What is a Leveraged ESOP & How Does it Work?

There are two types of employee stock ownership plans (ESOPs): 

1. Leveraged ESOPs 
2. Non-leveraged ESOPs

Both are qualified retirement plans used by privately held companies, but how they are funded and structured differs slightly. Leveraged plans are the more common arrangement, at least during initial formation, so let’s explore their structure and function. 

What Is a Leveraged ESOP?

Leveraged ESOPs are a type of employer-sponsored retirement plan often used as a business transition tool for a retiring owner. 

The company that establishes an ESOP is referred to as the plan sponsor. In a leveraged ESOP transaction, the plan sponsor takes out a loan, "leveraging" its own credit to fund the plan through an ESOP trust. The trust then uses those funds to purchase company shares and repay the loan over time. 

An ESOP essentially creates a market for a company's own stock. Shares are allocated to the accounts of employee participants as the loan is paid down. Participants can take distributions upon retirement, selling their shares back to the company.

How Does a Leveraged ESOP Work?

A leveraged ESOP transaction involves several coordinated steps, from initial financing to the eventual distribution of shares to employees. Here's how the process typically unfolds:

• A leveraged transaction is financed via a loan from a lender, often a bank. The company stock is used as loan collateral.
• An ESOP trust is set up to act as the legal shareholder/purchaser of the shares on behalf of employee participants.
• The trust buys the shares/stock from the plan sponsor and holds them in a suspense account until they are released through loan repayment.
• The plan sponsor makes an annual tax-deductible contribution to the ESOP. The ESOP trust uses those funds to repay the original loan debt.
• As the loan is repaid, shares are released from the suspense account in an amount proportionate to the loan repayment.
• Those shares are allocated to individual employee accounts.
• Once employees are vested, they are eligible to receive distributions from their ESOP account when they retire or leave the company.
• The price of shares is established by an independent appraiser retained by the ESOP trust. Shares cannot be bought or sold for more than fair market value, which is why an annual appraisal is required.

How Are Shares Allocated in a Leveraged ESOP?

Shares purchased by the ESOP trust are initially held in a suspense account rather than being allocated to employees all at once. These are considered “unearned ESOP shares” – which refers to shares that have been purchased by the trust but not yet released to employee accounts. As the plan sponsor makes contributions and the loan is repaid, a proportional number of shares is released from the suspense account and allocated to individual employee accounts. 

Because the inside loan – the loan from the company to the ESOP – is typically repaid over 10 to 30 years, share allocation happens gradually over time rather than in a lump sum. Employees become entitled to their allocated shares according to the plan's vesting schedule, which can extend up to six years.

Leveraged ESOP Tax Benefits and Considerations

Leveraged ESOPs provide tax advantages to both the sponsoring employer and employee participants.

• Employer contributions are tax-deductible.
• Dividends paid by the employer and used to repay the loan, or passed through to plan participants, are tax-deductible.
• The company owner/seller may be able to sell shares while deferring capital gains taxes on the sale proceeds, subject to certain conditions.
• Employees are not taxed on their shares until they take a distribution.

Advantages and Disadvantages of a Leveraged ESOP

There are a number of tangible and intangible benefits to forming an ESOP.

• It creates an immediate, ready market for selling privately held company stock.
• A company can set up this employee benefit without needing all the required capital upfront.
• A leveraged transaction can be funded with pre-tax dollars.
• Plan sponsors receive a tax deduction for contributions used to fund the ESOP, subject to IRS contribution limits.
• The selling owner may be able to defer capital gains taxes if certain conditions are met.
• Employees receive financial rewards directly tied to company performance and, by extension, their own contributions. This often has a meaningful, positive effect on employee morale and company culture.
• The founder can sell their ownership interest in the business while still retaining operational control, allowing for a gradual transition to new management.

There are a few downsides to forming a leveraged ESOP: 

• The sponsoring company must qualify for a loan and find a willing lender.
• As a stock ownership plan, there is an inherent risk common to all stock-based investments.
• Company owners are limited to selling their shares at fair market value.
• There is a lack of stock diversification in employee accounts.
• ESOPs are subject to strict rules and regulations under, and reporting requirements to, ERISA, the IRS, and the DOL.
• The plan requires an annual appraisal process.
• Administering the plan and forming the trust requires the assistance of qualified outside professionals.
• The sponsoring company is generally responsible for repurchasing shares from retirees seeking distributions.
• Leveraged ESOP debt can give the appearance of a higher debt-to-income ratio on company accounting records.

Leveraged ESOP vs. Non-Leveraged ESOP: What Is the Difference?

Leveraged and non-leveraged ESOPs both provide tax advantages and benefits to employees and employers. The primary difference between the two is in how they are funded and how shares are allocated.

A leveraged ESOP is funded by a loan, with company stock used as collateral. 

A non-leveraged ESOP is not funded by a loan. 

A leveraged ESOP allocates shares to employee accounts as they are released from the suspense account when the loan is repaid. 

A non-leveraged ESOP allocates cash or shares to employee accounts at specific times during the year. 

A leveraged ESOP may delay distributing shares attributable to the loan until it has been paid off.

A non-leveraged ESOP must generally begin distributions no later than one year after the close of the plan year in which the participant became eligible.

Although an ESOP may start out as leveraged, it can become non-leveraged once the loan is paid in full. Likewise, a non-leveraged ESOP may need outside financing due to changing business conditions, and in that case, it may seek a loan and become leveraged. This kind of financing flexibility is one of the advantages of ESOPs.

Is a Leveraged ESOP Right for Your Company? Aegis Trust Can Help

A leveraged ESOP can be an effective exit strategy and employee benefit, providing tax advantages and transforming company culture. 

Learn more about ESOPs at the National Center for Employee Ownership (NCEO) and its book, Leveraged ESOPs and Employee Buyouts. 

To find out if a leveraged ESOP makes sense for your business, contact Aegis Trust Company to schedule a consultation.