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What Is a Leveraged ESOP?

 

In a leveraged ESOP, the ESOP or its corporate sponsor borrows money from a bank or other qualified lender. The company usually gives the lender a guarantee that it will make contributions to the trust, which enables the trust to:

  • Amortize the loan on schedule.
  • Or, if the lender prefers, the company may borrow directly and make a loan back to the ESOP.

If the leveraging is meant to provide new capital for expansion or capital improvements, the company will use the cash to buy new shares of stock in the company.

If the leveraging is being used to buy out the stock of a retiring owner, the ESOP will acquire those existing shares.

If the leveraging is being used to divest a division, the ESOP will buy the shares of a newly created shell company, which in turn will purchase the division and its assets.

ESOP financing also can be used to make acquisitions, buy back publicly-traded stock, or for any other corporate purpose.

 

Tax Incentives of Leveraged ESOPs

Two tax incentives make borrowing through an ESOP extremely attractive to companies.

  • First, since ESOP contributions are tax deductible, a corporation that repays an ESOP loan gets to deduct principal and interest from taxes. This can significantly cut the company's financing cost, slashing the pre-tax dollars needed to repay the principal by as much as 34 percent, depending on the company's tax bracket.
  • Second, dividends that are paid on ESOP stock that is passed through to employees or used to repay the ESOP loan are tax deductible, if the ESOP sponsor operates as a C corporation. (If the ESOP sponsor is an S corporation, dividends may be used to pay the ESOP debt, but there is no tax deduction as the S pays no corporate income tax.
This provision of federal tax law may increase the amount of cash available to a company, compared to one utilizing conventional financing.