other types of installment sales, the focus here is on the installment sale of company stock as part of the ESOP transaction.
What is the 453A “Sting Tax”:
Section 453A became effective in 1989 and essentially reduces the time value benefit of the installment method’s tax deferral. In an ESOP transaction, Section 453A applies to an installment sale where the selling price exceeds $150,000 and the total amount of all installment sale obligations that arose during the tax year and were outstanding at the end of the tax year exceed $5 million. Once interest is required on an obligation on year one, it must be paid for any later tax years as long as there is still an outstanding obligation even once the remaining balance drops below $5 million.
Although ESOP transactions typically involve an individual or trust as the seller, the Section 453A also applies to entities such as corporations and partnerships. The $5 million threshold is applied and calculated at the shareholder or partner level for passthrough entities.
Steps to Calculate the 453A Amount:
There are four steps to calculate the Section 453A amount that will be reported on the tax return.
The first step in this calculation is determining the amount of the deferred tax liability. This calculation requires the deferred gain on the sale to be multiplied by the maximum capital gain rate in the year of sale. The deferred gain is calculated by first calculating the gross profit percentage on the sale. This calculation sums the sales price less the basis sums the sales price less the basis then divides it by the sales price.
For example, if the basis in the stock sold was $3 million and the gross sales price was $30 million, the gross profit percentage would be 90% ($27 million gain divided by $30 million sales price).
To calculate the deferred tax liability, the remaining uncollected proceeds at year end is multiplied by the original gross profit percentage and then multiplied by the maximum capital gains tax rate in effect for that year. Note that the 3.8% Net Investment Income Tax (“NIIT”) is not considered in the Section 453A calculation.
In the example, let’s assume $10 million of the $30 million proceeds were collected in the year, leaving a remaining principal balance of $20 million. When the $20 million is multiplied by the gross profit percentage of 90%, the unrecognized (or deferred) gain equals $18 million. Then, multiplying the unrecognized gain of $18 million by the 20% capital gain rate for 2024, results in a deferred tax liability $3.6 million, completing the first step in the calculation.
The second step requires a calculation of the applicable percentage. This is done by taking the outstanding installment obligation at year-end, subtracting $5 million, and dividing the result by the outstanding installment obligation. Continuing with the example, the $20M uncollected proceeds is divided into $15 million ($20 million minus $5 million), resulting in a 75% applicable rate. This applicable rate is computed in Year 1 and remains constant in future years until the full proceeds have been received.
The third step requires looking up the IRC 6621(a)(2) underpayment rate for the final month of the taxable year. This rate changes annually and would need to be referenced each year of the calculation. For December 2024, the rate was 8%.
In the final step, the computed interest on the deferred tax liability is calculated so it can be reported on the return. Using the above example, the calculation beings with the $3.6 million deferred tax liability from Step 1, multiply by the applicable rate of 75% from Step 2, and then multiply that by the underpayment rate of 8% from Step 3. The result is a 453A “sting tax” of $216,000, which would be added to the taxpayer’s tax for 2024. It should be noted that many states also adopt the 453A calculation, so a state calculation may also be required using their capital gains rate.
In the first year of the installment obligation, it doesn’t matter if the sale occurred on the last day of the tax year or much earlier in the tax year; the interest charge is calculated at year end for the entire year (see CCA 201021020). Nor does it matter if the underpayment rate changed during the year; the rate in effect at year end controls.
Below is a table illustrating the federal calculations, assuming the transaction occurred in 2024 and an additional $5M of the proceeds are collected in 2025:
| 12/31/24 | 12/31/25 | |
| Remaining Proceeds | $20,000,000 | $15,000,000 |
| Deferred Tax | $3,600,000 | $2,700,000 |
| Applicable % | 75% | 75% |
| Underpayment Rate | 8% | 7% |
| Total 453A Tax | $216,000 | $141,750 |
Other Considerations/Opportunities:
Below are some considerations and opportunities that should be discussed as part of the initial election annually:
- Section 453A interest is considered personal interest and is not deductible (see Carlson v. Commissioner, 112 TC 240, 1999).
- Fully vetting the Section 1042 alternative to compare the projected tax cost with the 453A against the cost of 1042 prior to the ESOP transaction.
- It is important to remember that $5 million threshold is per person. If the stock is community property or can be transmuted to community property, it would allow for the doubling of he $5 million exclusion, potentially saving tens of thousands of dollars per year (see TAM 9853002).
- Many ESOP deals include an AAA or basis note and a seller note. Weighing the benefits of paying down the seller note first to reduce the sting tax could be valuable; however, it also accelerates capital gains recognition. The AAA/basis note is tax-free but does not reduce the annual 453A amount.
- Consider electing out of the installment sale method and paying the full amount of the tax in Year 1, especially if the taxpayer has significant capital losses to offset much of the gain. However, this requires careful consideration of the amount of tax due compared to the case received, as well as the opportunity cost of that cash.
- Gifting of the notes post sale will reduce the outstanding balance and will be reflective in a lower 453A amount due that year, but the gifting of the notes is generally treated as a disposition which would trigger the taxable gain on the amount gifted.
- If there is a later write-down of the seller note, a seller cannot claim a refund of the interest paid in a prior period (see TAM 9853002).