In a leveraged ESOP, the ESOP or its corporate sponsor borrows money from a bank or other qualified lender, and uses the loan proceeds to buy shares from current owners or the company. If the ESOP is the borrower, the company guarantees the loan. As part of the guarantee, the company agrees that it will make contributions to the ESOP that will enable the ESOP to pay back the loan on schedule. If the borrower is the company—which is the arrangement preferred by many lenders—the company lends the funds from the loan to the ESOP so the ESOP can buy the shares.
If the leveraging is meant to provide new capital for company expansion or improvements, the ESOP will use the cash to buy newly issued shares of stock from the company. If the leveraging is used to buy shares of stock from a shareholder, the ESOP generally will acquire those existing shares directly. If the leveraging is being used to divest a division of the company, the ESOP will buy the shares of a newly created shell company, which in turn will purchase the division and its assets.
Two tax incentives make leveraged ESOP financing very attractive. First, contributions to an ESOP are tax deductible so that: • The company makes contributions to its ESOP. • The ESOP in turn pays those contribution dollars back to the company to pay down its loan from the company. • The company then uses those contribution dollars to pay down its loan from the bank or other lender. In effect, the company gets to fully deduct the loan’s principal and interest (not just the interest, as is the case for non-ESOP loans). By reducing the number of post-tax dollars needed to repay the loan principal, a company’s cost of financing can be cut significantly. Second, dividends paid on shares of a C corporation held in an ESOP are tax deductible if they are used in any of the following ways:
• To repay the ESOP loan.
• Passed through to employees.
• Reinvested by employees for more company stock.
This provision of the federal tax law well may increase the amount of cash available to a company, compared to one utilizing conventional financing.