Shakespeare warned of the following:(1)

“Neither a borrower nor a lender be when purchasing 1042 QRP”

Okay, so we took some liberties with the Bard’s verse. However, our paraphrased warning is well suited to business owners seeking to sell their businesses to an ESOP through an IRS section 1042 election (or advisor fiduciaries operating on behalf of a client). A borrower and a lender is exactly what such sellers become when they purchase floating rate notes (“FRN”) to monetize their 1042 election sale proceeds. At Alpha Architect, we believe business sellers under 1042 elections have better and more affordable tax-deferred roll-over options. Sellers who bear in mind the FACTS(2) might conclude that direct investment in a diversified portfolio of large cap, blue chip equities will capture greater after-tax value from their 1042 qualified replacement property (“QRP”) portfolios.

In our detailed market survey of 1042 QRP investment strategies, which you can read here, we described and ranked the range of options available to business owners who elect to sell their shares through a 1042 tax deferred sale. The most prevalent of those strategies is a complicated and expensive floating rate note approach, designed to preserve the seller’s capital gains tax deferral while freeing a significant portion of the sale proceeds for reinvestment. We likened it to a structured product, in which the usual payment features of a traditional security, such as a conventional investment-grade bond, are replaced with non-traditional payoffs derived not from the corporate issuer’s own cash flow but rather from the performance of one or more different assets.(3) In the case of a floating rate note monetization strategy, the purchaser trades away the coupon payments of the FRN for the ability to invest in a separate portfolio of assets purchased with loan proceeds from the hypothecated QRP. The seller bears a negative carry charge for the pleasure of accessing his ESOP sale proceeds, because the interest rate paid on the loan exceeds the FRN’s coupon payment. The graphic depiction below highlights this strategy’s flow of funds.

1042 QRP

As we described in our detailed market survey, there are arguably more affordable alternatives to floating rate notes that can achieve investor goals more efficiently. One alternative approach is to invest the sale proceeds directly in qualified replacement property consisting of a diversified portfolio of carefully selected large-cap, blue-chip equities, designed to replicate a passive equity index fund. There are many reasons why an investor would select such an asset.  Between 1927 and 2016, the stocks of the S&P500 had a total annual average return of 9.93%, gross of any fees and transaction costs. Warren Buffet’s views on the attractiveness of such an investment asset reaffirm our own beliefs. For the non-charitable assets of his estate, Buffet has left very straightforward and powerful instructions:

“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”(4)

The IRS rules defining 1042 QRP are complicated, so investors need a rigorous approach to screening and documenting their due diligence for such a portfolio. Nevertheless, such a solution is not impossible.

Comparison of 1042 QRP Strategy Costs and Outcomes

A simple comparison exercise will highlight the differences in expected costs and investment outcomes for investors in both of the above 1042 QRP roll-over strategies. Below we compare the hypothetical cases of two selling shareholders pursuing share sales to ESOPs through 1042 elections.

Assumptions common to both sellers are as follows:

  • Net cash sale proceeds received from the ESOP trust for shares = $10,000,000;
  • Seller Objective 1: Seek permanent deferral of capital gains taxes by passing 1042 QRP wealth to heirs through estate;
  • Seller Objective 2: Generate annual after-tax income of $200,000, adjusted upward annually for assumed 2.5% inflation rate;
  • Seller Objective 3: Achieve equity-like returns on invested wealth in order to capitalize on 30-year assumed investment horizon.

Scenario 1 – Floating Rate Notes as 1042 QRP

In our first case, assume the seller rolls his sale proceeds into 1042 QRP consisting of a floating rate note, which he has purchased from his broker as Step 1. We assume that the business seller must bear the gross spread(5) (underwriters’ fee) for the note’s issuance, and that the floating rate note pays a variable coupon of 0.69%.(6) We base this coupon estimate on the pricing terms from a sample of five floating rate note issues, each indicating reference rates of 3-month LIBOR and spreads of minus 30 bps to minus 35 bps.  The following table sets forth the impact of these terms on the seller’s funds:

1042 QRP

So far, so good. The seller has purchased 1042 qualified replacement property consisting of $9.9 million worth of a floating rate note, issued by a US operating company and paying an annual interest coupon of approximately $69,000 per year, at current rates.  The transaction’s cost was $100,000.

In Step 2 of this monetization strategy, Seller 1 then pledges the QRP notes as collateral to his broker, who extends the seller a cash loan for 90%(7) of the notes’ face value.  There now remains $8,910,000 available to invest from the seller’s original $10 million of proceeds, due to the over-collateralization required by the lending broker. The seller must also pay annual interest on the loan in the area of LIBOR plus 50 bps (about 1.5%, currently), a rate that is consistent with 70-80 bps of negative annual carry on the entire transaction amount. In our hypothetical example, this negative carry results in $69,717 of annual net interest expense borne by the seller, after accounting for the offsetting interest received from the floating rate note coupon payments.

1042 QRP

We caveat our example to note that the above assumptions are aggressive and reflect the favorable prevailing credit environment. Loan-to-value ratios have generally ranged between 75% and 90% during the past decade, reflecting recession and credit market challenges. Were the general economy, or indeed the specific creditworthiness of the FRN issuer itself, to deteriorate, it is likely that this strategy would generate less loan proceeds than our assumed 90% of QRP value. How likely is the LTV ratio to deviate below 90%?  Consider whether the next 40 years hold any less potential for economic and geopolitical upheaval than the past few decades witnessed.

In Step 3, the seller then reinvests his remaining sale/loan proceeds, which he monetized through his QRP, in the asset of his choosing. For the sake of simplicity in this illustration, we assume that both sellers capitalize on their long-term investment horizons by purchasing a low-cost portfolio of large cap US equities, such as represented by the S&P500.

The following table summarizes the investment costs and results obtained by the first seller, through the FRN monetization strategy. It reflects the annual withdrawal of income, consistent with both sellers’ objectives, set forth above, and our assumption that both sellers earn an annual total pretax return of 9.93% on their portfolios:

1042 QRP

Assumed annual total return of investment assets of 9.93% is gross of fees and transaction costs. The assumed cost of the large cap equities investment portfolio of 12 bps reflects the avg. expense ratio in 2015 of passive US

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