Leveraged ESOPs and Employee Buyouts

From Chapter 1, "A Primer on Leveraged ESOPs"

An ESOP can borrow money for any business purpose. The most common of these is to buy out shares of an existing owner in a closely held C corporation. Under Section 1042 of the Code, a company can set up an ESOP and have it borrow money to buy shares from an existing owner. If the ESOP owns at least 30% of the shares in the company after that transaction, that sale, plus any subsequent sales, qualifies the seller to reinvest the proceeds in securities of U.S. operating companies and defer tax on the gain made from the sale to the ESOP until these replacement investments are sold. This tax benefit applies only to closely held C corporations; the seller must be an individual, an estate, one of certain trusts, a partnership, or an S corporation. Shares must have been held for at least three years (if the ownership form changes, such as from a partnership to an S corporation, the ownership of the shares in the new entity "tacks" onto the shares of the old one).

While this is the most common application of a leveraged ESOP, it is only one of several potential uses. For instance, an ESOP can be used to buy another company, an increasingly common application. Because contributions to the ESOP to repay the loan are tax-deductible, the acquisition can be made in pretax dollars. In this application, a company can, for instance, print new shares or issue treasury shares to sell to an ESOP, which borrows money to acquire them. Then the company uses the loan proceeds to purchase the target and repays the loan with tax-deductible contributions to the ESOP. Alternatively, the acquiring company could do a tax-free stock-for-stock merger with the target. Then the ESOP could borrow money to buy out the shares (now shares of the acquiring company) from the owners of the target. If both companies are closely held C corporations, as explained in the chapter on mergers and acquisitions, it is possible to structure this transaction so that if it meets the rules for the tax-deferred rollover described above, the seller or sellers can qualify for a tax deferral of gains on the sale.

Another application for a leveraged ESOP is to acquire new capital. Any ESOP, whether in a C or S corporation, or a public or closely held corporation, can use an ESOP this way. Here, the company issues new shares or treasury shares and sells them to the ESOP, which borrows the funds to acquire the stock. The sale proceeds then are used to acquire new machinery, buildings, inventory, or any other property that might otherwise be financed. The company can then repay the loan through the ESOP in pretax dollars. Of course, this will have the impact of diluting other shareholders, but it also provides an employee benefit at the same time it is financing growth more efficiently. A similar approach can be used to refinance debt. Public companies also use leveraged ESOPs to buy back shares from the market.

ESOPs are also commonly used in divestitures of subsidiaries. Here, a new acquisition corporation is established. It sets up an ESOP for the employees of the entity being sold. The acquisition company ("Newco") then borrows money, which it reloans to the ESOP, to enable the ESOP to buy newly issued shares in Newco. Newco uses the money from the sale to buy assets for the parent and then repays the ESOP loan out of future revenues.

In all these transactions, it is possible and sometimes necessary to combine the ESOP purchase with equity investments from managers, outsiders, or even the employees themselves. These investments do not count as ESOP ownership, however, when calculating tax benefits. For instance, if an ESOP buys 30% of a company and managers 20%, the seller in a C corporation can defer taxes only of the sale of the 30% to the ESOP.

From Chapter 5, "Senior Credit Underwriting for ESOP Transactions"

It is imperative that the lender consider all borrowing needs of the company in conjunction with the ESOP. A lender generally prefers to have long-term debt secured by the long-term assets and current debt secured by the current assets. With a strong company that has historically self-financed its working capital needs, there can be an "overcollateralized" position with respect to current assets covering revolver needs and an "undercollateralized" position with respect to long-term assets covering term debt needs. In this situation, some lenders will find it acceptable to secure all or part of the ESOP term debt with current assets. This can be done formally with a "block" on the borrowing base as illustrated by table 5-7, or informally with a minimum availability covenant. With the BBC (borrowing base certificate) in table 5-7, a "block" would be executed for a company with a $13 million current asset loan value and revolver needs that are never projected to exceed $9 million.

From Chapter 7, "Accounting for Employee Stock Ownership Plan Transactions"

Initially, for financial statement reporting purposes, these dividends were still dividends chargeable to retained earnings, not compensation expense. The exception was for dividends on unallocated shares arising from an excess contribution or a prepayment of debt. In such cases, the transaction is accounted for under the treasury stock method, and these dividends are treated as compensation expense (see EITF Issue 86-27).

This is an area that changed dramatically under SOP 93-6. The rules are reflected in the most complicated section of the standard. Effectively, when ESOP dividends can be used to satisfy an obligation that otherwise would have had to have been satisfied by an employer contribution, the dividends will affect the income statement presentation of the plan sponsor.

The clearest argument can be made for dividends paid on unallocated shares. Under the terms of the plan, these dividends can be applied by the trustee to make debt payments on the securities acquisition debt; to be distributed to plan participants; or to be retained in the trust (although allocated to the accounts of plan participants) for other purposes, including building up the value of participants' accounts. In all cases, these dividends are treated as having lost their character as dividends. This is simply because the value of those dividends does not remain attached to the securities on which they were paid. Instead, the plan sponsor, through plan design or directions to the trustee, is able to use them to satisfy other objectives or benefit other participants within the plan. The effect of this argument is that dividends paid on unallocated shares will generally result in compensation cost.