An employee stock ownership plan (“ESOP”) is a type of employee benefit plan in which company stock is acquired by, and held in accounts for, the employees of the company. More and more companies are taking advantage of this structure because ESOPs provide a vehicle for employees to obtain an ownership interest in their employer, thereby aligning the interests of the employees with the shareholders of the company. There are various tax advantages that forming an ESOP provides to the existing shareholders, employees and company, all of which support the continued growth and stability of the businesses that elect to pursue this structure.
Authorized by the Employee Retirement Income Security Act (“ERISA”), ESOPs create employee-owned business and, under certain conditions, are eligible for SBA 7(a) financing. However, they must also be in compliance with all applicable IRS, Treasury, and Department of Labor regulations. It is due to these compliance challenges that all ESOP SBA loans are handled through a lender’s non-delegated authority.
The SBA allows ESOP financing for two purposes: 1. for “purchasing a controlling interest (at least 51 percent) in the employer small business;” or 2. for “re-lending loan proceeds to the employer small business by purchasing qualified employee securities. The small business may use the funds for any general 7(a) purpose.” SOP 50 10 6 at p. 137-138.
When 7(a) loans do not involve an ESOP, the general rule is that the loan must be guaranteed by at least one individual or entity. However, an ESOP transaction only requires a guarantor in certain limited situations. Since IRS and ERISA laws prohibit an ESOP from guaranteeing a loan, the SBA does not require the ESOP’s guaranty, regardless of the percentage ownership that it has in an applicant. In addition, the SBA does not require members of the ESOP to personally guarantee the loan unless they also own 20% or more of the employer small business outside of the ESOP or are a seller that retains an ownership interest in the employer small business (in any amount) outside of the ESOP. The owners of the employer small business who hold an ownership interest in the small business outside of the ESOP are all subject to the SBA’s guaranty requirements as set forth in the SOP. See SOP 50 10 6 at pp. 203- 204.
Unlike other 7(a) loans for changes of ownership, in an ESOP transaction, the seller may remain as an owner, officer, director, stockholder or key employee of the employer small business if the ESOP purchases a controlling interest (51% or more) in the employer small business. However, as discussed above, if the seller remains and also retains an ownership interest in the employer small business in any amount outside of the ESOP, then that seller must provide his or her personal guaranty.
While all loans involving an ESOP or a business owned by an ESOP must be submitted to the Loan Guaranty Processing Center (“LGPC”) for general processing, it is important to note that although costs associated with the ESOP purchasing the controlling interest in the small business may be included in the use of proceeds, the costs of establishing the ESOP itself cannot. It is also important to note that an ESOP transaction cannot be structured using an Eligible Passive Company/ Operating Company (“EPC/ OC”) structure because the ESOP’s inability to guaranty the loan directly conflicts with the SOP’s requirement that all 20% or more owners of the EPC and OC guaranty the loan with no exceptions. Therefore, an EPC/OC structure is not available in ESOP transactions.
Due to the complexity of ESOP transactions, it is recommended that your borrowers assemble an experienced team of advisors who can help guide them. This group can assist SBA’s LGPC to navigate the intricacies and, with your help, achieve a successful transaction. For assistance with SBA lending matters, contact the attorneys at Starfield & Smith, PC at 215.542.7070 or visit us at www.starfieldsmith.com.