ESOPs and Estate Planning

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Implementing a leveraged ESOP transaction creates a number of gift, estate, and charitable planning opportunities. The valuation effect that a leveraged ESOP produces – the “post-transaction drop-in-value” – provides a business owner with a unique opportunity to make lifetime gifts of interests in his company (shares of stock or warrants) at a deeply discounted value. An ESOP also presents the opportunity for equitable estate planning (treating active and inactive children fairly) as wells as various charitable planning strategies for the philanthropic business owner.

Gift Tax Leverage. One of the principal goals of gift and estate tax planning is to make lifetime gifts of assets whose values are temporarily deflated, but that will appreciate rapidly in the hands of the donee. The concept of the ESOP “post-transaction drop-in-value” presents an opportunity for a business owner to make a gift of this type of asset (a “leveraged gift”). In order to fully understand how this opportunity arises in connection with an ESOP transaction, it is imperative to understand the concepts of enterprise value and equity value.

The appraiser will determine enterprise value using one or more of the generally accepted valuation approaches mentioned above. However, calculating enterprise value is only the first step in valuation, because a company does not sell for its enterprise value. Rather, a company sells for its equity value, which is its enterprise value less long-term debt plus excess cash and other non-operating assets. If a company with an enterprise value of $10,000,000 has $1,000,000 of long-term debt and $1,000,000 of excess cash, then its equity value is equal to its enterprise value of $10,000,000. The selling shareholders would receive $10,000,000 for a sale of 100% of their stock to an ESOP.

Immediately following the ESOP sale, the company will have a different – and usually much lower – equity value, which is attributed to the debt the company incurred to finance the transaction. The result of this debt is known as the “post-transaction drop-in-value.” To illustrate this concept, suppose a business owner wishes to sell 100% of his stock in his closely held company for $10,000,000. The company borrows $6,000,000 from a bank, and lends that amount to the ESOP. The ESOP pays the business owner $6,000,000 in cash and issues a Seller Note paying six percent interest annually with 100,000 detachable warrants for the remaining $4,000,000. This company has an enterprise value of $10,000,000, but also has $10,000,000 in debt. Ending the calculation there produces an equity value of $0; however, the leveraged ESOP transaction that created the debt also produces a substantial tax benefit in the form of tax-deductible annual ESOP contributions. Valuing this tax benefit requires calculating the net present value of the corporate tax deduction produced by the annual ESOP contributions at a discount rate equal to the company’s weighted average cost of capital. In this case, the net present value of the ESOP tax benefit is calculated to be $2,007,507. The company’s 1,000,000 shares of stock now have a value of $2.01 per share, which will also be the strike price of each warrant.

Suppose that after the ESOP transaction closes, the business owner makes a gift of the warrants he received in connection with his Seller Note. For gift tax purposes, the value of the warrants is calculated using the Black-Scholes model, which is the most widely used option valuation model, and which is based on a number of assumptions specific to the issuing company. Under this model, the value of the warrants will be substantially less than the value of the stock prior to the transaction, creating an opportunity for the business owner to make a highly leveraged gift. As the company grows and pays its ESOP debt, the warrants produce a leveraged growth rate exponentially higher than the company’s organic growth rate. Here, at the end of ten years, the total value of the warrants in the hands of the donee is $1,428,144, which represents a leveraged growth rate of 21.68%.

Suppose now that the business owner only sold 49% of his stock. The business owner could make a gift of his 51% ownership interest in the company outright to his children; he could transfer his 51% interest to a family limited partnership (FLP) and make lifetime gifts of the heavily discounted limited partnership units to his children; or he could make a gift to a grantor retained annuity trust (GRAT) or grantor retained unitrust (GRUT) meeting the requirements of § 2702 of the Code, and retain an income stream.

Active Child vs. Inactive Child Challenge. A business owner can also utilize an ESOP sale to address the “Active Child vs. Inactive Child” planning challenge that many BBBOs face. Many BBBOs own closely held companies with a child (or children) who are active in the business and a child (or children) who are not active in the business. The challenges that this situation presents are fairly evident; however, using an ESOP to solve this dilemma requires some explanation.

Assume the owner (“Owner”) of a private company, ABC, Inc. (“ABC”), a Subchapter C corporation, has two children, one of whom is active in the business (“Active Child”) and the other of whom is not active in the business (“Inactive Child”). Owner is 65 years of age, and would like to achieve some liquidity from the company while ensuring that Active Child remains with the company and has an opportunity to succeed Owner at ABC. Another of his goals is to treat Inactive Child fairly. Selling ABC to a third party would provide Owner with some liquidity, but that liquidity comes with a significant tax liability and it is likely that Active Child will not be able to succeed his father as president of ABC. Instead of selling ABC to a third party, Owner can sell a part of his company to an ESOP to obtain some liquidity – without paying taxes – and potentially allow Active Child to succeed him as the president of the company.

An ESOP sale also presents strategies Owner can use to provide for Inactive Child. ABC establishes an ESOP which purchases 51% of Owner’s stock in a leveraged transaction. ABC is able to borrow $5,100,000 from its bank (Outside Loan), and then loans this amount to the ESOP (Inside Loan). The ESOP uses the proceeds of the Inside Loan to pay Owner $5,100,000 in cash for 51% of his stock in ABC. Because ABC is a Subchapter C corporation, Owner defers $1,213,800 in capital gains taxes by electing the tax deferral provided by §1042 of the Code, and he receives income from the reinvestment of his QRP on the full amount of his ESOP sales proceeds.

Owner has accomplished his goal of achieving some liquidity, but how does an ESOP allow him to provide for Active Child? After the transaction, Owner makes a gift to Active Child of the remaining 49% of ABC stock. This gift results in Active Child receiving a significant equity interest in the company and the opportunity to succeed Owner as the president of the company. In addition, this gift is very tax-efficient as a result of the post-transaction drop-in-value. The value of Owner’s gift to Active Child is not $4,900,000 (49% of $10,000,000). The company’s $10,000,000 enterprise value is reduced after the transaction by the $5,100,000 of ESOP debt resulting in an equity value of the entire company of $4,900,000. The value of Owner’s 49% retained interest is $2,401,000 (49% of $4,900,000). Assuming the gift tax appraiser applies a minority interest discount of 25%, the value of the gift to Active Child is $1,800,750 which is within Owner’s Unified Credit amount. Therefore, the ESOP sale coupled with Owner’s election of tax-favored treatment under § 1042 of the Code, along with the avoidance of gift tax liability, enables Owner to transfer an asset worth $10,000,000 without paying taxes.

Assuming that Owner receives a high enough annual return on his qualified replacement property to live comfortably, Owner could pass his entire investment portfolio at his death to Inactive Child. Because Owner held his qualified replacement property until his death, Inactive Child receives a stepped-up basis in the inherited property equal to the fair market value of the securities on the date of Owner’s death. The result is that no income will tax will ever be paid on Owner’s qualified replacement property.

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