AF: Since they are buying the stock, they would need to earn, at an average income tax rate of 20%, $2,400,000 in pre-tax income to pay $400,000 in income taxes and have $2,000,000 left over to pay you.
However, the ESOP enables the company to deduct all principal and interest payments on the loan from the bank. That means the company only needs to earn $2,000,000 in pre-tax earnings to pay the bank the $2,000,000.
As you can see, the government has given you $300,000 and your company $400,000, or a total of $700,000 to assist in this transaction.
Now, let’s go back to the steps:
Step Four: The ESOP pledges the stock of the company for the $2,000,000 loan. Your bank is now double collateralized. It has the $2,000,000 in high grade corporate bonds and the stock of the company so there is a total of $4,000,000 securing the $2,000,000 loan.
C: What happens to my bonds, by the way, why do I have to buy bonds?
AF: Two reasons, if you purchase stock, there is little income for you to live on and the bank will not feel as secure with stocks instead of high grade bonds.
While you could sell some stocks, you would recognize gain on the sale with a carry over basis based on your basis in the stock of the company.
As the company contributes funds to the ESOP, either as a pension contribution or a tax deductible dividend, the bank releases the appropriate portion of your securities.
C: Well, your idea doesn’t sound so crazy after all. I don’t see any other choice for me.
AF: I think it is something you should consider.