An ESOP is a kind of employee benefit plan. Governed by ERISA (Employee Retirement Income Security Act), ESOPs were given a specific statutory framework in 1974. In the ensuing 12 years, they were given a number of other tax benefits. Like other qualified deferred compensation plans, they must not discriminate in their operations in favor of highly compensated employees, officers, or owners. To assure that these rules are met, ESOPs must appoint a trustee to act as the plan fiduciary. This can be anyone, although larger companies tend to appoint an outside trust institution, while smaller companies typically appoint a manager or create an ESOP trust committee.
The most sophisticated use of an ESOP is to borrow money (a "leveraged" ESOP). In this approach, the company sets up a trust. The trust then borrows money from a lender. The company repays the loan by making tax-deductible contributions to the trust, which the trust gives to the lender. The loan must be used by the trust to acquire stock in the company. Proceeds from the loan can be used by the company for any legitimate business purpose. The stock is put into a "suspense account," where it is released to employee accounts as the loan is repaid. However, for purposes of calculating the various contribution limits described below, the employee is considered to have received only his or her share of the principal paid that year, not the value of the shares released. After employees leave the company or retire, the company distributes to them the stock purchased on their behalf, or its cash value. In practice, banks often require a second step in the loan transaction of making the loan to the company instead of the trust, with the company reloaning the proceeds to the ESOP.
In return for agreeing to funnel the loan through the ESOP, the company gets a number of tax benefits, provided it follows the rules to assure employees are treated fairly. First, the company can deduct the entire loan contribution it makes to the ESOP, within certain payroll-based limits described below. That means the company, in effect, can deduct interest and principal on the loan, not just interest. Second, the company can deduct dividends paid on the shares acquired with the proceeds of the loan that are used to repay the loan itself (in other words, the earnings of the stock being acquired help pay for the stock itself). Again, there are limits, as described below in sections on the rules of the loan and contribution limits.
The ESOP can also be funded directly by discretionary corporate contributions or cash to buy existing shares or simply by the contribution of shares. These contributions are tax-deductible, generally up to 25% of the total eligible payroll of plan participants.
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