Structuring the Sale of Shares to a Leveraged ESOP

We read and hear of many ways that stock is sold to an ESOP. We’ve heard some interesting discussion recently about several ways attorneys have structured these sales; and we thought it was worth sharing. Below are only some of the ways an ESOP transaction can be structured (but we believe these may be the most common):

A. One option is for the seller to sell directly to the ESOP.

1. If the seller wants to make a Code Section 1042 election (an election on the personal tax return to invest the proceeds in domestic stocks and bonds, and then defer capital gains until those assets are sold), then the plan sponsor must be a C corporation at the time of the sale and the sale must be made directly to the ESOP.
2. An owner can take a note for 20 or 25 years, or whatever period it takes to allow for annual contributions that can fit within the deduction limits, annual additions limits, and the company’s budget.
3. However, most sellers, especially those wishing to fully retire immediately, or within a few years of the sale, want to be paid much faster – maybe in 5 to 10 years, if the corporation can generate the cash that fast.
4. The seller can then turn around and sell his new note back to the corporation in return for a second note with a higher interest rate and/or a shorter duration. The higher interest rate reflects the true risk the seller is taking on with a note that is probably subordinate to the corporate line of credit or other corporate debt.

B. Another option, if the seller is not interested in a Code Section 1042 election, is to have the corporation retire the selling owner’s shares in return for, say, a 7-year note at 10%, while the corporation turns around and makes a simultaneous sale of the same shares to the ESOP for a longer term at a lower rate. For example,

1. Assume the company is worth $10,000,000.
2. The seller might get a 7-year note at 10%.
3. The corporation might sell the same shares to the ESOP for $10,000,000 using a 20-year note at 6%.
4. Since the two sales are simultaneous, many advisors have argued that the value of the shares for both transactions would be the same $10,000,000.

C. A somewhat newer two-step approach is a variation on the previous item (B). The two-step approach does not argue that the transaction is “simultaneous” – in other words, even if it all occurs in one day, it is treated as if the owner gets one value for selling his or her shares to the corporation in return for a note; and the ESOP gets to purchase those same shares for a lower value (using what we frequently call the “inside note”), recognizing that the corporation’s value has now been reduced by taking on the liability of the note to the seller (what we frequently call the “outside note”). For example:

1. A company is wholly owned by one person and its value is $100,000,000 --- with a million shares outstanding (and thus a $100 value per share). The owner sells all the shares to the corporation in return for a 10% down payment, and a 10-year note for $90,000,000 with annual payments at 9% interest.
2. Immediately after this first transaction, the appraiser (discounting the future payments on the outside note at something higher than 9%) says the company is now worth $15,000,000.
3. So the corporation sells the same one million shares to the ESOP for $15,000,000, using a 20-year note and 6% interest.
4. As explained to us, there are several advantages to this approach:
   1. The Department of Labor and the IRS are less likely to argue that the ESOP was overcharged because the lower value is being used.
   2. If the DOL later decides that the ESOP note is off by, say, 10%, then the dollar amount of any correction is a much smaller amount than had the second note been for the same amount as the first note.
   3. By having a smaller note with the ESOP, the annual debt service will be less, and the annual contributions to service that debt are more likely to be within the deduction limits.
   4. Similarly, annual allocations are more likely to not exceed the annual additions limits (the $50,000 limit on what any one person can have allocated to him in 2012). This could also mean it is less likely to need 401(k) refunds due to the combined plans annual additions limits.
   5. The ESOP participants don’t see a large drop in price between the initial sale and the first renewal valuation.
   6. Finally, when the outside and inside notes have the same value, then people reading the Form 5500 (and related audit, if applicable) can often determine the amount that the seller received for his shares. However, when the inside note is different from the outside note, then the seller still has some privacy about the proceeds of his sale of a closely held company.