It is common for an ESOP to be established with a leveraged stock purchase from the selling shareholder(s). When a leveraged ESOP is established, the shares acquired initially are not allocated to participants. Those shares initially sit in a suspense account. Then as the company makes contributions to the ESOP, the ESOP uses those contributions to make a payment on the loan between the company and the ESOP. When that occurs, a portion of the shares in the suspense account are released and allocated to eligible participants’ accounts based on the provisions in your plan document.
You may often find yourself confused as to how the number of shares released each year is calculated. There are two methods in which the release of shares is calculated: The Principal-Only method (or Special Rule) and the Principal and Interest method (or General Rule). The Principal-Only method is much less common, as the loan must meet certain requirements in order to qualify to use it.
The Principal-Only method requirements are threefold: 1) the loan must provide for annual payments of principal and interest at a cumulative rate not less rapid than level annual payments over 10 years, 2) the term of the loan cannot exceed 10 years, and 3) the interest included in any payment is disregarded only to the extent that it would be determined to be interest under standard loan amortization tables. The share release formula using the Principal-Only method is:
The Principal and Interest Method does not have special requirements in order to use it. The formula is very similar to the above, but it includes interest in the calculation, as its name suggests. The share release formula using the Principal and Interest method is:
The share release method for your plan is typically outlined in the pledge agreement, which is one of the internal ESOP loan transaction documents generally created when a leveraged ESOP is established. The ESOP plan document may also specify which release method must be used.
A loan amortization schedule is created when the internal ESOP loan is established. There are situations which may require your original repayment schedule to be revised. Examples include if your internal ESOP loan is refinanced, if you make prepayments on that loan, or if you do not make payments in a timely manner. If any of those situations occur, the loan amortization schedule must be revised. Revisions in the amortization schedule also impact the annual share release calculation.
If you ever have any questions about how the shares released are calculated for your plan, don’t hesitate to contact your plan administrator. Additionally, you will always find a copy of the share release calculation as part of your final allocation reports package for each plan year.