ESOP and Estate Planning Case Study

PCE Investment Bankers recently advised the owners of a business in the sale of the majority of their ownership interest to an employee stock ownership plan (ESOP). Prior to the sale, our client involved their longtime trusted wealth advisor to assist in personal wealth and estate planning. As expected, the outcome was very beneficial for our client's estate planning—so much so, in fact, that sharing the highlights here of the various elements leading to that outcome seems worthwhile.

A "Step-Up In Cost Basis" Using QRP

Business owners who sell closely held stock to an ESOP have multiple opportunities to enhance their tax, estate, and transfer planning under IRC Section 1042. By reinvesting the proceeds from the ESOP in qualified replacement property (QRP), business owners may defer their capital gains.

As detailed in our article ESOP Tax Incentives for Selling Shareholders, if you're a shareholder of a privately owned C corporation, you can sell all or part of the privately-owned stock you hold to an ESOP. And if you meet the requirements of IRC Section 1042, you can defer and potentially eliminate the capital gains tax you would otherwise pay on the sale of the business. Section 1042 requires that the selling shareholder reinvest the proceeds received from the ESOP in qualified replacement property (QRP). As the owner of the QRP, you will then be taxed only on any capital gains realized on the subsequent sale of the QRP, so the tax deferral lasts only for as long as the QRP is held. However, a transfer of the QRP at death, by gift, or into a trust does not constitute a disposition and consequently does not trigger any capital gains tax.

QRP held in the name of an individual taxpayer will receive a step-up in cost basis for tax purposes to its then fair market value at the client's death. The tax basis of the stock our client sold to the ESOP was very low, so if the QRP (now carrying the transferred basis) is transferred through our client's estate upon our client's death, the QRP could then be sold without any federal, and in many cases, state capital gains tax. The wealth advisor's firm was in the process of assisting our client in a QRP monetization, which involves allowing the client to borrow against floating-rate note securities they had purchased as QRP.

Gifting and Transferring Within the Family and with an FLP

The wealth advisor worked with our client's family estate planning attorney to set up a family limited partnership (FLP) rather than the limited liability corporation they had initially considered.

At that point, our client had sold only a portion of the company to the ESOP and retained a minority ownership in the now ESOP-owned company. Immediately after the ESOP transaction, the value of the retained shares was considerably less due to the recapitalization of the company balance sheet (i.e., the swapping of equity for debt used to fund the ESOP transaction). Additionally, because the remaining stock represented a minority interest, its value was subject to both marketability and minority interest discounts. This presented an ideal time for our client to make significant transfers of wealth through the gifting of the "discounted" stock directly to family members or into the FLP.

For years, our client's daughter has worked in the company alongside our client, gradually taking on increasing responsibilities in day-to-day operations. Therefore, our client elected to gift and sell a portion of the remaining shares to his daughter. The discounted share value minimized the cost to the daughter and limited the use of the federal lifetime gift exemption. At the same time, our client has accomplished his goals of continued direct family ownership and family leadership roles in the company.

On the advice of his attorney, our client contributed to the FLP the balance of the retained shares along with several other nonmarketable assets unrelated to the business. Our client will become the general partner in the FLP, allowing him to exercise control over the assets. Ownership of the FLP interests can now be transferred or gifted into a trust or directly to family members and beneficiaries, with additional discounts resulting from the illiquid nature of the assets and the minority interest held in the FLP. The wealth advisor emphasized that all of this was done with the advice and involvement of our client's estate-planning and tax attorney.

ESOP Seller Note and Warrant Gifting Opportunity

Our client's ESOP transaction was structured with the seller receiving a note that included warrants. Senior financing was not sufficient to fund the entire transaction, and while mezzanine lenders were willing to lend more to fill the gap, our client was not comfortable with the pricing and terms. As a result, the seller took back a note from the company, expecting payment of principal and interest over many years and, in this case, principal only after the senior lender is repaid in full.

This seller note was priced at below-market rates, providing some regular current interest payments to the seller but subordinating the note's interest to that of the senior lender. As compensation for the lower price and subordinated interest , the seller note received a significant discount in present value and included detachable warrants to be issued to the seller when the note's principal is paid. If the company continues to do well, then the warrants will appreciate. If not, the warrants may become worthless.

The detachable warrants are currently valued at or close to zero, given the imminence of the sale. This, along with the significant discount in present value on the seller note, makes the warrants and the note ideal assets to transfer directly to an individual or to a GRAT (grantor-retained annuity trust). Our client elected to gift the warrants and a portion of the seller note to his son, who is not working in the business, rather than add more complexity with a GRAT. He had been searching for a way to provide financial income to his son as he continues to grow his success as an artist, and this gift provided a way to do that.

As this case study shows, the current federal estate transfer rules and tax rates coupled with the unique structure provided in the sale make ESOPs an attractive alternative to traditional M&A transactions.