Initially, an ESOP is a “Qualified Deferred Compensation Plan.” It is a “Defined Contribution Plan,” and is governed under ERISA. But, again, much of what ESOPs do would constitute prohibited transactions but for special exceptions. For instance, stockholders can sell company stock to an ESOP, they can lend to an ESOP, and ESOPs can borrow money to buy stock. Actions such as these would be prohibited transactions, but the law provides that they are not when ESOPs are involved. Normal ERISA rules as to coverage, vesting, and anti-discrimination apply to ESOPs the same as they apply to other qualified plans. It is specifically provided, however, that in order to qualify as an ESOP the assets of the plan must be primarily invested in employer securities. That generally means, over time more than 50% of an ESOP’s assets must be its sponsoring company’s stock. But there is leeway. For instance, I have a client that put money in its ESOP that then used some of that money to buy company stock, but also used a lesser sum to buy stock in a newly-formed bank. The Company has done well, but the bank has done superbly well. Before long, the assets of the Trust were more than 50% invested in the bank. Accordingly, the ESOP had to sell some of that bank stock and use the proceeds to pay off participants or buy more company stock so that, over time, the primary asset of the ESOP would, again, be company stock.
C corporations can contribute to an ESOP and deduct considerably more than would otherwise be permissible if the plan was other than an ESOP. In defined contribution plans, the maximum deductible contribution is normally 25% of covered compensation. But, when ESOP is in the picture, deductible contributions can go well beyond that–up to 40% or more. This is because in ESOPs of C corporations you don’t have to count against that 25% the portion of the contribution that the ESOP uses to pay interest on stock acquisition debt. Accordingly, in the early years, when the ESOP usually has considerable stock acquisition debt, the company will be making contributions that are used by the ESOP to pay interest which will not count against that 25%. Moreover, when a C corporation’s ESOP still has stock acquisition debt, a second 25% contribution should be available. Deductible contributions could then move up to, say, 70% of covered compensation.