Estate Planning with ESOP Warrants

Jun 27, 2024

Warrants are often packaged with seller subordinated notes as consideration for sellers to an ESOP.

Due to the highly-leveraged nature of an ESOP transaction, the warrants have a very low value when they are issued and, as the company pays off the transaction debt and grows (often with the tailwind of S-corp. ESOP tax savings), the warrants can appreciate rapidly. It is not uncommon for a warrant that is worth $1 million when issued to be worth $10 million ten years later.

As a result of this anticipated value escalation, warrants present an excellent opportunity for estate planning wherein the warrant holder transfers the warrants out of his or her estate as a gift. In the above example, the warrant holder (the grantor) gifts the warrants soon after the transaction when they are worth $1 million, and that gift counts towards their lifetime gift exemption. If they did not gift the warrants out of their estate, the ultimate $10 million of value would be subject to estate taxes in the future whereas the $1 million gifting removes the warrants from the estate and the $10 million value would not be subject to estate taxes of the grantor.

A Properly-Filed Gift Tax Return is Crucial

When warrants are gifted, the grantor should file a gift tax return with the IRS to document the gift. Given that the value of the gift is determined at the time of gifting, it is important to gift the warrant and conduct the valuation soon after the grantor initially receives the warrants, before the value begins to appreciate.

A properly-filed gift tax return with supporting documents regarding the value of the gift will commence a three-year statute of limitations after which the IRS cannot legally challenge the value of the gift. Grantors can choose not to file a return or to file a return that does not have the correct documentation to substantiate the value of the gift, however they would run the risk that the IRS might contest the valuation as well as the gifting regardless of whether three years have passed since the filing. 

Don’t Take The Risk: Partner with a Credible Appraiser for a Second Valuation

The key to documenting the warrant value properly is by submitting a valuation of the warrants with a gift tax return. It is important that the appraisal is conducted by a credentialed appraiser and that the specific purpose and subject of the appraisal are to value the warrants that are gifted. It can be tempting to use the ESOP appraisal for this purpose. After all, while the ESOP appraisal values company stock, it may include a discussion on the value of warrants. However, such an appraisal fails the IRS requirements on two fronts: 1) the ESOP appraisal is not for tax purposes and 2) the subject of the ESOP appraisal is company stock, not the warrant that is the subject of the gift tax return. Such a failure risks leaving the taxpayer exposed indefinitely.

Most trustees discourage or outright prohibit its ESOP valuation firm from doing work for selling shareholders, even after the transaction. While it can seem inefficient to have a second valuation performed, for sellers with large estates the benefits far outweigh the appraisal costs.

Written by Jim Higgins of the Pilot Hill Adamy Valuation partnership.

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