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ESOP Operational Issues

Making ESOP Debt Payments with Dividends or S Corporation Distributions

Nancy Dittmer

January 20, 2010

(Nancy Dittmer)As a shareholder of the company, an ESOP may receive either C corporation dividends or S corporation distributions. These dividends or S distributions are generally available to be applied to the ESOP's debt payments. However, there are some key considerations applicable to that use of the dividends/S distributions.

First, only the dividends/S distributions attributable to the shares acquired with a given loan can be applied to the payments made on such loan (note that there is a limited exception for dividends paid on certain shares acquired before August 4, 1989.) So, if your ESOP has two loans outstanding, only the dividends/ S distributions paid on the shares acquired with Loan #1 can be used to repay Loan #1 and the same would be true for Loan #2. Also, if your ESOP has shares that were not acquired with a loan, the dividends/S distributions on such shares are not available to make payments on any loan.

The second issue relates to the use of dividends/S distributions attributable to allocated shares in a participant's account to make debt payments. These dividends/ S distributions are available to be applied to debt payments as long as a value test is satisfied. The value test is satisfied if the value of the shares allocated due to the debt payment made with the dividends/S distributions is at least equal to the dollar amount of the dividend/S distribution used. For example, if the dividend/ S distribution allocated to a participant's account is $100 and it is used to pay debt, then the participant's account will need to receive a share allocation with a value of at least $100 due to the debt payment made with that dividend/S distribution. Satisfying the value test can be an issue simply due to a post transaction drop in the value of the shares. It can also be more difficult if the value is decreasing due to company performance and/or general economic factors.

If the value test is not initially satisfied, it may be possible to correct by changing the allocation method of shares that are released from suspense due to the use of the dividends/S distributions on unallocated shares to make debt payments. The allocation of the shares released due to the use of these unallocated dividends/S distributions is often based on relative compensation rather than relative share balances. However, that allocation methodology can be modified to ensure compliance with the value test. This concept can best be explained via an example.
(1) Participant(2) Compen-sation(3) Share Balance(4) Unallo-
cated Dividend
(5) Allocated Dividend(6) Shares Released Due to (4)(7) Shares Released Due to (5)(8) Value of (5)(9) Total Shares Released
So if the value of shares (@$6.50 per share) allocated back to participants A and B due to the use of the allocated dividend would only be $130 and $195 respectively, additional share allocations of approximately 11 and 16 would needed to satisfy the value. Those shares would be removed from the pool of shares allocated on a compensation basis.
(1) Participant(2) Original Allocated Share Release(3) Addition to Allocated Share Release(4) Value of (2) and (3)(5) Unallocated Share Release(6) Total Shares Released
As you can see, the re-allocation will likely shift more of the released shares to longer term participants with greater shares balances (e.g., participant B in this example) so it can magnify a Haves vs. Have Not situation.

Also, there may not be enough shares released due to the use of the unallocated dividends to be able to correct the value test failure. There are other possible correction methods that may be available but they are more involved.

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