Need Capital? Check out the Break Room: Employee Stock Ownership Plans, and Leveraged ESOPs, Represent a Tax-Advantaged Source of Capital. in S Corporations They Pack a Special Punch, and They May Give Management a Special Edge in Troubled-Bank Situations

Article excerpt

In the current environment, regulatory capital demands on community banks have grown commonplace. Although capital can be raised through debt (trust preferred is much harder to come by for a small transaction) or equity, i.e., the sale of common stock to existing shareholders or rich and smart investors, the most tax-effective way to raise capital and provide an employee benefit at the same time may be through a leveraged Employee Stock Ownership Plan.

If your community bank or holding company wants to raise capital through a tax-effective method that will also have employees thinking like owners, then consider a leveraged ESOP or KSOP. Plans can be established quickly, leveraged quickly (provided a lender can be found), and capital injected expeditiously.

Mechanics of ESOPs

An ESOP is simply a trust established to hold the stock of the bank or holding company for the benefit of employees. If the ESOP is combined with an existing or newly created 401(k) plan, then it is generally referred to as a KSOP, i.e., a 401(k) ESOP. For banks under $500 million in assets, the most tax-effective means to raise capital for the bank is through leveraging a KSOP or an ESOP. ESOPs and KSOPs can be established quickly. Capital can thus be injected quickly and relatively inexpensively compared to the other equity-raising alternatives.

From a mechanical standpoint, the bank holding company creates an ESOP, which is a trust, to hold holding company stock for the benefit of the bank's employees. This plan requires the creation of plan documents; the consideration of plan terms and conditions; and filing for a determination letter with the Internal Revenue Service. If the establishment of a KSOP is desired, then the bank holding company will generally start with the existing 401(k) plan in which the employees participate, and amend it to provide ESOP features.

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To raise capital through a leveraged ESOP or KSOP, the ESOP would find a lender; borrow the money from the lender; take the cash generated through the loan into the ESOP; and buy stock from the holding company. This generates cash in the holding company. The cash is then contributed by the holding company to the subsidiary bank as new capital.

Because of the relatively new, expanded small bank holding company guidelines--which do not provide for consolidated capital requirements unless the consolidated assets of the company come to over $500 million--the ESOP leverage works extraordinarily well. Cash received by the bank from the holding company increases the bank's capital. The debt generated by the ESOP is reflected on the balance sheet of the holding company for regulatory accounting purposes, but since the holding company's capital is not tested on a consolidated basis, the ESOP debt on the holding company balance sheet is immaterial, provided it is within the tolerance levels of the small bank holding company guidelines. (These guidelines, a discussion of which is beyond the scope of this article, can be found at 12 CFR Part 225. See www.fdic.gov/regulations/laws/rules/6000-2100.html# 6000appendixc)

The primary tax advantages of increasing the bank's capital in this manner arise because the funding for the ESOP results from tax-deductible compensation expense by the bank. The bank makes contributions to the ESOP (within statutory limits) which it then deducts on its consolidated tax return for the holding company. The ESOP uses the cash to repay the ESOP loan, effectively allowing the consolidated organization to deduct principal and interest on the ESOP loan.

Focus on the leverage

As a practical matter, most loan transactions with ESOPs (particularly where the lender is sophisticated or specializes in ESOP loans) are structured as a simultaneous loan from lender to bank holding company, and then as a loan from the bank holding company to the ESOP. This is primarily because if a lender lends directly to the ESOP, the only collateral the lender can obtain from it is the stock purchased by the ESOP with the proceeds of the loan; employer contributions to the ESOP to meet its obligations; earnings attributable to such collateral; and the investment of the contributions. …