ESOP Stock Purchase Transaction Structures

  • Tuesday, August 15, 2017

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What are the most common transaction structures used for an employee stock ownership plan’s (ESOP’s) purchase of company stock from company shareholders? Given the two different types of taxation of corporations, the following will describe first the common structure used in selling company stock in a C corporation to an ESOP, and, second, the common structure used in selling company stock in an S corporation to an ESOP.

C Corporation Sale of Stock to an ESOP

 In a C corporation the structure of the transaction is oftentimes designed to ensure that the selling shareholder(s) is able to make an IRC Section 1042 election. See ESOP Tax Advantages to learn more. Thus, the ESOP must purchase the shares directly from the selling shareholder(s). Here’s what a very common transaction structure looks like:
 
Step 1: The C corporation establishes a new ESOP plan and trust and appoints the ESOP Trustee.
 
Step 2: The corporation borrows funds from a senior lender (aka bank), which creates a promissory note and obligation of the corporation to repay the senior lender. This is referred to as the “Bank Note”.
 
Step 3: The ESOP borrows the same funds from the corporation, which creates a promissory note and obligation of the ESOP to repay the corporation. This is referred to as the “ESOP Note”.
 
Step 4: The ESOP purchases shares from the selling shareholder(s) with the cash borrowed using the ESOP Note.
 
Step 5: The selling shareholder(s) reinvests the sale proceeds received from the ESOP to purchase QRP. See ESOP Tax Advantages to learn more.
 
On an annual basis the following will occur after the transaction is closed:
 
Step 1: The corporation will make a contribution of cash to the ESOP equal to the amount the ESOP needs to make the current annual payment on the ESOP Note. This is a tax deductible contribution subject to certain limitations.  See ESOP Tax Advantages to learn more.
 
Step 2: The ESOP will pay the cash received back to the corporation as the current annual payment on the ESOP Note. This may be needed in order to receive the tax deduction. See ESOP Tax Advantages to learn more. Additionally, when the ESOP makes a payment on the ESOP Note, a certain number of shares are allocated to the participants of the ESOP who are eligible for an allocation in that year. See How to Determine the Release of Shares to learn more.
 
Step 3: The corporation can then use the cash received to make payment on the Bank Note. To the extent the contribution to the ESOP is an amount equal to the payment on Bank Note, the corporation will effectively be using pre-tax dollars to repay the Bank Note.
 

S Corporation Sale of Stock to an ESOP

 In an S corporation the purchase of company stock is not eligible for an IRC Section 1042 election. See ESOP Tax Advantages to learn more. Thus, the ESOP is not required to purchase the shares directly from the selling shareholder(s). Here’s what a very common transaction structure looks like in an S corporation in which the ESOP becomes the 100% sole shareholder:
 
Step 1: The S corporation establishes a new ESOP plan and trust and appoints the ESOP Trustee.
 
Step 2: The corporation borrows funds from a senior lender (aka bank), which creates a promissory note and obligation of the corporation to repay the senior lender. This is referred to as the “Bank Note”.
 
Step 3: The corporation purchase 100% of the shares from the selling shareholder(s) with a combination of (i) cash borrowed using the Bank Note, (ii) cash on the balance sheet, and (iii) issuing a promissory note to the selling shareholder(s) for the balance of the purchase price.
 
Step 4: Following the corporation’s purchase of shares, the ESOP purchases shares from the corporation by issuing a promissory note to the corporation equal to the purchase price for the shares. This is referred to as the “ESOP Note”. The ESOP is now the sole shareholder.
 
On an annual basis the following will occur after the transaction is closed, which is identical to the annual process in the C corporation structure described above:
 
Step 1: The corporation will make a contribution of cash to the ESOP equal to the amount the ESOP needs to make the current annual payment on the ESOP Note. This is a tax deductible contribution subject to certain limitations.  See ESOP Tax Advantages to learn more.
 
Step 2: The ESOP will pay the cash received back to the corporation as the current annual payment on the ESOP Note. This may be needed in order to receive the tax deduction. See ESOP Tax Advantages to learn more. Additionally, when the ESOP makes a payment on the ESOP Note, a certain number of shares are allocated to the participants of the ESOP who are eligible for an allocation in that year. See How to Determine the Release of Shares to learn more. The difference in the S corporation structure is that the corporation does not generally need to maximize its tax deductible contributions to the ESOP because, as a 100% ESOP owned S corporation, the corporation will not pay federal income tax. See Why Should a Company Consider a 100% ESOP Ownership Structure? to learn more.

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