Reprited frm
AMERICAN BANKER,
THE FINANCIAL SERVICES DAILY
Friday, October 25, 2002
VIEWPOINTS
The Benefits of Using Loans To Help an ESOP Buy Shares
BY GREGORY K. BROWN and DAVID. SCHAFFER
Ata time when many financial services
companies have sen lending activity dwin-
dle because of the weak economy and reg-
latory pressures, opportunities still exist
to lend to employee stock ownership plans.
‘The owners of many privately held com-
panies need to diversify their holdings on
a tax-deferred basis and address business
succession issues. Many companies can use
their ESOPs to purchase outstanding shares
of their stock, refinance outstanding debt,
oor make acquisitions with pre-tax dollars,
‘An ESOP qualified under sections
401(a) and 4975(¢)(7) of the Internal
Revenue Code is the only type of employ-
ce benefit plan that may be used to borrow
money. But special issues arise in connec-
tion with the structuring of loans made to
fund the acquisition of a company’s stock.
‘The general structure is simple: The
ESOP borrows money and purchases an
agreed-upon number of shares at fair
market value from the employer or share-
holders. These leveraged shares are placed
ima suspense account and are used as col-
lateral. As the loan is repaid, the suspense
account shares are released from pledge
and allocated to employees’ accounts
based on relative compensation
‘Two different leveraged ESOP structures
are typical. In one, the ESOP gives a note
to the lender, accompanied by a guarantee
from the employer that it will contribute
to the plan sufficiently to enable it to
amortize the loan, ‘The loan may be
secured by a pledge of the newly acquired
shares and, ifthe lender requires, a pledge
of the corporation’s asses,
The loan also may be made directly to
the corporation, which can then lend the
proceeds to the ESOP. This may reassure
lenders who are uncomfortable about
lending directly to such plans.
When shareholders of a C corporation
sell company stock to its ESOP — result-
ing in the plan owning at least 309% of the
corporation's equity — the selling share-
holders may be able to defer taxation of
the gain on the sale to the ESOR.
A.C corporation can then make annual
tax deductible contributions to a leveraged
ESOP, up to 25% of aggregate participant
compensation plus interest. payments.
One benefit: Reasonable dividends paid
con leveraged shares that are used to repay
the ESOP loan are separately deductible.
{An S corporation is limited to 25% of
aggregate participant compensation for its
annual contributions to an ESOP.
‘The purchase price fr the employer shares
cannot exceed the fair market value of the
securities. When the shares are in a private
company, the law requires that an independ:
entappraiser determine the fair market value.
Lenders should study both the appraiser's
qualifications and the methodology of the
appraisal, to make sure that the price is no
higher than fair market value.
Employer shares purchased with the
Joan’s proceeds must be released annually
from encumbrance as the loan is repaid.
The formula for the release is usually set
forth in the loan documents. Lenders who
take the security interest in the employer's
shares should pay careful attention to the
release formula: A lender could easily find
itself having to release more shares if the
formula is based upon the repayment of
principal and interest than if the formula
is based on principal repayment only
Because of the tax benefits, cash flow
under ESOP financing is higher than it
would be with conventional debt financ:
ing, Thus, an ESOP enhances a company’s
debt servicing ability.
‘While ESOP transactions can be com-
plex, the loan itself should not be. The
Jender will usually conduct the same credit
analysis as it would in a conventional lend~
ing situation, and the cash flow benefits
should enhance that credit. In most cases,
the loan is structured and documented like
a conventional loan, with the addition of
provisions and documents reflecting the
special requirements necessary to ensure
that al parties can realize the respective tax
benefits and other advantages .
Ger K Brown sa Parente Ele Benefit and
sive Compensation Practice of atten Machin
Reserman LP