Leveraged ESOP with a mirror loan--Does the interest rate paid by the

[Guest bobkovell]

In a leveraged ESOP with a "mirror" loan, can the interest rate(the AFR 5.59%)paid by the ESOP to the corp. be lower than the interest rate(8%)paid by the corp. to the bank? Loan proceeds went from the bank to the corp. to the ESOP. The bank charged the corp. 8% while the corp. charged the ESOP only 5.59%, the AFR at the time. This will allow the ESOP to pay off the loan faster.

The IRS auditor currently auditing the corp. says the rates

have to be the same(8%)under IRC Sec 482-2(a).

We are arguing that ERISA and Sec 4975 take priority over 482 and that the ESOP can pay a lower rate(which will benefit all participants in the ESOP).ANY HELP WOULD BE

GREATLY APPRECIATED--THANKS!!

[RLL]

I agree with you that the IRS is wrong.....in fact, the auditor's position is silly. How does sec 482 apply? The interest charged on the loan to the ESOP is a 'wash" with respect to the company.....the company's deduction under sec 404(a)(9)(B) is equal to the company's interest income. If the interest rate were higher, the company would contribute the additional amount and deduct it. It seems that sec 7872(B) would apply (not 482), but only if the interest were at a "below-market" rate.

I don't understand your statement that the lower interest rate allows the ESOP to pay off the loan faster. I assume that the company contributes whatever is needed to make scheduled loan payments. The interest on the ESOP "mirror" loan is a "wash" to the company....if the interest were higher, the company would contribute more.

[Guest bobkovell]

I'm sorry---didn't explain myself very well.

The corp. is an S corp. owned 2/3 by the ESOP and 1/3 by an individual. ESOP contributions are limited to 25% of eligible compensation and must cover both interest and principal since we have an S corp. Contributions have typically covered about 80-90% of required loan payments

and the rest we're doing with dividends.

If the interest rate was higher ,i.e,the ESOP had to pay 8%

then less principal would be paid (since our contributions are limited) and it would take much longer to pay off the loan. And the corp. would have additional interest income ,

taxable to the 1/3 shareholder.

Please look at Regs. Sec. 1.482-2(a)(2)(ii) which does appear to say that the rates have to be the same.

[RLL]

Your additional facts may change the anaysis. Clearly, sec 404(a)(9) isn't available for computing deductions to an S corp leveraged ESOP.

Sorry, but I don't look at IRS regs anymore....the print is too small and, even if you can read 'em, it's too much work just to answer a message board post.

Doesn't the "safe haven" interest rate exception under sec 482 apply?

[Guest bobkovell]

Not sure if the safe haven under 482 would apply.

Reg. Sec 1.482-2(a)(2)(ii)states: "Funds obtained at situs of borrower. Notwithstanding the other provisions of paragraph (a)(2)of this section[which allows for a safe haven rate equal to the AFR], if the loan represents the proceeds of a loan obtained by the lender at the situs of the borrower, the arm's length rate for any taxable year shall be equal to the rate actually paid by the lender increased by an amount which reflects the costs incurred by the lender in borrowing such amounts and making such loans..."

And all of this gets us back to the question of whether 482 takes priority over ERISA and 4975. Since 4975 is simply an

excise tax provision the IRS may have a point??

We appreciate your time--wow, how do you do it? THANKS!!!!!!

[BeckyMiller]

Interesting, I have often wondered if the IRS would ever take this position. In my practice, I have seen many ESOP loans for substantially lower interest rates than what was charged on the outside debt, even where such outside debt was incurred specifically to provide the financing for the ESOP. I have even seen cases of zero interest loans.

For the reasons that you and RLL raised, the interest charged on the inside loan was frequently not significant because of the special rules under Section 404(a)(9) and 415©(6). However, where the conditions of 415©(6) were not met or for a less 100% ESOP owned S corporation, the interest element does become significant in measuring taxable income.

To justify the lower rate attached to the inside loan, we considered the following:

1. The ESOP loan is made between the plan sponsor and the plan for the exclusive benefit of the plan participants. As such, it should be made at a lower rate than that required of an outside lender since it should not include the profit motive to the lender. (I realize that this argument is very weak when the terms between the corporation and the lender and exactly the same as the terms between the corporation and the ESOP.)

2. Did you borrow all the money? If the amount loaned to the ESOP was greater than the amount borrowed commercially, you could argue that the ESOP note represents a blended rate of interest.

3. We generally suggest that the loan terms not be the same as the commercial loan - longer repayment period, more flexibility on prepayment, first dollar offset on prepayments, different types of security, etc. All of this breaks the link between the commercial loan rate and the ESOP loan rate. (I know it is too late for this, but maybe you do have some of these differences, already. You put "mirror" in quotes and clearly there is already the difference in the rates.)

I would really appreciate hearing how this progresses, as it is the first instance in my knowledge of this being raised.