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 enable 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 will in turn purchase the division and its assets. ESOP financing can also be used to make acquisitions, buy back publicly-traded stock, or for any other corporate purpose.

Two tax incentives make borrowing through an ESOP extremely attractive to companies which might otherwise never consider financing their employees acquisition of stock. First, since ESOP contributions are tax deductible, a corporation which repays an ESOP loan in effect gets to deduct principal as well as interest from taxes. This can cut the cost of financing to the company significantly, by reducing the number of pre-tax dollars needed to repay the principal by as much as 34%, depending on the company's tax bracket. Two, dividends paid on ESOP stock 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.