One significant difference between an employee stock ownership plan (ESOP) and other qualified defined contribution plans are that an ESOP can use the proceeds of a loan for the purchase of employer securities.
This is what’s known as a leveraged ESOP, and it’s a pretty common occurrence, whether for the initial purchase of the business or later in the ESOP’s life cycle.
ESOP administrators and fiduciaries need to understand that while an ESOP can borrow funds for other purposes, a loan taken for the purchase of company shares — and which meets certain other requirements — may allow the ESOP to delay distributions to plan participants and their beneficiaries.
This is what’s known as the ESOP exempt loan exception, and it permits an ESOP to borrow money using a direct loan, loan guarantee, or installment sale from a party in interest to purchase shares of employer stock.
In general, ESOP distributions of company shares that were purchased with the proceeds of an exempt ESOP loan don’t have to begin until the close of the plan year in which the exempt ESOP loan is repaid in full.
U.S. Federal Code states that an ESOP’s qualified status won’t “be adversely affected merely because it engages in a non-exempt loan,” but distribution rules provide an exception for ESOPs that have not yet paid the full balance of an exempt loan.
So to determine whether an ESOP can use the loan exception to delay distributions, both the loan and the use of funds must meet certain criteria.
Determining If an ESOP Loan is Exempt
An ESOP may only borrow money to purchase employer stock from a party in interest or have a loan guaranteed by a party in interest when the loan meets the following exempt loan requirements:
- Taken primarily for the benefit of the ESOP participants and their beneficiaries
- Entered into for the purpose of acquiring employer stock or repaying a prior exempt loan
- Nonrecourse against the ESOP (doesn’t allow the lender to pursue anything other than the collateral for repayment of the debt)
- Collateralized solely with the employer securities purchased
- Reasonable interest rate
- Fixed term
- Lender is not allowed to accelerate payments in the event of default, and the loan may not be payable on demand of lender except in case of default
- Purchase price of stock must not be so high that it depletes plan assets
- Loan terms must be as favorable to the ESOP as terms that could be reached from “arm’s-length” negotiations between two independent parties
ESOP’s repayment liability is limited to the collateral provided for the loan, non-securities contributions made to the ESOP for the purpose of loan repayment, and earnings on contributions and collateral
The ESOP loan amount is limited by the size of the company’s payroll. Because of tax law deduction limits, annual employer contributions for loan payments must not exceed 25 percent of participating employees’ annual compensation. Contributions by C corporations aren’t counted toward this limit if certain nondiscrimination rules are met.
The Path of Exempt Loan-Financed Stock from Purchase to Distribution
All ESOP shares purchased with proceeds of an exempt loan must be allocated initially to a suspense account and not allocated to participants’ accounts. The plan document must provide for a suspense account to hold shares acquired with the proceeds of the exempt loan, and for a method of releasing the stock from the suspense account as the loan is repaid.
The ESOP company makes cash contributions to the plan every year in an amount sufficient to pay the principal and interest due under the loan schedule.
Each year, as the exempt loan is repaid, shares are released from the suspense account and allocated to participants’ accounts. Shares provided as collateral must be released by the lender on a prorata basis as the loan is repaid (based on principal and interest payments, or solely on principal payments) and allocated to the participant accounts generally based on their proportional annual compensation, within covered compensation limits.
If the ESOP buys shares of more than one class of stock using the proceeds of an exempt loan, at allocation, participants must receive substantially the same proportion of each class of stock.
The ESOP is also required to provide participants certain rights related to plan assets acquired with the proceeds of an exempt ESOP loan. Essentially, no employer security acquired with the proceeds of an exempt loan may be subject to a put or similar arrangement when it is held by or distributed from the plan.
After the loan is repaid, distributions must generally begin no later than six years after a participant terminates employment (and within one year in the case of death, disability or normal retirement age).
Distributions can be made in substantially equal installments over five years — unless the employee consents to a longer period.
Is the ESOP Exempt Loan Exception Also for S-Corporation ESOPs?
This is a particularly interesting question, since regulatory language leaves room for some uncertainty, and no business wants to run afoul of the law.
In its language covering exempt ESOP loans, the Code of Federal Regulations specifically references ESOP deduction limits for C corporations. Because an ESOP-owned S corporation is not subject to federal income tax, the deductions referenced in the Code don’t apply to them.
Does that mean the loan exception also doesn’t apply?
In fact, many S corp ESOPs utilize the loan exception — and a best practice for these ESOPs is to specifically articulate the loan exception in the ESOP plan documents, in order to gain greater comfort when the ESOP determination letter is obtained.
Does Your ESOP Distribution Policy Need a Second Look?
Whether or not your ESOP has a written distribution policy, if you’ve made plan distributions, your decisions have established precedent for your policy. A written policy covering distribution timing, form, and method can help your plan demonstrate regulatory compliance and nondiscrimination. Click below to get your copy of our free ebook covering distribution policy essentials.