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.