An Introduction to ESOPs, 21st Ed.

Excerpts

From Chapter 2, "Types of ESOPs and Their Financing"

An ESOP may be funded either with a loan (a “leveraged ESOP”) or with discretionary contributions (a “nonleveraged ESOP”), and at the beginning can be funded solely by cash. Additionally, ESOPs may be combined with or converted from other employee benefit plans.

Prefunding with Cash
Although an ESOP must be primarily invested in employer stock over the life of the plan, it is possible to start an ESOP with cash contributions that are allowed to build up for a few years before the ESOP starts acquiring stock. This can prefund a large stock purchase, allowing for a smaller leveraged transaction down the road. There is no clear rule as to how many years an ESOP may be cash-funded for a stock purchase.

Nonleveraged ESOPs
With a nonleveraged ESOP, the sponsoring employer contributes newly issued or treasury stock and/or cash to buy stock from existing owners or the company (see figure 2-1). Contributions generally may equal up to 25% of covered payroll, which is the combined payroll of all employees benefitting under the plan, excluding pay over $350,000 (as of 2025; this limit is indexed for inflation). Employer contributions to other defined contribution plans are included in the same 25% limit and may reduce the amount the company can contribute to the ESOP.

A significant minority of ESOPs are funded by the company making annual discretionary cash contributions to the plan. The ESOP uses these contributions to buy shares from the owner(s) year-by-year. The company might continue this way until all shares that are to be sold are sold, or the ESOP may at some point borrow funds to acquire the remaining shares.

From Chapter 4, "Uses of ESOPs"

Aside from their obvious use as a tax-advantaged way of providing an employee benefit, ESOPs have a variety of special applications, such as the following.

For Business Continuity

The most common use of an ESOP is to sell part or all of an owner's interest in a closely held company. In this situation, an ESOP provides substantial advantages over other alternatives:

• It provides a ready market for the stock.
• The company can fund the transaction with pretax dollars.
• The owner(s) may sell to the ESOP partially, or in stages over a period of years so they can gradually ease out of the company—a particularly important consideration for sellers with management responsibilities.
• In a C corporation, the selling owner(s) may defer taxation on the gains by using the Section 1042 "rollover" explained above.
• In an S corporation, distributions that would otherwise be used for shareholders to pay taxes on S corporation income may be used to fund a portion of the ESOP share purchase.

As a Tool of Corporate Finance

A leveraged ESOP can be used to borrow money that could be used to buy another company or new equipment, or to refinance debt. To accomplish these goals, the company issues new shares and sells them to the ESOP in a leveraged transaction, using the proceeds from the sale of new shares to finance acquisitions or to refinance debt. The company raises new capital by allowing the ESOP to buy new shares; this is funded by corporate contributions to the ESOP that come from pretax company cash flow. While this dilutes the ownership of the non-ESOP shareholders, it allows a much less costly repayment of the loan and simultaneously provides an employee benefit plan. If properly structured, the corporation’s growth due to the additional capital will exceed the dilution caused by issuing new shares. A leveraged ESOP can be used to borrow money that could be used to buy another company or new equipment, or to refinance debt. To accomplish these goals, the company issues new shares and sells them to the ESOP in a leveraged transaction, using the proceeds from the sale of new shares to finance acquisitions or to refinance debt. The company raises new capital by allowing the ESOP to buy new shares; this is funded by corporate contributions to the ESOP that come from pretax company cash flow. While this dilutes the ownership of the non-ESOP shareholders, it allows a much less costly repayment of the loan and simultaneously provides an employee benefit plan. If properly structured, the corporation's growth due to the additional capital will exceed the dilution caused by issuing new shares.

Either the ESOP borrows money or, more commonly, the company borrows money and relends it to the ESOP. The ESOP then buys stock from the company, which repays the loan and deducts both the principal and the interest. Companies have used leveraged ESOPs to refinance debt, buy stock back from a public market, acquire assets or other companies, and buy out owners.

From Chapter 6, "ESOPs for S Corporations"

The S corporation election alone, with the single taxation it brings, is attractive to many private companies. In addition, a major tax advantage has especially motivated many S corporations to set up ESOPs, and ESOP-owned C corporations to elect S corporation status: as a tax-exempt trust, an ESOP in an S corporation is not subject to federal income tax on its share of the corporation’s net income. Most states mirror this provision. An ESOP provides an S corporation with the potential to retain much more of its earnings than it would otherwise. For example, take an S corporation with $3 million in taxable income. Without an ESOP, the shareholders would collectively be responsible for perhaps $1 million or so of income tax. The company would normally make $1 million in distributions to shareholders to pay their taxes on their share of S corporation income. However, if an ESOP owns 100% of the company, that $1 million remains for the company to keep and use as it wishes.

When there are both ESOP and non-ESOP S corporation shareholders and the company makes a distribution to the non-ESOP shareholders to fund their tax payments, it must also make a pro rata distribution to the ESOP based on its ownership percentage. Having an ESOP makes no difference in the corporation’s responsibility to fund its shareholders’ tax bills. Because an S corporation distribution is still a dividend under state law, all shareholders of the same class (and there is only one class of stock in an S corporation) have equal rights to distributions. Even though the non-ESOP owners might wish the ESOP did not have to receive such distributions, the cash flow advantages are still significant. S corporation distributions to the ESOP may be used to pay ESOP administration expenses, including annual appraisal and legal costs; fund benefit distributions, thus easing liquidity concerns at the corporate level; repay an ESOP loan; or buy more shares from sellers or the company. When distributions on ESOP-held shares are used to repay a loan, the loan must be the one used to acquire those shares, and when distributions are paid on allocated shares, the value of the shares released to any participant’s account must at least equal the distributions that otherwise would have been allocated to that participant. However, if the company wishes to pass through distributions to employees, as a C corporation might do with dividends on ESOP shares, the distribution from the ESOP would have to meet the “in-service” distribution rules for active employees. There are also early distribution excise tax and participant consent issues that may make it impractical, unlike the case with C corporation dividends, which can be distributed by the ESOP trustee without participant consent.

From Chapter 10, " Fiduciary and Trustee Matters"

Under the law, a fiduciary is someone who has a duty to act for the benefit of another with the highest standard of care, good faith, and honesty regarding the management of money or property. In the context of employee benefit plans such as ESOPs, ERISA defines a fiduciary as anyone who:

• exercises any discretionary authority or control over managing the plan or over the management and disposition of its assets;
• renders paid investment advice regarding its assets or has the authority or responsibility to do so; or
• has any discretionary authority or responsibility regarding plan administration.

This definition is broad and includes people such as plan administrators (as noted below, this is not the ESOP’s third-party administrator [TPA]), trustees, investment managers, and in turn those who appoint others as fiduciaries. It includes not just those making decisions but also those who cause decisions to be made, regardless of their title. For example, a CEO who influenced the voting of an ESOP administrative committee was found to be fiduciarily responsible for that action. Board members, executives, and sellers can be deemed fiduciaries if they provide misleading information to the appraisal firm. They also have a fiduciary duty to monitor the trustee to ensure that the trustee is performing all of its duties, including using prudent procedures to value the ESOP’s stock.

ERISA requires plan fiduciaries not only to act in the exclusive interest of plan participants but also to act prudently. Failure to do so may result in legal liability under ERISA for losses.

From Chapter 11, "The Rights of ESOP Participants" (footnotes omitted)

The plan administrator must give plan participants and any beneficiary (“beneficiary” here means one receiving benefits under the plan) a summary plan description (SPD) (a summary of the plan’s provisions in easy-to-understand language) within 90 days of becoming a participant or beneficiary (or 120 days after the establishment of a new plan), within 30 days thereafter if the participant or beneficiary requests it, every five years if there have been changes to the plan, or every 10 years if there haven’t been changes. The SPD must include information such as eligibility terms, how benefits vest, how participants will receive distributions, the name and business address of the trustee(s), and how to file a claim. When (depending on the number of participants) a certain percentage of participants are literate only in the same non-English language, the SPD must include a notice in their language(s) offering assistance in their language(s) in understanding their rights and benefits under the plan. Whenever the plan is amended to change something described in the SPD, a summary of material modifications (SMM) must be distributed to participants and beneficiaries within 210 days after the end of the plan year in which the amendment took place.