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Tax Considerations When Using Warrants in an ESOP Transaction

Katrina R. Samarin, CPA, MT
Katrina R. Samarin, CPA, MT Director, Tax Strategies

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. The seller debt as part of a transaction is more akin to mezzanine financing which bears higher risk and related interest rates. 

Warrants can bridge the gap to allow the seller notes to bear a lower stated interest rate but provide for a balloon payment at the end of the note, also allowing the sellers to receive “a second bite at the apple.” The existence of warrants can provide for more flexibility to the business to minimize interest costs and related cash outlay. The existence of warrants is negotiated as part of the ESOP sale to determine the appropriate rate of return.

A warrant is a form of stock option that allows the holder to exercise the warrant 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 increase in value from the date of issuance to eligible exercise date(s). Warrants are typically eligible to be exercised after the pay down of the related debt.

Even though a warrant represents a future right, the receipt of warrants as part of an ESOP transaction presents current income tax consequences. An appropriate value must be assigned to the warrant at the time of issuance.

The tax treatment of the warrant upon receipt will depend on the overall structure of the transaction. The receipt of the warrant may be taxed at ordinary income rates (as additional interest income over the life of the loan) or as capital gain for additional consideration received. Any imputed value that is recognized as income (either upon receipt or over the term of the debt) establishes ‘basis’ to determine applicable capital gain or loss upon exercise of the warrants.

In the right circumstances, warrants present a very useful estate planning tool. The value of warrants at issuance tends to be low as the company has a substantial amount of debt. Warrants have the potential to be a highly appreciable asset which makes them an ideal tool to move significant wealth to the next generation.

Careful consideration must be taken to ensure that warrants are not viewed as a second class of stock in the case of an S corporation. Warrants are considered synthetic equity and must be considered as part of a company’s Section 409(p) testing to ensure that company deemed ownership is not concentrated within a few individuals or related groups.

Warrants can be a useful tool in financing an ESOP transaction. However, care must be taken to understand the unique income tax consequences and impact on cash flow over the term of the loan.

If you would like to learn more about the tax implications that may come with using warrants in your ESOP transaction, please contact us.


Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.

Contact the Author

Katrina R. Samarin, CPA, MT

Katrina R. Samarin, CPA, MT

Director, Tax Strategies

ESOPs Specialist, Business Tax Specialist, Individual Tax Specialist

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