Employee stock ownership plans (ESOPs) are unique buyers of company stock. ESOPs are generally viewed as a benefit plan that can borrow money to purchase shares of common stock of a sponsoring corporation.
When an ESOP borrows money to acquire shares of stock, it is usually referred to as a leveraged ESOP. Often, that leverage is provided to the ESOP directly from the sponsoring company. The sponsoring company often raises capital to loan to the ESOP from a third party bank. The ESOP repays principal and interest due over time using contributions or dividends received from the sponsoring company, and the sponsoring company ultimately repays its principal and interest due to the bank using loan payments received from the ESOP.
As with all tax-qualified benefit plans, contributions are tax deductible to the sponsoring company. In addition, something unique to an ESOP is the ability of the company to make tax-deductible dividend payments in certain circumstances. The use of these funds by the ESOP to meet principal payments due to the company effectively results in the ability of the company to deduct principal payments due to the bank. The ability to deduct principal payments on a loan (in addition to interest) makes the ESOP a unique technique in corporate finance that ultimately lowers a company’s cost of capital.
The common shares purchased by the ESOP with debt financing are initially held as collateral against the ESOP’s loan. As the ESOP makes principal and interest payments, a portion of the shares held as collateral is released with each payment over the term of the loan. The shares are then allocated to participating employees based on provisions governing the operation of the ESOP. The economic value of these shares ultimately accrues to participants based on the number of allocated shares held and the value of the company’s stock.
Due to the statutory requirements governing the tax benefits afforded to a leveraged ESOP, it is important to seek the help of professionals experienced in negotiating and structuring ownership transition using an ESOP to insure the benefits of the tax savings are fully realized.