Post-ESOP Transaction Estate Planning with Warrants

Thoughtware Alert Published: Mar 02, 2022

For business owners looking toward retirement, ownership and management succession planning is imperative. Employee stock ownership plans (ESOP) deliver a great opportunity for business owners to reach their retirement goals while preserving company legacy and culture, rewarding long-term employees for loyalty and hard work, and providing incentive programs to retain and attract executive leadership. However, the planning opportunities don’t end once the ESOP transaction is complete! For most sellers, it is prudent to review the effects of an ESOP transaction on their current estate plan and evaluate wealth transfer strategies as part of the transaction with their trusted advisors. Many times, selling stockholders will receive warrants as part of the overall transaction financing structure. Gifting of these warrants can serve as a powerful estate planning tool under the right set of circumstances. 

What is a warrant?

A warrant is a financial instrument that provides a holder the right to purchase stock of the issuer at a specified price on or before a set expiration date. 

How are warrants used in ESOP transactions?

Many leveraged ESOP transactions involve some level of seller financing since commercial lenders will typically not be willing to finance 100 percent of the company’s equity value. This seller financing structure often involves using a lower cash interest rate to allow the company to maintain sufficient cash flow to service the debt payments and provide greater cash flow flexibility. Because seller notes are typically subordinated to the senior lender, they are considered riskier and demand a higher rate of return in the market. Warrants are often issued as an interest rate enhancement to compensate the seller for the risk associated with this type of debt. 

ESOP-owned S corporations generally wish to remain 100 percent ESOP-owned to preserve their preferred tax status, so the warrants are often structured with put rights requiring the company to purchase the warrant from the holder in lieu of receiving the exercise price and delivering the shares. This put may result in a potentially large cash flow event to the seller. Immediately following a leveraged ESOP transaction, the company has a substantial amount of debt and thus the post-transaction share value is typically very low. Since warrants generally have an exercise price equal to the post-transaction ESOP share value, the net appreciation in the stock from the date of the issuance of the warrants through the date of put can mean substantial additional money in the seller’s pocket (less applicable capital gains taxes and taxes associated with original issue discount) depending on the increase in the company value during the term of the warrant. 

Example: On December 31, 2021, in addition to cash and a promissory note, Seller is granted warrants entitling them to purchase 10,000 shares at an exercise price of $0.50 per share (total exercise price of $5,000) and a 10-year term. On December 31, 2031, when the company ESOP value is $22.50 per share, the Seller puts the warrant for total net consideration of $220,000.

Net proceeds from put of warrants $220,000
Capital gain tax due on warrants1 ($44,000)
Net cash flow from warrants   $176,000

How can warrants be used in estate planning?

For high-net-worth individuals, it is important to consider wealth transfer opportunities during one’s lifetime. A common goal with estate and wealth transfer planning is to remove as much future value from your estate as possible while reducing the usage of your lifetime exemption2.  In the example above, the warrants are expected to appreciate substantially in 10 years’ time, but the fair market value of the warrants at the date they are granted is very low, which makes them an ideal asset to consider for wealth transfer once received as part of the ESOP transaction. This will facilitate the opportunity to move significant wealth on to the next generation while using minimal lifetime exemption to transfer the asset.

For more information, reach out to your advisor or submit the Contact Us form below.

For discussion purposes, assumes a capital gain rate of 20 percent federal tax and no state income tax. Also assumes 3.8 percent net investment income tax does not apply to the capital gain on the sale of an activity in which the shareholder materially participates in the active trade or business. This analysis does not consider the tax impact of any original issue discount associated with the warrant. 
$12,060,000 for each individual in 2022, but scheduled to sunset back to $5,000,000 indexed for inflation in 2026 (expected to be about $6,200,000). 

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