By Damien Vira
Floating rate notes (FRNs) are bonds that have a variable coupon that is pegged to a reference rate, typically LIBOR, plus a fixed spread. There are several variations of FRNs, but this article will focus on those utilized to fulfill IRC Section 1042 requirements. In previous articles we've discussed a few rules and requirements to be aware of when electing the Section 1042 tax deferral, as well as an article that served as an overview of qualified replacement property (QRP).
So, what are FRNs?
As briefly mentioned above, FRNs are long-term bonds issued by corporations that fulfill a selling shareholder's QRP requirement as part of the 1042 tax deferral election. It is critical to note that there are several types of FRN's issued by numerous entities. Many FRNs do not fulfill the requirements of QRP and/or do not provide the investor with sufficient protection against prematurely triggering capital gains taxes. Similar to any other QRP security, FRNs will qualify as QRP only if they are issued by a corporation domiciled in the U.S. - the domestic operating company rule, and the issuing corporation must meet both an asset test and an income test. Finally, it is prudent to select FRNs with maturities of 30-40 years, and ones that are non-callable for at least 30 years. This is because callable FRNs give the issuing company the option to "call back" the bonds by paying the face value and any coupon amount accrued. The IRS would view this type of transaction as an asset disposition, and it would trigger a tax event for the selling shareholder even if the seller wished to immediately purchase another QRP. Therefore, to ensure the tax deferral is maintained one must purchase FRNs with call protection. When referring to FRNs herein we are referring to those that fulfill QRP requirements, have maturity lengths of between 30-40 years, and have call protection.
How FRNs work
Bonds, including FRNs, are fixed income securities. However, unlike other bonds, FRNs have variable interest rates tied to a certain reference rate. For example, an FRN bond might use the three-month LIBOR as the reference rate with a spread of minus 0.25 percent. As illustration, the three-month LIBOR as of August 26, 2015 is 0.33 percent, therefore the coupon rate paid to the bond holder for the period would be 0.08 percent. Similarly, if interest rates were to rise significantly and the three-month LIBOR were to move to 1.00 percent, then the interest paid would be 0.75 percent for the given period.
Since FRNs have interest rates that reset in accordance with the market, their interest rate risk is very low, resulting in FRNs possessing a level of principal stability that fixed rate bonds do not have. The primary risk that an FRN bondholder faces is credit risk. That is, if an issuing firm's credit rating is downgraded then the value of the bond will be negatively affected. To minimize this risk, FRNs that fulfill QRP requirements are investment grade securities, commonly A/A2 rated or above.
As illustrated in the example above, the rate of return on FRNs currently is very low. FRNs as QRP are not intended to be part of a selling shareholder's buy and hold investment strategy due to these low returns. Instead, FRNs are used primarily in two scenarios: (1) when the selling shareholder wishes to defer capital gains on their sale to the ESOP, but has taken a note back from the company for part of the transaction amount; and (2) when a selling shareholder wishes to defer capital gains but would like to pursue a more actively managed portfolio of securities.
In either—or even both—of these situations FRNs can play an important role in meeting the objectives of the selling shareholder. To accomplish this, FRNs are first monetized. A monetization loan is a credit facility, which is a loan from an institution to the selling shareholder. The lending institution uses the FRNs as collateral for the loan, much like a car is used as collateral for an auto loan. Since FRNs have variable rate coupons, the risk to the lender is minimal and most institutions will lend on margin up to 90 percent.
So, in this simplified scenario a selling shareholder would only need to "put down" 10 percent of the total value of FRN's they would need to elect Section 1042 on the entire amount of stock sold to the ESOP. For example, if the ESOP purchased $5 million worth of stock directly from the shareholder, but $4.5 million of the purchase was in the form of seller's note, then the selling shareholder can still defer capital gains on the entire $5 million by placing the $500 thousand in a margin account and purchasing $5 million worth of FRNs that meet QRP requirements. As the company repays the seller the remaining $4.5 million in installment payments the seller can reinvest those proceeds in any manner they deem fit without having to pay capital gains tax on the principal amount being repaid.
A monetization loan, like other loans, comes at a cost to the borrower. As an example, a loan might have an interest rate of one month LIBOR plus 1.00 percent. Since the one month LIBOR as of Aug. 26, 2015 is 0.20 percent, the result would be an interest rate charged to the borrower of 1.20 percent. Note that the cost of a $4.5 million loan at 1.20 percent interest is greater than the return one would get on the FRNs in our example ($5 million in FRNs returning 0.08 percent). The difference between the income received from the FRNs and the cost of the monetization loan is termed the "net cost to carry." The net cost to carry will depend on the prevailing interest rates and the amount of leverage a selling shareholder used to purchase the FRNs. Portfolios can be structured that blend FRNs with other equities to reduce the net cost and meet the objectives of the selling shareholder. There are other legal, regulatory, and structural complexities involved when buying FRNs as QRP. It is prudent to seek an adviser who specializes in the securities and has experience with using FRNs as QRP.
Strategically using FRNs
In summary, incorporating floating rate notes to partially or wholly fulfill one's 1042 QRP requirement allows a selling shareholder to separate the tax deferral benefits of Section 1042 election from their investment decisions. Under IRC Section 1042 once QRP is elected a selling shareholder cannot dispose of it or exchange it for other QRP without triggering the deferred capital gains taxes. Therefore, monetizing FRNs affords a seller both flexibility and liquidity. Since FRNs meet the requirements of QRP, the seller is now free to pursue an active investment strategy that would otherwise be prohibited.
This article is for information purposes only. The Beyster Institute does not provide legal or tax advice. Please consult with your legal and tax advisors.
Damien Vira, 2015 Rady MBA graduate