Now that Congress and President Biden have extended the PPP loan application deadline to May 31, 2021, there is still time for ESOP-owned companies to consider using a PPP loan to refinance their ESOP loan. Depending on the size of the ESOP loan, a PPP loan can provide enough cash to pay off bank debt or a seller note and still qualify for forgiveness. This is a great opportunity to pay off all or some of that ESOP debt for free.
Financing an ESOP Transaction
The two most common scenarios for financing an ESOP transaction are:
A company borrows money from a bank and loans it to the ESOP for the ESOP to buy stock.
A selling shareholder loans money to the ESOP to buy company stock and the company assumes the obligation to repay the seller in exchange for a promissory note from the ESOP. Some ESOP transactions use a combination of these methods.
Use PPP Loan to Pay Off ESOP-related Debt
In either scenario, it may be possible to use PPP loan proceeds to pay off all or a portion of that ESOP-related debt and have the PPP loan forgiven. Here’s how it would work.
In Scenario 1, assume the company borrowed $1M from a bank and loaned that $1M to the ESOP to finance the purchase of company stock. The company now owes the bank $1M at 5% interest and the ESOP owes the company $1M at 2% interest. The company then borrows $1M from a PPP lender and contributes that amount to the ESOP. The ESOP uses the $1M to pay off its loan from the company and the company then uses that $1M to pay off its original bank loan. If the PPP loan qualifies for forgiveness, the company and the ESOP will have paid off the ESOP transaction financing for free.
In Scenario 2, assume the selling shareholder loaned $1M to the ESOP to buy company stock and that the company assumed the ESOP’s obligation to repay the selling shareholder. In exchange, assume the ESOP issued a $1M promissory note to the company. Now, the company owes the selling shareholder $1M at (for example) 7% interest and the ESOP owes the company $1M at (for example) 2% interest. The company then borrows $1M from a PPP lender and contributes that amount to the ESOP. The ESOP uses the $1M to pay off its note to the company and the company then uses that $1M to pay off its note to the selling shareholder. As in Scenario 1, if the PPP loan qualifies for forgiveness, the company and the ESOP will have paid off the ESOP transaction financing for free.
In either scenario, any unforgiven portion of the PPP loan will be repayable over 5 years at 1% interest. That may still be a better deal than the existing ESOP debt.
Limits and Trade-offs
Of course, there are limits and trade-offs to this strategy. These include:
- The limits on PPP loans still apply to both “First Draw” and “Second Draw” loans. This requires the company to have no more than 500 employees for a “First Draw” loan and no more than 300 employees for a “Second Draw” loan and be able to demonstrate at least a 25% reduction in gross receipts between comparable quarters in 2019 and 2020 for a “Second Draw” loan.
- At least 60% of the PPP loan must be used for payroll costs, which may include ESOP contributions paid or incurred by the borrower during the covered period after the loan is disbursed.
- The contribution to the ESOP must fit within the Code section 404(a) eligible compensation deduction limits. This is generally, 25% of compensation for S corporations, or 50% for C corporations.
- The ESOP’s note payment will release stock held in the ESOP’s suspense account to participants. Depending on the amount of the ESOP note payment, this could be an unusually large benefit to ESOP participants in one year and deplete the ESOP’s “reserve” of stock available to allocate to new participants.
- PPP loans up to $150,000 are eligible for “automatic” forgiveness. This means supporting documentation is not required to be submitted with the forgiveness application. This must still be maintained by the company for audit purposes.
There are other factors to take into account, including PPP lender requirements in addition to the SBA’s loan requirements. If you are considering taking advantage of this “free” ESOP debt refinancing opportunity, we recommend that you talk to your CPA and ESOP counsel for guidance. As always, we’d be happy to start a conversation about your ESOP needs.