To 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.
There can be some flexibility in the method of ESOP distributions. Most plan documents will indicate distributions can be made in lump sums or installments.
ESOP Distribution Method: Lump Sum Distributions
The Internal Revenue Code provides that an ESOP can pay distributions in a lump sum.
Paying distributions in a lump sum will accelerate the company’s ESOP Repurchase Obligation, will protect former employees from sharing in future losses in the value of the company, and allow current employees participants to share in the potential growth of the company.
Distributions generally take place as soon as possible after the latest stock price has been finalized by the independent ESOP appraiser and established by the ESOP trustee and the annual ESOP administration has been finalized. In order to minimize the administrative burden, many companies process distributions in distribution window(s) following the completion of plan year administration. If eligible participants do not request a distribution during the provided time periods, they will not be provided another opportunity for a distribution until the next plan year.
ESOP Distribution Method: Installments Distributions
The Internal Revenue Code also provides that an ESOP can pay distributions in substantially equal payments over a period not longer than 5 years.
For balances greater than a certain threshold ($1,330,000 in 2023), the company can increase the number of installments paid to participants. For each additional increment ($265,000 in 2023), an additional year (up to 5 additional years) can be added to the payout period.
Paying distributions in installments will enable the former participants to continue to participate in the ownership of company stock to the extent stock remains in the participant's account. This will have an impact on the company’s ESOP Repurchase Obligation.
ESOP companies can use one or both distribution methods, depending on the reason for termination (e.g. death, disability, retirement, other separation). The distribution policy should clearly define the method for each situation so there is no uncertainty.
The method of distributions can also be amended and there is an exception to the anti-cutback rules of IRC Section 411(d)(6) to provide ESOP companies with more flexibility. That being said, changes must be made in a nondiscriminatory manner and you should work closely with your ESOP counsel and advisors before making changes that could be perceived as a “cut-back”.