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Bank and/or Selling Shareholder/Owner
Company Loan (External Loan)


reflects actual payments that will be made to the former owner. The ESOP loan (internal loan) is usually a longermaturity loan. (This loan regulates the release of shares to participants accounts, which will be discussed going forward.)

[2] [3]
ESOP Loan (Internal Loan) ESOP Purchase of Company Stock



Generally, corporations can deduct up to 25% of covered eligible payroll to any and all qualified defined contribution plans they sponsor, including an ESOP. However, with certain limitations, in a leveraged C corporation ESOP, the interest on payments on an ESOP loan doesnt count toward the 25% limit; in S corporations, it does. The contribution limit can be important in determining the amortization of the internal loan (ESOP loan) in Exhibit 1. A higher covered payroll means a company can theoretically contribute more each year and therefore opt for a short amortization schedule. There are pros and cons associated with a shorter or longer internal loan amortization schedule that youll want to discuss and consider with your advisors. From a participant point of view, an advantage of a shorter internal loan amortization is that the shares are allocated to participant accounts at a faster rate, thereby increasing the value of his or her account at a faster rate. An advantage of a longer internal loan amortization is that the company reduces the likelihood of a haves vs. have nots situation whereby once all the shares are allocated to participants, new employees will have fewer or no shares available to allocate to their accounts. Another advantage of the longer internal loan amortization is that the company is spreading the repurchase obligation over a longer period. After the transaction has closed, the shares purchased arent immediately allocated to participants accounts. In a leveraged transaction, all shares go into a suspense account and are released to participants as the ESOP debt (internal loan) is repaid. As the company makes annual contributions to the ESOP (which the ESOP uses to make payments on the internal loan), shares are then allocated to individual employee accounts within the trust. In Exhibit 2 on the next page, we illustrate the company making its annual contribution to the ESOP as it would any other retirement plan. The ESOP then makes a payment on the loan for funds borrowed from the company as part of the initial transaction and illustrated in Exhibit 1.

Whats more, ESOPs work well in the context of both S and C corporations. Even if your company isnt an S or C corporation, your advisors may be able to create a structure that still makes an ESOP feasible.

Structure of a Leveraged Transaction

To establish an ESOP, the company creates an ESOP trust that oversees the plan. The owners shares are then sold to the ESOP at fair market value. The selling shareholder receives one or a combination of the following forms of payment:

Cash (if outside financing is available) A seller note with interest paid to the owner at prevailing market rates
Once the initial transaction is complete, the seller receives annual payments on the seller note as any creditor would. The typical leveraged transaction looks similar to Exhibit 1 above. An ESOP transaction is similar to a traditional leveraged buyout. However, in a leveraged ESOP setting, depending on the circumstances of the transaction, some or all of the principal in addition to the interest expense may be tax deductible. And, under current law, a 100% ESOP-owned S corporation pays no federal income tax. (Many state income tax regimes yield the same result, but since the rules are state-specific, youll want to verify your situation.) This makes it easier for the sponsoring company to service the debt, thus reducing risk in the transaction compared with the traditional leveraged buyout. In Exhibit 1, the company loan (external loan) is typically similar to the terms one would get in a more traditional loan with a maturity of, for example, seven years. This loan
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Employee Eligibility
Stock is allocated to employee accounts using a number of different methods. The most common allocation formula is in proportion to employee pay. The ESOP plan document defines who is eligible to participate in the ESOP. Generally, all full-time employees over age 21 who meet a minimum number of hours of service participate in the plan. The ESOP typically doesnt include employees who are organized under a labor agreement; its for nonunion employees only. ESOPs are broad-based defined contribution employee retirement plans governed by the Employee Retirement Income Security Act (ERISA). The company makes contributions to the ESOP; there are no out-of-pocket expenses for the employees. Aside from general requirements to become a participant in the plan, the company cannot use its own discretion to determine who does and does not get to participate in the ESOP. Nor can it set up different vesting schedules or payment terms by employee class. As employees accumulate shares in their accounts, they usually dont have immediate access to the shares; the shares must vest. There are generally two vesting options available: EMPLOYEES DONT RUN MISCONCEPTIONS



fact, this is often the case: Employees continue contributing to the other retirement plan while company contributions go to the ESOP. There have been concerns regarding the concentration of retirement benefits in the employers stock. However, evidence from studies reported by the NCEO suggests this is not a significant threat. Diversification options also must be provided as part of the ESOP for participants that reach a certain age. COMPANY & OTHER

Under an ESOP, the employees dont run the company, and they technically dont own it on an individual basis. An ESOP makes the employees beneficial owners of stock in the sponsoring company. The stock is owned by the trust. In fact, for private companies, in only a few situations do participants vote on the stock allocated to their accounts. These situations include the sale of all or substantially all of the companys assets, merger, liquidation, recapitalization, reclassification, dissolution, or consolidation. ESOP-owned companies also dont have to disclose their sponsoring companys financial statements, officer salaries, or other such information. All ESOP-sponsoring companies must provide a document to all employees explaining the rules of the ESOP, including how and when they become participants and how and when ESOP benefits can be distributed. Within seven months after the close of each fiscal year of the plan, the ESOPsponsoring company must issue a summary annual report on the U.S. Department of Labors Form 5500 that includes financial information about the ESOP trust. A two-and-ahalf-month extension can be filed. For example, a company

No vesting for the first two years and then full, or cliff, vesting at the end of the third year Twenty percent vesting per year until fully vested
Exhibit 3 on page 24 illustrates how shares are released to the participants under a 20-year amortization of the internal loan. RETIRING/DEPARTING EMPLOYEES Upon an employees termination, disability, death, or retirement, the IRS requires the participant to be granted a put option, exercisable against the employer for the fair market value of his or her accumulated stock (the repurchase obligation). When the put option is exercised, the shares can be redeemed by either the company, in which case they typically go into treasury and are no longer in circulation, or the ESOP, in which case theyre reallocated to the remaining participants accounts. The latter option is often referred to as recycling. The price at which the participant can sell his or her stock is based on an independent valuation that must be performed at least annually. OTHER RETIREMENT PLANS If the company had a 401(k) or other profit-sharing plan in place prior to the ESOP, these other plans can continue. In



Monthly Loan Payment

Annual ESOP Contribution


Annual Loan Payment


Annual Stock Allocation from Suspense Account

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For companies that require bonding, one aspect is very important: A favorite metric of bonding companies book value of equity is significantly impacted by a leveraged ESOP transaction. U.S. GAAP requires companies to record the shares held in suspense in a contra equity account called Unearned ESOP Shares. This means that immediately following the transaction, theres a negative amount entered into shareholders equity equal to the dollar amount of the transaction. In addition, the companys loan from an external lender will also be recorded on the companys balance sheet, so theres a negative impact in three areas:


that has a fiscal year ending December 31 has to file the 5500s by October 15. Once the ESOP is in place, the current management team usually remains intact. This means the selling shareholder can, and most often does, remain a key employee of the company at the executive level at least until the seller note is repaid. By and large, there is no material change in dayto-day operations.

Impact to Financial Statements

As the person likely responsible for the accounting and finance aspects of the company, youll be interested to know how adopting an ESOP and experiencing a leveraged transaction will affect the companys financial statements from a U.S. general accepted accounting principles (GAAP) perspective. Youll also likely be the point person for the valuation firm as it gathers information and asks questions regarding operating performance and outlook. As is the case with any leveraged buyout, the income statement will reflect increased interest expense, which will decrease taxable income as long as the debt is being serviced. Stated earnings on the income statement will also be reduced by ESOP compensation expense. In a leveraged ESOP transaction setting, ESOP compensation is based on the fair value of the shares committed to be released each year. As previously mentioned, shares are released into participant accounts as debt payments are made. If the ESOP loan is amortized over 20 years, in theory it will take 20 years for all the shares to be allocated to the participants. The ESOP compensation expense is a noncash expense.

Reduced reported profitability Increased leverage Reduced or negative book value of equity
All these items can be explained, and its very important to discuss them with your bank and bonding company before going through a transaction. This is important to avoid business disruptions that could result from the financial statement impact of the ESOP. Bonding companies and banks are becoming more familiar with ESOPs and the impact they have on the sponsoring companys financial statements. Nonetheless, it is important to plan appropriately and ensure that all stakeholders are involved in the process. The repurchase obligation will not have a direct impact on the sponsoring companys financials. As the ESOP matures, management will want to prepare to fund the repurchase obligation by discussing options with the companys advisors and understanding how the obligation is reflected in the annual valuation.



ESOP Challenges
There certainly are some disadvantages to consider before establishing an ESOP. GOVERNMENT SCRUTINY The companys plan documents, plan administration, annual valuations, and annual tax filings are all subject to oversight by the U.S. Department of Labor and the IRS. As a result, its essential to rely on ESOP-savvy professionals to establish and administer the plan.







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