In the typical leveraged ESOP used in ownership succession planning, the employer borrows money from an outside lender, such as a bank. In ESOP parlance, this is known as the “Outside Loan.” The company then loans the Outside Loan proceeds (sometimes along with additional company cash) to the ESOP, which is known as the “Inside Loan.” The Inside Loan is structured to meet the requirements outlined above, and is thus exempt from the prohibited transaction rule set forth in § 4975(e)(7) of the Code. The ESOP then uses the proceeds from the Inside Loan to purchase company stock from the selling shareholder(s) in exchange for cash, a promissory note (a “Seller Note”), or a combination of the two. The Seller Note is a form of loan to the ESOP; therefore, it must also meet the requirements of § 4975(d)(3) of the Code. The ESOP holds the purchased stock in its suspense account, and these shares are known as “unallocated shares.”
Each year the company will ensure that the ESOP has enough money to permit the ESOP to make its annual loan payments. The bank typically requires a pledge of the ESOP’s unallocated stock to serve as additional security for the Outside Loan. As part of the ESOP transaction, the selling shareholder might refinance the Seller Note so that the company assumes all of the ESOP’s obligations under the loan agreement between the ESOP and the selling shareholder. This refinancing transaction has no economic effect on the parties involved and generally provides the selling shareholder with a more secure debt instrument.
The company will make an annual contribution of cash to the ESOP, which provides an employee benefit to the ESOP participants and a tax deduction to the company. The ESOP uses this contribution to make payments on the Inside Loan (and the Seller Note in the event the selling shareholder does not refinance the loan). In addition to making annual cash contributions, the company can pay C corporation dividends or make S corporation distributions, as applicable, to the ESOP, which it can also use to pay the Inside Loan. This circular flow of funds from the company to the ESOP and back to the company is “cash-neutral” to the company because all of the contributions are immediately paid back to the company in satisfaction of the Inside Loan obligation. However, money should actually change hands as opposed to the parties merely making journal entries. The company uses the Inside Loan payment from the ESOP and other operating cash, if necessary, to make payments on the Outside Loan and the Seller Note (in the event the selling shareholder refinances the loan).
As the ESOP makes payments on the Inside Loan using the company’s contributions, the ESOP releases a proportionate number of unallocated shares from its suspense account and allocates them to the accounts of eligible ESOP participants (that is, employees who have satisfied the plan’s eligibility requirements) based on the participants’ respective amount of compensation up to certain limits (allocations of shares released that are attributable to Inside Loan payments made from dividends or distributions, as applicable, are based on the participants’ respective account balances). The ESOP document will specify whether the ESOP will release unallocated shares under the “principal only” method or the “principal and interest” method; provided, however, that if the term of the Inside Loan is longer than ten years, the ESOP must release shares under the “principal and interest” method.