ESOP Distribution Policy - Form

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Mon, Nov 11, 2013
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ESOP DistributionsTo the extent consistent with regulatory requirements and your plan documents, a written ESOP distribution policy documents the timing, method, and form of how the company processes ESOP distributions.  A written distribution policy can be modified as needed to ensure the policy continues to meet the objectives of the company, to manage cash flow, and to control the employee benefit level. 

We previously looked at the ESOP Distribution Timing.  This article will discuss the form of ESOP distributions.

There can be some flexibility in the form of ESOP distributions.  Most plan documents will indicate distributions can be made in the form of stock or cash. 

ESOP Distribution Form: Stock Distributions

If you are a C corporation and your articles or bylaws do not restrict the ownership of employer securities (or if you met one of the other limited exceptions, see below), then you are generally required to offer distributions in the form of stock. This is because a participant that has company stock in their account that is not publicly traded has the right to demand payment in the form of employer securities with a put option. 

ESOP Put Option

A put option gives the participant a right, but not the obligation, to require the company to repurchase the stock under a fair valuation formula as determined by an independent ESOP appraiser.  The ESOP put option is provided for under IRC Section 409(h) – Right to demand employer securities; put option.

The company may permit the ESOP to purchase shares tendered under the put option.  However, the company cannot transfer the put option requirement to the ESOP.  Amounts diversified are not subject to the put option.

Exceptions to Stock Distributions

IRC Section 409(h) provides exceptions when the plan sponsor does not have to offer stock distributions:

  • Has a charter or bylaws that restrict the ownership of substantially all outstanding employer securities to employees or to a qualified plan trust;

  • Is a bank that is prohibited from purchasing their own stock; or

  • Is an S Corporation (although an S Corporation may still distribute stock with the requirement that it be immediately sold to the company or ESOP)

If one of the above exceptions is not met, the plan sponsor generally must offer stock distributions.  If a stock distribution will not be available due to an exception, the ESOP participant must have the right to receive the distribution in cash.  You may still elect to offer share distributions, even if they are not required.

ESOP Repurchase Obligation

The right to demand securities with the ESOP put option is what creates the company’s ESOP repurchase obligation.  Regardless of the distribution being paid in stock or cash, the plan sponsor has to plan for the redemption of the stock or getting cash in the plan to fund the distributions.  A company needs to have an understanding of the short-term and long-term financial commitment needed to satisfy the future liability obligation.  The most common method to obtain this understanding is by performing a repurchase liability study.

Once the company has determined its ESOP repurchase obligation, it will also have to determine how it will provide the funding for the ESOP repurchase obligation.  The details of determining and funding the future repurchase obligation are beyond the scope of this article, however it is crucial to the success of your ESOP, and your company, that you know your future repurchase obligation and plan accordingly.   

No Cost Repurchase Liability Consultation

Stock Distribution Mechanics

If you are paying distributions in shares, who will purchase the shares and what will happen to them?  If the company purchases the shares, will the shares become treasury shares or will they be re-contributed to the ESOP. 

technical advice memorandum (TAM) provides a look at how the IRS views stock distributions, details the steps a company took, and the forms it used, to offer share distributions with an immediate put back to the company.

Net Unrealized Appreciation (NUA)

One significant benefit of offering share distributions is providing the participants with the ability to take net unrealized appreciation (NUA) treatment on their ESOP distribution.  To qualify for the favorable NUA tax treatment, a participant must take an in-kind lump sum distribution (within one tax year) directly from the plan. 

Promissory Notes

In the past some ESOP companies opted to pay their participants with a lump sum share distribution, with the shares immediately put to the company in exchange for a promissory note. The following reasons for exploring this option are:

  • To provide NUA treatment;

  • To comply with the share distribution requirements;

  • To protect the participants from the fluctuations in company stock when they are no longer with the company;

  • To reduce the number of shares in the trust; and/or

  • For other repurchase planning reasons

The promissory note must have a reasonable interest rate and provide adequate security.  Promissory notes secured by a company's full faith and credit are not sufficient to satisfy the adequate security requirements.  The marketplace has changed and it is very difficult to obtain adequate security sufficient to satisfy the IRS requirements. For this reason the promissory note option is rarely used in practice.

ESOP Distribution Form: Cash Distributions

If participants have cash in their accounts, or if you do not want to pay distributions in the form of stock, then you will need to pay distributions in the form of cash. 

If you are paying distribution in cash, where will the cash come from? You will generally need to use existing cash in the plan, contribute new cash to the plan, pay a dividend or S distribution of earnings, establish an exempt ESOP loan, or redeem the shares (which will require a new stock appraisal as of the date of the redemption).  

If you contribute cash, will you have enough IRC Section 404 deduction room to include both the cash for distributions and for contributions for loan payments (if applicable)? 

If you pay dividends or S distributions of earnings, will you satisfy the fair market value requirements?  Will you be creating a haves vs. have nots situation.

ESOP Reshuffling

ESOP reshuffling occurs when the company buys all, or some, of the shares of the accounts of participants that have separated service from the company. The cash is invested in other prudent investments until distribution.  It is also known as segregation of accounts, or cash conversion of accounts. 

Reshuffling prevents former employees from sharing in future gains, and protects former employees from sharing in future losses in the value of the company, and provides them with additional diversification.

This strategy is used by many ESOP companies to manage their repurchase obligation, enabling them to purchase the shares of terminated participants at the current fair market value. This approach essentially speeds up the repurchase obligation to the time of segregation. Assuming an increasing stock value, this strategy accelerates your repurchase obligation in the short-term and reduces it in the long-term.  Reshuffling can also free up more shares for allocation.

Recycle or Redeem

One of the most frequent questions asked by ESOP plan sponsors is whether to recycle or redeem.  This decision ultimately drives the decision to pay distributions in the form cash or shares.  

There are many complexities to creating a distribution policy. The above-mentioned items are only some of the issues and complexities that need to be explored. The importance of a well-planned distribution policy should not be taken lightly.

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Topics: ESOP distributions, Employee Stock Ownership Plan (ESOP)

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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