Warrants are often used in private company Employee Stock Ownership Plan (ESOP) transactions to supplement the return to sellers providing subordinate debt to finance the sale.
Seller debt in such transactions resembles mezzanine financing, which bears higher risk and related interest rates.
Warrants can bridge the gap to allow seller notes to bear a lower stated interest rate while providing a balloon payment at the end of the note. This structure allows sellers to receive “a second bite at the apple” and offers flexibility for businesses to minimize interest costs and related cash outlay.
The existence and terms of warrants are negotiated as part of the ESOP sale to determine the appropriate rate of return. In this article, we’ll discuss how tax comes into play when using warrants in ESOP transactions.
What Are Warrants?
A warrant is a form of stock option that allows the holder to purchase stock at a future time for a defined exercise price. The potential value of the warrant depends on the company’s performance and the increase in value from the date of issuance to the eligible exercise date(s). Typically, warrants become eligible for exercise after the related debt is paid down.
How Can Warrants Be Advantageously Used in an ESOP Transaction?
When a company is sold to its employees through an Employee Stock Ownership Plan, the seller often provides a type of loan to help finance the sale. To make this deal more rewarding for the seller, the company might include "warrants," which are like bonus opportunities to buy stock later at a set price. This helps boost the seller's overall earnings from the transaction and can foster tax benefits when using warrants in ESOP transactions.
Warrants can help reduce the interest rate on the loan by promising a larger payment at the end. This setup offers the opportunity to earn extra money later and helps a business manage its cash flow more easily. The specific details of how warrants work are determined during the ESOP deal negotiations to ensure a fair return for everyone.
The Taxation of Warrants
Warrants can have immediate tax impacts and their treatment varies based on the transaction structure. Understanding the tax implications of warrants is critical to effectively using them in an ESOP transaction.
1. Current Tax Treatment
Even though warrants represent a future right, receiving warrants as part of an ESOP transaction can present current income tax consequences. Assigning an appropriate value to the warrant at issuance is essential.
2. Ordinary Income vs. Capital Gains
The tax treatment of warrants depends on the transaction’s structure. Warrants may be taxed as additional interest income over the loan’s life (ordinary income) or like profit you make when you sell something for more than you paid for it (as a capital gain) for additional consideration received. Any imputed value recognized as ordinary income establishes a basis to determine applicable capital gain or loss upon exercise.
Warrants as an Estate Planning Tool
Under the right circumstances, warrants can serve as a highly effective estate planning tool. Since the value of warrants at issuance tends to be low due to significant company debt, warrants have the potential to become highly appreciable assets. This characteristic makes them ideal for transferring wealth to the next generation.
Considerations When Using Warrants for S Corporations
There are other factors relating to S corporations that need to be understood prior to using warrants in an ESOP transaction, including but not limited to:
1. Class of Stock
Care must be taken to ensure that warrants are not considered a second class of stock in S corporations. S corporations can only have one class of stock, and warrants must be structured carefully to avoid jeopardizing this requirement. If warrants are viewed as creating a second class of stock, the company’s S corporation status could be revoked, leading to significant tax consequences.
2. Section 409(p) Testing
Additionally, warrants are treated as synthetic equity and are subject to Section 409(p) testing. This testing ensures that company ownership is not concentrated within a few individuals or related groups, which could lead to significant excise tax consequences. Proper structuring and compliance are essential to preserve the benefits of both the warrants and the S corporation election.
Kreischer Miller Can Help You Tap Into Tax Benefits When Using ESOP Warrants
Warrants can be a valuable tool in financing an ESOP transaction, offering benefits such as reduced interest costs, estate planning opportunities, and additional returns for sellers. However, it is essential to understand the unique tax treatment and potential impact on cash flow.
Our tax and ESOP consultants can assist in maximizing your return on your employee stock ownership plan by leveraging the power of warrants. Explore our ESOP Advisory Services or reach out to learn more about the tax implications of using warrants in your ESOP transaction, today.