It would be quite disturbing to a person to wake up, look in the mirror and see the reflection of someone else. However, this is what happens when a leveraging transaction is set up, expected to be a mirror note, but the provisions of the note are not at all identical. You might be thinking that this is ludicrous, how could this happen to an ESOP? The answer is a lot more common than you would think. Understanding the ESOP loan is extremely important and vital to maintaining a compliant Plan.
It is very common for an ESOP to purchase shares through a leveraged transaction. It is also very common to see a two part transaction agreement between three entities: the Company, the ESOP and a financial institution. In stage one, a financial institution will lend the money to purchase the ESOP shares to the Company with a loan agreement, from this point on referred to as the External Note (aka Company Note). The second stage is the loan agreement between the Company and the ESOP to purchase the shares, from this point on known as the Internal Note (aka ESOP Note). In this scenario you have two separate loan agreements. When the provisions of the loan agreements are exactly identical, you have what is called a mirror note.
Why would a Plan Sponsor set up the loans with different provisions? Understanding how the shares are allocated to participants might better help you understand why the loans are established in a particular way. An ESOP Note that has purchased 1,000 shares will have those shares in suspense which means they are not owned by any participant in particular. As the ESOP Note is paid off, the shares are released from suspense and allocated to the eligible participants in that particular year. Notice that the shares are released based on the payments on the Internal (ESOP) Note not the External (Company) Note.
The ESOP is set up to be a long term retirement plan for the participants both now and in the future. The loan might be set up with a long term payment plan over 10 to 15 years, sometimes as long as 50 years. This way, the shares are released and allocated over a long period of time to benefit participants that are currently employed as well as any employees who may be hired and become eligible during the term of the note. However, the Company might be averse to debt or have the funds on hand to pay for the shares outright. These are a few reasons that the External (Company) Note might have different terms than the Internal (ESOP) Note.
If the Company wants to establish a 5 year loan so as to pay off the debt in a short amount of time, they might not want a mirror note because the ESOP Note would then require that shares be released over the next 5 years. This is hardly a long term benefit plan to the participants.
Simple enough, right? So how is it that Plans can wake up 10 years down the road and realize that they are seeing the reflection of someone else in the mirror?
This is part of the crux of the discussion. Let’s look at an Internal (ESOP) Note and an External (Company) Note that are very similar, but not mirror notes. Both loan terms require payments over 10 years, both loans have the same principal payment but the interest rate is different.
I would say that the majority of confusion is caused by the payments that are being made. When the Company Note is established, there are payments that are being made to a financial institution. However, when the ESOP Note is being paid, the payments are between the ESOP and the Company, which is, essentially, the same entity.
To some Plan Sponsors, the ESOP Note payment does not really seem like a note payment but rather a transfer of money between the left and right pocket in the same pair of pants. When they have a discussion with their TPA after the close of the year about the payments that are made, they will provide the payments that were made to the financial institution on the External (Company) Note and not the Internal (ESOP) Note. The problem with this is that even slightly different loan provisions will provide different release calculations and if the release is based on the payments from the Company Note, the Plan is not allocating the correct amount of shares each year. This can cause a lot of headaches if it is found 10 years later and involves participants who have already been paid distributions from the Plan.
How can a Plan Sponsor prevent this from happening? The ancient Greeks inscribed a very useful maxim on the front of the Temple of Apollo which I think is still insightful today: Know Thyself. Read the terms of the two loan agreements; understand the differences between the note payments and note provisions, identify the differences between the loans.
The Internal Revenue Service has indicated that Plan Sponsors should facilitate loan payments through actual cash transfers instead of journal entries.
When you understand the terms of the loans and you make the transfer of cash to pay the Internal (ESOP) Note, you will be better prepared and protected against any possible discrepancies that might cause reallocations and corrections.