An ESOP is a unique form of a defined contribution plan. An ESOP has the ability to borrow money and to make plan investments in qualified employer securities. ESOPs are used by companies for a variety of reasons. The most common private company application is to facilitate a transfer of ownership of the Company to its employees. Such arrangements generally involve debt financing (leveraged ESOPs). This debt is often with the financial assistance of a related party (such as the plan sponsor).
A leveraged ESOP borrows money to acquire shares of the employer. The debt is usually collateralized by the employer’s shares. The shares initially held by the ESOP in a suspense account are called suspense or unallocated shares. The debt is generally repaid by the ESOP from employer contributions and dividends on the employer’s stock. As the debt is repaid, shares are released from the suspense account and the released shares must be allocated to individual accounts as of the end of the ESOP’s fiscal year
For public companies, ESOPs are typically combined with a 401(k) plan (frequently referred to as KSOPs).
Other forms of financing the ESOP transaction are available. The employer may make a loan to the ESOP without the need to arrange additional outside financing. The ESOP may borrow funds directly from a commercial lender. A shareholder selling shares to the ESOP may take back a note. Frequently, an ESOP will make distributions of securities to former plan participants and subsequently repurchase such shares from the participants with a note.
So, What Is Unique To ESOPs?
- The plan should obtain an independent annual appraisal of the securities.
- Leveraged ESOPs will have obligations to a financial institution or a related party lender (such as the plan sponsor).
- Participant allocations are subject to unique attributes arising from plan design considerations, nonexempt transaction compliance, or specific Internal Revenue Code provisions. These include additional restrictions on eligibility, contribution allocations, specific definitions for annual additional limitations, allocation of income from suspense shares, or other specific considerations included in the plan agreement.
- There are many tax advantages available to the company by implementing an ESOP.
The rules for implementing and maintaining an ESOP are complex. Plan sponsors interested in instituting an ESOP for their company would be well advised to contact qualified legal counsel and other qualified professionals as needed for this initiative.
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For more information on this topic, please contact a member of Withum’s Employee Benefit Plan Services Team.
