The Uses of Leveraged Employee Stock Ownership Plans (ESOPs)

The Uses of Leveraged Employee Stock Ownership Plans (ESOPs)

The following is excerpted from Matthew Bender & Co.'s Employee Compensation and Benefits Tax Guide *


One of the chief goals of ESOP legislation has been to provide a source of funds for capital formation through tax-favored leveraging techniques. Not surprisingly, then, the ESOP is the only form of qualified employee benefit plan which is permitted to borrow funds to acquire employer stock... [W]hen the employer corporation repays this loan through contributions to the ESOP, it is allowed to deduct amounts which represent both principal and interest. In addition, the limitations for allocations to participants' accounts and deductions for such contributions by the employer are increased if the special rules are met. Two of the most common uses of leveraged ESOP transactions are outlined below.

Financing Corporate Growth

The basic steps in using an ESOP to finance corporate growth are as follows:

(1) the employer corporation creates an ESOP;
(2) the ESOP borrows money from a bank to buy stock in the employer corporation, and the employer guarantees the loan;
(3) the ESOP uses the money to purchase employer stock and pledges the stock as collateral on the note;
(4) the employer uses the proceeds for working capital, for plant expansion, or to acquire another corporation;
(5) each year, the employer corporation contributes enough cash to the ESOP to enable the ESOP to make the payments on the loan. All amounts so contributed, both principal and interest, are generally deductible up to the limits imposed under  
IRC § 404(a)(9);

(6) as the loan is paid off, the bank releases the pledged stock, which is then allocated to the individual accounts of the participants.

The result of the above transaction is that the employer corporation has expanded, the employees have acquired an equity interest in their employer, and the lender has earned a higher rate of return than normal, since 50 percent of the interest earned on the ESOP loan may be excludable from taxable income (for loans made prior to August 20, 1996).

Leveraged Buyouts

Perhaps the most classical use of ESOPs, however, is in leveraged buyouts, or "going private." Instead of purchasing new shares (or treasury shares) from the employer corporation, the ESOP purchases the stock from the existing shareholders. This is usually accomplished in one of two ways.
The first method involves setting up a new company, commonly referred to as the "Newco" approach. The basic steps involved under this approach are:

(1) key management of the employer corporation forms a new corporation, the "Newco";
(2) the Newco forms an ESOP;
(3) the ESOP secures a loan from a lending institution, with the Newco providing the guarantee for its repayments;
(4) the ESOP purchases stock from the Newco at the same time as the employer corporation merges into the Newco;
(5) pursuant to the statutory merger, the shareholders of the employer corporation receive cash from the Newco;
(6) Newco annually contributes enough cash to the ESOP to service the ESOP loan.

The second method of leveraged buyout is the use of a public tender offer. The steps involved in this case are not very complicated, and are similar to the steps in financing corporate growth:

(1) the corporation forms an ESOP;
(2) the ESOP obtains a loan from a financial institution, with the corporation as the guarantor;
(3) the ESOP makes a public tender offer to buy the stock of the corporation;
(4) the corporation annually contributes enough cash to the ESOP to service the ESOP debt.

Each of the two methods has advantages and disadvantages. The chief advantage of the tender offer is that it takes much less time to accomplish, which would make outside competition more difficult. Thus, financing should be easier to obtain. The main advantages of the Newco approach are that there is less public notice, which would reduce the chances of a hostile takeover, and the costs of SEC registration for a tender offer are avoided.

 * Copyright 2013, Matthew Bender & Company, Inc., a member of the LexisNexis Group.
RELATED LINKS: For the synopsis of content in this chapter of this new Matthew Bender treatise, see:

Employee Compensation & Benefits Tax Guide is also available in print at the LexisNexis® Store.

Discover the features and benefits of LexisNexis® Tax Center

For quality Tax & Accounting research resources, visit the LexisNexis® Store