ESOPs provide unique tax benefits.

Publicity generated by the proposed $5 billion employee buyout of at least 53% of UAL Corp. stock using an employee stock ownership plan (ESOP) drew attention to the tax benefits available to sponsors of such plans.

Typically, an ESOP is established using either a direct loan to the plan or a so-called mirror loan to the sponsor, which in turn lends the funds to the ESOP. In either case, the loan is made to acquire employer securities and is paid with employer contributions. In return, the employer is entitled to a deduction for contributions used to pay interest on the loan. Contributions used to repay the loan principal also are deductible as long as they do not exceed 25% of the compensation that is paid to participating employees.

To encourage lenders to make ESOP loans at reasonable rates, Internal Revenue Code section 1042 allows banks, insurance companies and corporations actively engaged in lending money to exclude 50% of the interest received on an ESOP loan if

1. The loan term does not exceed 15 years.

2. The plan provides for the full pass-through of voting rights on stock allocated to participants.

3. The ESOP owns more than 50% of each class of voting stock or 50% of the total value of all stock.

Section 1042 permits deductions for cash dividends paid to an ESOP. To qualify, the dividends must either be distributed to the plan participants within 90 days of the close of the plan year in which the dividend is paid or be used to make payments on the ESOP loan. In the latter case, the plan must allocate employer securities (at a value equal to the dividends) to the participants. Dividends used for debt repayment may be paid in addition to the 25% payroll contribution limit on principal payments.

Section 1042 allows a seller of qualified securities to an ESOP to defer the gain, provided the proceeds are reinvested in qualified replacement property within a period starting 3 months before and ending 12 months after the sale. Qualified replacement property is broadly defined as securities of a domestic operating corporation. The securities sold must be those of a corporation with no traded securities outstanding, and the ESOP must own at least 30% of the sponsor's total outstanding qualified securities immediately after the sale.

Observation: Normally, the tax law restricts net operating loss carrybacks generated by interest expense allocable to a corporate equity reduction transaction (CERT), in which one corporation acquires at least 50% of another's stock. However, when an ESOP is the buyer, such a transaction is not classified as a CERT. Therefore, losses generated by ESOP leverage are available in full as carrybacks.