Am I correct that an ESOP can be leveraged without involving a third-party lender? In other words, employer loans $1,000,000 to ESOP. ESOP turns around an buys out majority shareholder for $1,000,000 who defers gain on the sale. Employer then makes cash contributions to ESOP which ESOP uses to turn around and pay back to the employer to pay off debt. Basically a round-robin transaction cash-wise that allows shareholder redemption with pre-tax dollars.

Anyone seen this done or is third-party financing more popular?

The simple answer is "Yes." The prohibited transaction exemption for lending to ESOPs involves direct or indirect loans or other extensions of credit between the plan and a party-in-interest/disqualified person. In my experience, most ESOP loans are done through the plan sponsor with or without outside financing to provide the loaned funds.

BUT, like any ESOP matter, these are complicated, nit picky events and your client is well advised to put together a strong ESOP team - ESOP counsel, valuation adviser, etc.

With respect to the "round robin" effect, it can't really be a redemption of the selling shareholder. The active employees need to retain a long-term interest in the shares. See Rev. Proc. 87-22.

I want to clarify the last remark made by BeckyMiller.

Compliance with Revenue Procedure 87-22 is only necessary if you are seeking a private letter ruling from the IRS that the sale to the ESOP will qualify for capital gains treatment so that the amounts received won't be treated as ordinary income. (This is a simplification of the legal issues involved.)

It is very unusual to seek a PLR on that point. I don't recall ever having seen any.

Also, many practitioners think that the conditions imposed by that Revenue Procedure are too burdensome, so that courts would not uphold them. In other words, they believe that the courts would allow persons who sold stock to an ESOP to get capital gains treatment even if they didn't comply with the dictates of that Revenue Procedure.