An ESOP is a qualified retirement plan like a profit-sharing plan, stock bonus plan, and a 401(k) plan, and must thus comply with § 401(a) of the Internal Revenue Code of 1986 (the “Code”). However, an ESOP differs from other types of qualified retirement plans in three primary ways:
- An ESOP must be designed to “invest primarily in” the stock of the sponsoring employer;
- An ESOP is permitted to borrow money (known as a “leveraged ESOP”); and
- An ESOP can engage in transactions with a party-in-interest, which means that the ESOP can purchase stock from the sponsoring company’s shareholder(s).
While an ESOP can be non-leveraged, ESOPs used in ownership succession planning typically are leveraged. The general rule is that a qualified retirement plan is not permitted to borrow money from its sponsoring employer. Doing so constitutes a “prohibited transaction” under the general law governing employee benefit plans, the Employee Retirement Income Security Act of 1974 (ERISA), and subjects the employer to certain excise taxes. However, an exemption to the prohibited transaction rule exists for a loan to an ESOP, so long as the loan satisfies certain statutory requirements. The first of these is that the ESOP itself must satisfy all of the requirements in the Code applicable to qualified retirement plans and rules set forth in ERISA. In addition, the loan must be “primarily for the benefit of” the ESOP’s participants and beneficiaries, the interest rate on the ESOP loan must be reasonable, and the ESOP may only use the proceeds of the loan from its sponsoring employer for certain purposes, including the purchase of “qualifying employer securities” (that is, shares of company stock). The Regulations list the relevant factors that the Department of Labor considers in its reasonableness determination. If the ESOP loan meets these requirements, then it will be classified as an “exempt loan.”