how to navigate your esop sale - bloomberg …...•installment distributions require single sum...
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How to Navigate your ESOP Sale
Seller and Company Considerations
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Seller side
• Tax Incentives
– Capital gains on partial disposition of ownership
– Tax deferred sale under Section 1042
• Followed by charitable gift
– Installment sale on seller financed transactions
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Seller side
• Investing the 1042
– Qualified replacement property
• Securities of domestic, operating companies– Stock or debt
– Taxable upon DISPOSITION with few exceptions
– Investment period
• 3 months before through 12 months after CLOSING
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Seller side• 1042 investment strategies
– How long?• Until death• 10 years or more• Less than 10 years
– For whom?• To live on• To gift to heirs• To gift to charity• To finance other investments
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Seller side
• Financing
– ESOP sale
• Subsequent refinancing
– Redemption
• Warrants
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Company side• Loan structure
– Under GAAP All ESOP debt hits company’s balance sheet– Offsetting entry is a contra equity account– Consequence
• Negative equity• Consideration for push-down accounting in change in control
transactions– Treatment of resulting goodwill
• Commercial loan considerations• Solvency considerations
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Company side
• Cash flow management
– Loan terms
• Length
• Interest Rate– Warrants
• Prepayments
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Company side• Cash flow management
– Plan terms
• Allocations– Contributions
– Dividends
• Vesting
• Distributions, including diversification
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Company side• Financing distributions to participants for private company
ESOP– Maximize flexibility– Put Option
• 2 events• Prior year appraised value• Installment distributions require single sum cash redemption• Lump-sum distributions permit 5 year note with 6 payments, first
upon execution of put.– Reasonable interest– Adequately secured
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Illustration Financing a 1042 Transaction
• 1042 transaction REQUIRES stock to be sold to ESOP
– Seller may be interested in paying tax on a portion of the sales proceeds.
– Financing may be difficult for a 100% ESOP transaction
– Consider partial ESOP sale, partial redemption
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Illustration Financing a 1042 Transaction
• Example of partial direct ESOP sale, partial redemption
• Company worth $30 million for ESOP transaction.
• Redemption and ESOP sale happen simultaneously.– Redeem 45% for $13,500,000
– ESOP purchase 55% - $16,500,000
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Illustration Financing a 1042 Transaction
Borrow $16,500,000
NOTE
NOTE$16,500,000
$16,500,000
55% of stock
45% of stock for $13,500,000
Subordinated Note for $13,500,000
Warrants
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Illustration Financing a 1042 Transaction
45% of stock for $13,500,000
Subordinated Note for $13,500,000
Warrants
Installment Sale
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Illustration Financing a 1042 Transaction
$16,500,000
55% of stock
Sale Eligible for Tax Deferral
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Why structure this way?
Borrow $16,500,000
NOTE
NOTE$16,500,000
$16,500,000
55% of stock
45% of stock for $13,500,000
Subordinated Note for $13,500,000
Warrants
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Common Mistakes1. Prepayment language not negotiated
2. Collateral release miscalculated
3. ESOP S corporation technicalities violated
– 409(p) test
– Cash basis for all accruals to ESOP participants
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Common Mistakes4. Interest income in inside loan not reported for
tax
5. S Distributions treated as deductible when applied to loan
6. Book / Tax differences not recognized
7. Alternative minimum tax implications overlooked
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Common Mistakes8. Details of 1042 election not satisfied
9. Unique requirements for an ESOP loan not included inside loan documents.
10.Impact on financial statements not considered in planning transaction