Inside vs. Outside Loan: Why Complicate the Transaction?

By Damien Vira

ESOP transactions are complex animals, with many moving parts. These transactions lie at the intersection of ERISA law and the domain of mergers and acquisitions, straddling the world of finance and qualified retirement plans. Add to the mix that there is not a lot of common ESOP experience or knowledge in the general business community, and it is understandable that many ESOP topics seem counter-intuitive at first blush, including the role of the inside and outside loans in a transaction.

This article is a primer on a complex topic that initially arises during the ESOP feasibility process, and becomes a critical factor in an ESOP transaction. This topic and related concepts are relevant to what are referred to as leveraged transactions. That is, where money is borrowed to purchase stock from a shareholder.

What do you mean, “outside loan?” An outside or external loan is a term many ESOP professionals will use to refer to a loan between the company and the bank or to a loan between the company and the selling shareholder. In its simplest form, it refers to the fact that the ESOP Trust is not a direct party in the loan—the ESOP Trust is not the borrower or lender. Also, it is not uncommon for there to be multiple outside loans in an ESOP transaction. For example, in its ESOP transaction, ACME Company may have borrowed money from a bank, commonly referred to as a senior lender, as well as issued a promissory note to the selling shareholder, Mr. Bugs Bunny, for the remainder of the transaction value. Like the bank, Bugs Bunny is referred to as the lender, even though he is not technically lending cash to the company, he still becomes a creditor - he has sold his shares and received a promissory note. Both the senior debt loan and seller note will have their own unique amortization (payment) schedules, loan terms, loan covenants, etc. However, we will refer to both these types of loans as outside or external loans.

Why doesn’t the ESOP borrow directly? You may be wondering why the company is borrowing money from a bank in an ESOP transaction when the shareholder is the seller and the ESOP Trust is the ultimate buyer of the stock. Well, ESOP Trusts have no historical financials, no assets (prior to an initial sale), no business operations, and offer little recourse for a bank due to their ERISA protected status. Therefore, it is practically unheard of for a senior lender to be willing to lend directly to an ESOP. We will discuss in another question what happens when sellers need to sell directly to the ESOP and why even if a bank was willing to lend to an ESOP directly it may not be preferable.

What do you mean, “inside loan?” An inside or internal loan is the term commonly used to refer to a loan between the company and the ESOP Trust. Unlike an outside loan, the ESOP Trust is a direct party in an internal loan—the Trust is the borrower. For example, ACME Company will agree to sell shares to the ESOP Trust in return for a promissory note from the Trust. The inside loan will have its own unique amortization schedule, loan terms, etc. As the ESOP Trust pays down its debt to ACME Company it will release the shares it purchased into employee accounts. For instance, if a ten-year inside loan was used and the payment schedule adhered to, then approximately 10 percent of the original shares sold would be released into employee accounts every year.

How does the ESOP pay back the company? The ESOP Trust can fulfill its loan payment obligations to the company only after the company makes a tax-deductible contribution to the ESOP Trust—remember the ESOP Trust has no business operations and no initial cash. For example, if the ACME ESOP Trust’s internal loan called for annual payments of $100,000 to be made to ACME Company, then ACME Company would theoretically contribute $100,0000 to the ESOP Trust and the Trust would immediately send a $100,000 payment back to the company to meet the terms of the internal loan.

Are the terms of the outside and inside loans the same? Generally, the terms of the outside loan(s) and the inside loan are not the same, although they theoretically can be. Recall in this scenario that the ESOP Trust has purchased shares of stock directly from the company, and that the company is going to make contributions so the Trust can make its payments. Since this is a cash-neutral transaction, there is no incentive to charge the ESOP an interest rate above the applicable federal rate (AFR), currently set at 2.78 percent for long-term debt paid annually (for March 2017). In addition, since it is the inside loan repayment that determines the release of shares to employee accounts, there is typically no prepayment penalty with these loans. This allows ACME Company to make a larger contribution to the ESOP Trust in any given year, which the Trust can use to accelerate its debt payment and accelerate the release of shares into employee accounts. Lastly, inside loans are typically amortized over longer periods than outside loans. Banks and sellers want to be paid back as quickly as possible, and many companies would like to pay down these outside loans as soon as possible as well. For example, ACME Company may have a five-year fully amortized loan with a bank (outside loan), but it may have a ten-year note from the ESOP Trust.

What is the impact to the income statement? ACME Company will take a tax deduction for its $100,000 ESOP contribution. Under current tax treatment, it will also be able to deduct the interest it pays to the bank and Mr. Bugs Bunny for the two outside loans. However, ACME Company must recognize as income the portion of the $100,000 payment it received from the ESOP Trust that is interest, which is another reason to charge the ESOP Trust a nominal amount of interest.

What is the impact to cash flows? The company contribution of $100,000 to the ESOP is cash neutral: ACME Company will make the contribution and the ESOP Trust will repay $100,000 of its debt to the company. However, ACME will have the cash flow impact of the outside loan payments to the seller and the bank.

Aren’t ESOP loans completely tax deductible? ESOP contributions can be taken as a tax deduction for the company. However, since the inside and outside loans no longer mirror one another, then the tax deductibility will be spread out over a longer period, which is dependent on how quickly the inside loan is paid.

I am electing the IRC Section 1042 tax deferral; don’t I need to sell my stock directly to the ESOP? Yes, one of the requirements of electing the IRC Section 1042 tax deferral is that the seller sells their shares directly to the ESOP. That does not necessarily mean that the seller will be stuck with a note from the ESOP post-transaction, or that a separate inside loan cannot be utilized. Without diving into detail, I will state that it is completely possible to have a more traditional outside and inside loan structure when 1042 is elected, but there are just a few more steps (i.e., a couple more legal documents) that need to happen prior to that occurring.

Advantages of separating the two types of loans: Separating the inside loan from the outside loan has a host of advantages. First, it spreads out the employee benefit over a longer period, ensuring that employees hired a few years into an ESOP will still receive stock. Second, it gives the company greater flexibility. That is, the company can decide on a year-by-year basis if it wants to make a larger ESOP contribution than the minimum, thus helping the firm manage both the employee benefit level and the tax deduction it wants to take in any given year.

Disadvantages of separating them: Having two or more loans for one ESOP transaction can be initially confusing. There may also be additional documents that need to be drafted for the transaction, which is especially true when a seller elects IRC 1042. Lastly, the communication to management and employees can increase in complexity.

I have not quite decided if the ESOP process is more akin to learning a new vocabulary or learning a whole new language. In either case, the learning curve tends to be long and flat. The inside and outside loan dynamic is a topic that certainly takes time to digest. The impact on the financials and employees coupled with the various loan terms and structures is real and significant. However, the advantages of disentangling the two usually far outweighs the disadvantages.

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