The Gift of Giving - Warrant Gifting

Warrants are often packaged with seller subordinated notes as consideration in ESOP transactions. 

Due to the highly-leveraged nature of an ESOP transaction, these warrants have a very low initial value.  As the issuing 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 their value is low and avoids paying future taxes on the expected appreciation.  By contrast, if the grantor did not gift the warrants, the future $10 million value would be subject to estate taxes at some future date. 

When warrants are gifted, the grantor should file a gift tax return with the IRS to document the gift.  Since the value of the gift is determined at the time of gifting, it is important to conduct a valuation soon after receiving the warrants and before they begin to appreciate.

A properly-filed gift tax return with a supporting valuation will commence the three-year IRS statute of limitations, after which the IRS cannot easily challenge the value of the gift. Grantors may  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, but this runs the risk of having the IRS contest the warrant value as well as the gifting, regardless of whether three years have passed since the filing.

The key to documenting the warrant value properly is by submitting a valuation specific to 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 may be tempting to use the post-transaction ESOP appraisal for this purpose, however using the ESOP 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.  In addition, most trustees discourage or prohibit the use of its ESOP valuation for purposes other than for the ESOP.  While it can seem inefficient to have a second valuation performed, for sellers with large potential taxation, the potential tax savings far outweigh the appraisal costs.

By leveraging our familiarity with the business and the transaction, along with the estate planning appraisal experience of our partners at Pilot Hill Adamy Valuation, we can help you check this important step off your list after your successful ESOP implementation.

Give us a call if you’d like to discuss this further.