Understanding the Economics of Leveraged ESOPs

Abstract

Leveraged employee stock ownership plans (ESOPs) can be extremely useful as an antitakeover device or an employee motivational tool. But the actual economic benefits of a leveraged ESOP are complex and not as attractive as they may at first appear. In a leveraged ESOP, a corporation receives a tax deduction not only for interest payments, but also for principal payments. This may seem to be a tax advantage. In fact, however, the deduction for principal payments is merely equivalent to a tax deduction for employee compensation. Furthermore, the deduction is pegged to the stock price at the time of the ESOP's establishment; thus, when stock prices increase, a leveraged ESOP receives a significantly smaller tax deduction than does a corporation with an equivalent capital structure providing an equal amount of employee benefits. Leveraged ESOPs also receive a tax deduction on stock dividends paid out to employees or used to pay down the ESOP debt. This represents a true tax savings only for allocated ESOP shares. Taking a tax deduction on unallocated ESOP dividends is again equivalent to a tax deduction for employee compensation. With a leveraged ESOP, a company commits itself to a specific benefit funding schedule over the ESOP's life. If the company's condition deteriorates, it could find itself wed to a very expensive financing vehicle.