Can a company have a longer term for its "inside" ESOP loan (the loan from the company to the ESOP) than its "outside" loan (the loan from the lender to the company)?
Yes. Generally, ESOP loans involve a lender loaning money to a company, and the company reloaning that to the ESOP. The terms of the two loans do not have to be the same, provided that the internal loan meets the fiduciary standards for ESOPs. Most internal loans are for 10-20 years, with some even longer. Two issues would be paramount here. First, the loan rate would have to be at "arm's-length equivalent," generally meaning it would have to be no higher than the external loan rate. Second, while the term can be longer, the fiduciaries must be able to show that extending the loan is for the benefit of plan participants. The most typical application of this would be when loan repayments on the terms of the external loan would exceed the maximum allowable amounts that can be added to employee accounts each year. By extending the term of the inside loan, the company is able to fund the ESOP; otherwise, it would either have no plan at all, or the ESOP would have to acquire fewer shares, either of which would arguably not be in the interests of employees. In other cases, the loan limits are not a problem, but the company wants to spread the ESOP benefit over a longer period of time. For instance, the company may be repaying the outside loan over five years, which would translate into 25% of eligible pay each year (or more if dividends and distributions are used). This front-loads the allocations, leaving new employees with little to gain.
Deciding just how long to extend is a facts and circumstances issue, but should always be approved by the plan fiduciary as in the best interests of plan participants. For internal loans over 10 years, we recommend that companies not normally delay distributions until after the loan is repaid, as the loan allows, but instead follow the normal distribution schedule. To do otherwise makes it appear the company is using the extended internal loan term mostly to manage its cash for its own benefit.
For more details, see Selling to an ESOP and Financing the Deal and the ESOP Pre-Feasibility Toolkit.
Link to this FAQ Topic: Financing an ESOP