A corporate Swiss Army Knife: The Employee Stock Ownership Plan, Part 3: Shareholder Strategies

Part 3: Shareholder Strategies

An ESOP remains paradoxical – a tax-qualified ERISA-covered retirement plan that is intended and allowed to invest directly in the employer’s securities in order to promote employee ownership.  An ESOP’s ability to invest in the employer’s securities creates opportunities for shareholders to realize liquidity in a tax-advantaged manner.

How does an ESOP buy stock if it has no revenue?

As explained previously (see Part 1 and Part 2), the basic leveraged ESOP structure is as follows:

• Step 1: The employer obtains financing, e.g., from a bank
• Step 2: The employer makes an “acquisition loan” to the ESOP in the same amount that it borrowed
• Step 3: The ESOP uses its loan proceeds to buy employer stock, which is held subject to a pledge
• Step 4: The bank financing and acquisition loans are repaid through the annual funding cycle, generally, as follows:
  • The employer provides the ESOP with funds through contributions and dividends or distributions
  • Now that it has cash, the ESOP pays the annual installment on the acquisition loan (sending the funds back to the employer)
  • The employer pays the annual installment on its loan

How can an existing shareholder sell stock to an ESOP?

The statutory exemption that allows an ESOP to invest in employer securities does not distinguish between transactions in which the selling party is the sponsoring employer versus an existing shareholder – the exemption is available for both types of transactions. And, as previously explained, the statutory exemption applies to stock that is publicly traded, as well as stock that is not. Given these factors, so long as the requirements of the exemption are satisfied, an ESOP can purchase privately held stock from an existing shareholder.

Can a selling shareholder help finance a sale?

Yes! Either partially or in full:

Partial Seller Financing: Partial seller financing is typically facilitated by a one-day bank loan that is ultimately replaced with seller financing:

          Example 1: Partially Seller-Financed Leveraged ESOP: Will E. Coyote wants to sell his 240,000 shares of ACME Anvil Co. stock to the ACME Anvil Co. ESOP.  The purchase price is $24 million and Will is going to finance 75% of the purchase price. This is accomplished as follows:

• ACME obtains a $6 million term loan, an $18 million one-day loan, and makes a $24 million 30-year term acquisition loan to the ESOP
• The ESOP pays Will $24 million cash for 240,000 shares of stock
• Will loans $18 million to ACME for a note allowing ACME to pay off the one-day loan
  • Net Effect: Will receives $6 million cash and an $18 million note from ACME

• The term loan and acquisition loans are paid off through the annual funding cycle:

  • ACME provides the ESOP with funding in the form of contributions and dividends
  • The ESOP pays the annual installment on the acquisition loan back to ACME
  • ACME makes a payment on the $6 million term loan and on the $18 million loan from Will

100% Seller Financing: Typically, the employer buys the note from the seller sometime after the sale, the ESOP note remains long-term and the seller gets cash or a mix of cash and a shorter-term note from the employer:

          Example 2: 100% Seller-Financed Leveraged ESOP:  The circumstances are the same as in Example 1 except that Coyote will finance 100% of the purchase price. This is accomplished as follows:

• ACME obtains a $24 million one-day loan and makes a $24 million 30-year term acquisition loan to the ESOP
• The ESOP pays Will $24 million cash for 240,000 shares of stock
• Will loans $24 million to ACME for a 30-year term note allowing ACME to pay off  the one-day loan.
  • Net Effect: Will receives a $24 million note from ACME
     
• The acquisition loan and seller’s note are paid off through the annual funding cycle, per Example 1
• Two years later, ACME obtains favorable bank financing and buys the $24 million loan from Will for $12 million cash and a $12 million 10-year term note

  • NOTE:  The ESOP’s acquisition loan keeps its original 30-year term even if Will’s loan has a shorter term.

• The acquisition loan and new seller’s note are paid off through the annual funding cycle as described above

NOTE: In both examples, the interest rate paid by the ESOP on the acquisition loan must be “reasonable.”  That does not apply to the employer and selling shareholder, e.g., the note given by ACME to Coyote, and so Coyote could insist on a rate that better reflects the risk he is taking.

Where is the tax advantage for the selling shareholder?

If the circumstances are right, the selling shareholder can receive payment for the stock they sell to the ESOP and defer when capital gains tax may be owed. The circumstances are detailed in section 1042 of the Internal Revenue Code (“IRC”) and the key requirements include:

• The selling shareholder must have held the employer stock for at least three years prior to the sale
• The employer must be a C-corporation
• Immediately after the purchase, the ESOP must own at least 30% of the employer’s issued and outstanding stock
• The taxpayer must purchase “qualified replacement property” (or “QRP”) during the period starting three months before and ending 12 months after the sale of the employer stock

Important: These are not all of the requirements of IRC section 1042 and failing to meet other requirements could result in unexpected tax consequences

If all of the requirements of section 1042 are met, then capital gain tax is deferred until disposition of the QRP. 

What is Qualified Replacement Property?

In general, QRP is a security (stock, bond, etc.) issued by a domestic (US-based) corporation that:

• Uses 50% or more of its assets in the active conduct of trade or business
• Has no more than 25% of its gross receipts from passive investment income
• Is not the corporation that issued the employer stock it is replacing or any member of its controlled group (in Example 1, ACME or any member of ACME’s controlled group)

Given these requirements, common investments such as bank Certificates of Deposit (CDs) and mutual fund shares are not QRP.

What good is section 1042 if the selling shareholder helps finance the deal?

The note received by the selling shareholder, whether from the ESOP or employer, is not QRP. This, by itself, does not necessarily defeat section 1042 treatment because:

• Section 1042 treatment is not all-or-nothing: A taxpayer can elect section 1042 treatment as to some, but not all of the employer stock sold. In Example 1, Will could elect section 1042 treatment with respect to 60,000 shares by using the $6 million cash to buy QRP. The note and subsequent payments would not be QRP so section 1042 treatment would not be available as to 180,000 shares sold.
• Floating rate notes strategies can enable Section 1042 treatment: Floating rate notes (“FRNs”) are notes issued by corporations specifically designed to be QRP. They typically have very long maturities (30–40 years) and a variable rate of interest based on a short-term market index. Because of these features, some financial institutions are willing to make margin loans secured by FRNs. This can enable a shareholder who receives a note to elect section 1042 treatment on the total value received. Returning to Example 1 above:
   
  • Of the $6 million cash received, Will would deposit $2.4 million cash in a “section 1042 account” with a brokerage firm
  • The brokerage firm would loan Will $21.6 million with the proceeds deposited in the section 1042 account
  • The section 1042 account purchases $24 million worth of FRNs, which is QRP for all 240,000 shares (deferring capital gain on the stock sold to the ESOP)
  • Will can invest the remaining $3.6 million (and subsequent installments paid by the employer on the $10 million loan) however he wants

The FRN/loan strategy is far more complex legally and financially than the high-level explanation above. Someone considering this strategy should consult with a financial advisor with experience managing QRP and these types of strategies.

Conclusion

An ESOP remains a versatile tool that can be used to create shareholder liquidity in a tax-advantaged way.