Key Concepts: Basics of Leveraged ESOP Accounting

The rules for accounting for an ESOP are not always intuitive, but understanding some key concepts can make the process easier.

In a leveraged ESOP, the loan is almost invariably to the company, which reloans the money to the trust. The key issues to think about here are how to account for released shares, dividends or distributions, the impact of the debt on the balance sheet, and the how the shares show up on the balance sheet.

We can illustrate what happens with a simple example. Assume the company is an S corporation with an ESOP that owns 40% of the shares.

Before the transaction, the company has $10 million in assets and $5 million in liabilities. The company takes out a $3 million loan, which is then loaned to the ESOP to buy 40% of the stock. The shares are worth $75 per share, and the ESOP acquires 40,000 shares with a total value of $3 million. The table below shows what happens to the balance sheet.

To fund the plan, the company contributes cash to trust bank account, which is recorded as a compensation expense. The portion of the company’s contribution used by the ESOP to pay interest on the inside loan is recorded by the company as interest expense, but when the ESOP makes the inside loan payment back to the company, the company records an offsetting credit to interest expense. As a result, there is no net impact to interest expense or interest income from the inside loan with the ESOP.

In an S corporation, the company will likely make annual distributions to the shareholders, including the ESOP. The distributions (Non-ESOP liabilities dividends in a C corporation) must be allocated pro rata between the shares which have been released to participants and the unreleased shares. Distributions allocated to unreleased shares are treated as a compensation expense; the distributions to released shares are charged to retained earnings. S corporation distributions are typically not deductible, but C corporation dividends paid to the ESOP generally are.

On the balance sheet, the unearned ESOP shares are held in a contra equity account, a kind of negative equity (see table 1). As the inside loan between the company and ESOP is repaid and shares are released, the contra equity account is reduced by the number shares released during the year multiplied by their original cost.

Contribution Accounting

The total compensation expense will be the average fair value of the released shares during the year. The difference between original cost per share and the average fair value per share is recorded through paid-in-capital or retained earnings and is a non-cash adjustment. The ESOP compensation expense is part of operating income.

In our S corporation example, the company sells 40% of stock to an ESOP. The company has 100,000 shares outstanding. The fair market value of the shares sold is $3 million, or $75 per share (40,000 shares). The company borrows $3 million for seven years at 4.5% interest. The annual debt service for year one is $625,000; year two $500,000. For the inside ESOP loan, the company loans $3 million to the ESOP for 10 years at 1% interest. The annual loan payment to company is $300,000 plus interest.

After first year, the stock value drops from $75 to $50 largely because of the debt borrowed by the Company to establish the ESOP.

Shares will be released to employee accounts over 10 years at 4,000 shares per year. An additional $200,000 cash contribution is made to the plan. The tables below show what happens.

*Includes additional $200,000 contribution

*$100,000 is a book/tax difference and is deducted for tax purposes

**Based on average fair market value of released shares—4,000 shares released at $25 reduction per share

This article is based on a presentation at our Fall Forum by Andy Manchir and Andrew Browning of the ESOP Services Group at Katz, Sapper & Miller.