A nonleveraged ESOP -- still the most common variety -- is simply a trust set up to hold company stock for the benefit of employees. ABC Inc. creates the trust and annually contributes stock, treasury stock, or cash, up to 25% of covered payroll. If the contributions are in cash, the ESOP uses the money to buy stock from existing shareholders. Stock is then credited to individual employees' accounts, usually vesting over a period of up to seven years. Unless ABC is a publicly traded company, it must offer to buy the stock back when the employee leaves or retires (the payout can take place over several years). ABC's contributions of stock or cash are tax-deductible; so are cash dividends passed through the ESOP to employee shareholders.
A leveraged ESOP works in the same way, except the ESOP borrows the money to fund its purchase of company stock. ABC provides or guarantees the loan to the ESOP and contributes cash or pays dividends sufficient to enable the ESOP to repay it. As the loan is paid off, the stock it bought is credited to employee accounts. ABC can deduct the full value of loan repayments (principal and interest) from its taxable income, though contributions used by the ESOP to pay the principal can't exceed 25% of covered payroll. Since the bank gets a tax break on its earnings from the loan, rates are typically 75% to 90% of the company's usual rate. If the borrowed funds are used to buy new stock (rather than to buy out existing shareholders), the company gets full use of the proceeds.
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