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How Does an ESOP Work?

An ESOP works in many respects like any other type of qualified retirement plan.  But there are three distinct differences between an ESOP and every other type of qualified retirement plan.  And it is these three differences that make an ESOP work as effectively as an ownership succession strategy.

  • An ESOP can borrow money.
  • It can engage in transactions with parties in interest.  In this case, “parties in interest”
     would be the owner or owners of the business.
  • An ESOP is required to invest primarily in the stock of the Company that sponsors the plan.

The following chart and step-by-step description illustrate how stock is sold to an ESOP in a typical Ownership Succession Planning scenario:

 

 

In Step 1, the Company obtains a loan, often from its current bank.  This is referred to as the “Outside Loan.”  Due to technicalities in the lending laws, banks almost never loan money directly to an ESOP.  Instead, banks loan money to the company which then lends it to the ESOP.

In Step 2, the Company lends money to the ESOP.  Generally, the Company loans the same amount it borrowed from the bank in Step 1, although the Company could lend the ESOP more or less.  This is referred to as the “Inside Loan.”  The terms (repayment period, interest rate, etc.) of the Inside Loan often mirror the terms of the Outside Loan but there may be reasons, in certain situations, for the terms of the Inside Loan to be different from the Outside Loan.

In Step 3, the ESOP Trust, or ESOT, uses the cash it received in the Inside Loan to purchase Company stock from the selling shareholder(s).  The stock that is purchased will be held initially in the ESOTs “Suspense Account.”

The following chart and the step-by-step description illustrate the annual activities involved in an ESOP.  

 

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