As you have, no doubt, surmised, this thought process is complicated, and should usually be supported by the preparation of a “feasibility study.” Stockholders contemplating a sale of stock to an ESOP should not be left to wonder whether they are buying a “pig in a poke.” They should know what their alternatives are and just what the dollars crunch out to be. Accordingly, I almost always recommend doing a feasibility study. This is especially so when the company involved is already an S corporation and is thus not eligible for 1042, which is available only to owners of C corporation stock. Under those circumstances, a number of alternatives should be considered. The sellers can have their corporation retain its S status, make a long-term capital gain sale of stock to the ESOP, and then, in their capacity as “employees,” actually be participants in the ESOP and share in the allocation of the stock that was purchased from them. Alternatively, they can cause the corporation to renounce its S status, activate 1042, then by means of large contributions to its ESOP that are used to amortize the stock acquisition debt incurred to finance the sale, “zero-out” its taxable income for the five taxable years until it can re-elect S. By means of the feasibility study, I can prevent their eyes from “glazing over” and the way may well be cleared to make intelligent choices, including use of an ESOP.
Putting the Pieces Together
Let’s now look at Appendix 6. This is a real deal that appears to be a morass, but was anything but. Here a father who owned a very successful company died and left its stock to his three children—a son who ran the business and two uninvolved daughters. Animosity ensued because the daughters, who got neither salary nor dividends, felt cheated and wanted the company to be sold—something that their brother refused to do. Instead he asked them, “how much do you want for your stock?” and they each said $40,000,000. Well $80,000,000 would break the bank. So this is what he did. He said, “Well, I’ll tell you what I’ll do. I’ll put in an ESOP, and you sell to the ESOP, make a 1042 election, and I will pay you what you would have had left if you had made a taxable sale for $80,000,000.” The sisters agreed. This dropped the total price down to $66,000,000, which was doable. He then asked the company’s employees, who had $90,000,000 in the company’s 401(k) plan, if they would be interested in laterally transferring some of that money into their account in the ESOP and using it to buy some of the sisters’ stock. The employees then came up with $10,000,000, which, when added to borrowed money, made the deal feasible. The company borrowed most of the purchase price from its bank and lent it to the ESOP, but was still $10,000,000 short, which it borrowed from a “venture capitalist,” then closed on the deal and later elected to be taxed under Subchapter S. This complicated transaction involved lateral transfers, 1042 elections, bank and mezzanine-type loans, and much more. But it worked out well and was later written up in the Wall Street Journal.