Understanding ESOPs

From "An Overview of How ESOPs Work"

Plans have one or more "entry dates" for employees once they become participants. An employee who has satisfied the plan's minimum age and service requirements must begin participation in the plan not later than the first of (1) the first day of the plan year beginning after the date on which the requirements were met or (2) the date six months after the date on which the requirements are met. Participation can begin at an earlier date, however. Many plans, for example, have entry dates every six months or every year, and employees become participants at the first entry date after requirements are met.

Shares are allocated to individual employee accounts based on relative eligible compensation. Generally, all W-2 compensation is counted, but there is leeway to define compensation differently, such as by excluding bonuses, provided that it does not favor more highly compensated individuals; on a more level formula, such as per capita, by seniority, or by placing a cap on pay that can be considered; or some combination of the two, such as one point for seniority and one for relative pay. If relative pay is not used, however, plans must be tested annually to determine whether any highly compensated individual, generally defined as someone belonging to either the top 20% by payroll in the company or those making more than $105,000 per year (as of 2008), is receiving more than what the relative pay formula would indicate. In that case, the excess must be returned to the plan and reallocated to other participants. Finally, ESOP allocations can be used as a match to employee deferrals to a 401(k) plan, in which case all or part of the allocation may be determined by how much the employee defers. This approach requires complex anti-discrimination testing for both plans. Relatively few ESOPs use this approach.

From "Selling to an ESOP in a Closely Held Company"

As the chapter on financing in this book notes, seller financing (in which the selling owner receives a note from the ESOP for some or all of the sale price) is becoming increasingly popular. This creates issues when the seller wishes to elect Section 1042, however. Seller financing means that the seller will receive a stream of payments from the ESOP over a period of years, but the Section 1042 tax deferral is available only to the extent that the seller purchases QRP within 12 months after the transaction. If the seller does not have other funds available to invest in QRP within 12 months after the sale (as noted above, QRP need not be bought with the actual proceeds of the sale to the ESOP), then he or she cannot fully take advantage of Section 1042. This potentially means that electing Section 1042 treatment would have no value for an owner involved in a self-financed sale to an ESOP. However, the seller can borrow the money to buy QRP and then use income from the QRP to repay the loan taken out to buy it. This is usually done by buying "ESOP Notes," non-callable bonds qualifying as QRP. Banks will usually loan up to 90% of the face value of such bonds.