f a C-corp establishes an ESOP that purchases 51% of the outstanding C

[EGB]

If a C-corp establishes an ESOP that purchases 51% of the outstanding C-corp stock pursuant to an agreement signed by each shareholder, including the trustee of the ESOP, to convert the C-corp to an S-corp effective the next month, would a valuation premium for the 51% be appropriate in recognition of the fact that the ESOP will not be liable for federal income tax on its allocable share of the S-corp's earnings? While the participants of the ESOP will eventually pay federal income tax on the distribution from the ESOP to them, the present value of that tax burden should be far less than the present value of not having to pay any federal tax. Any thoughts would be appreciated.

[RLL]

A premium for S corporation status is not appropriate. The tax savings (if any)resulting from an S corp election does not make the company increase in value except to the extent that such tax savings are actually realized by the company.

From the company's standpoint, the ESOP is no different from any shareholder....it will receive the same per share dividends (S corporation distributions) as any shareholder. The fact that the ESOP is not subject to tax on its S corp dividends is no different than if the ESOP received dividends from a C corporation. The ESOP's tax exemption does not make the shares of the selling shareholders worth more.....so why should the ESOP pay more?

[Dowist]

Isn't the issue whether the company would be valued on an after-tax or pre-tax basis?

I have read that some appraisers take the view (at least for estate/gift tax purposes) that the appropriate measure of value is the after-tax value to shareholders and therefore the shares of an individual should be discounted to take into account the shareholder's tax rate?

If shares are valued on an after-tax basis, wouldn't the shares held by an ESOP, which are not taxed, have to be valued on a pre-tax basis?

This seems a little anomalous in that shares held by a tax-exempt entity are the same shares held by taxable entities - they're the same shares, so why should the value differ based on the shareholder?

The other side to it is that the ESOP gets to keep 100% of earnings whereas an individual keeps only 65%, and 100% is more valuable than 65%.

Does the definition of "adequate security" deal with this issue?

[RLL]

Even if the shares are "worth" more to the ESOP (by reason of the ESOP's tax exemption), the ESOP may not pay the selling shareholders more than "adequate consideration" (fair market value) under ERISA Section 3(18). Fair market value is determined by an independent appraiser based on a hypothetical willing buyer-willing seller analysis, which would not consider the ESOP's tax exemption.

Note that an ESOP has a tax-exemption applicable to dividends on employer stock whether the employer is an S corporation or a C corporation.

The fact that an ESOP is generally tax-exempt does not justify charging an ESOP more for employer stock than another buyer (presumably not tax-exempt) would pay for the stock.