Section 409(h) of the Internal Revenue Code requires that an employee stock ownership plan (ESOP) participant can demand that their ESOP benefits are distributed as employer stock. It also states that, if those shares “are not readily tradable on an established market, [the participant] has a right to require that the employer repurchase employer securities under a valuation formula.”
This section provides the “put option” that creates the ESOP repurchase obligation (also called the repurchase liability), or RO.
A closely held ESOP company is required to buy back distributed shares from ESOP participants according to the company’s ESOP plan document and ESOP distribution policy.
All this is because an ESOP is a qualified retirement plan. Employees anticipate using distributions to help fund their retirement, so a lot of the benefit’s value rests in employees’ being able to count on payment after distribution. The significant tax benefits of an ESOP are designed to facilitate the employer’s repurchase of participants’ shares.
In this article, we cover best practices for how to calculate the ESOP repurchase obligation.
Why You Need to Plan for ESOP Repurchase Obligations
Repurchase obligations have a major impact on a company’s future cash flow. While newer ESOPs experience less significant ROs, mature ESOP companies that don’t have debt often find their RO is among their largest cash demands.
The ESOP trustee has a fiduciary duty to ensure that ROs are paid in accordance with distribution plans and ERISA requirements. It’s equally important to make sure that repurchases don’t cause the company distress — since continued employment is also in the employees’ best interest. A distressed business is also likely to see its valuation suffer.
Planning for a repurchase obligation ensures that cash needs are addressed in advance. In the case of leveraged ESOPs, this planning also takes into account requirements for ongoing debt payments.
Problems that can arise for ESOP companies that fail to plan for ROs include:
- Increased cost of cash to repurchase shares
- Difficulty securing credit
- Stock price devaluation
- Degradation of company culture if stock values fall
- ESOP trustee fiduciary liability
- Company distress, forced sale, or failure
Repurchase Obligation Planning Starts With ESOP Plan and Distribution Documents
A company’s ESOP distribution policy addresses the timing, form, and method of distributions. Remember: if you don’t have a written distribution policy but you’ve made distributions, you have effectively adopted a policy. Get expert help to document it properly.
Here’s a rundown of the basic rules on timing of ESOP distributions:
- Participants who terminate due to death, disability, or retirement are eligible to begin taking distributions within one year after the plan year of termination
- Participants who terminate due to other separations of service will begin to receive distributions within six years after the plan year of termination (an ESOP loan exception allows distributions to this group to be delayed until the ESOP loan is repaid in full)
- Participants aged 55 with 10 years of participation are eligible to diversify 25% of their account for five years; the diversification percentage goes up to 50% in the sixth and final year
- Distributions generally cannot be forced by the company. However, a company can make mandatory distributions to terminated participants with an account balance of $5,000 or less. If the balance is greater than $1,000, then any forced distribution must be rolled into a safe harbor automatic rollover IRA.
Participants can also be forced to take a distribution if the participant reaches his/her latest commencement date (the latest from among: reaching age 65, termination from the plan, and attaining 10 years of participation) or is required to begin receiving required minimum distributions (for most participants, this is after they reach age 72 and terminate)
- Depending on plan rules, a plan may pay the alternate payee of a Qualified Domestic Relations Order (QDRO) before the plan participant is eligible for a distribution
- In addition to commencing distributions, a plan may effectively speed up the RO if the company employs an ESOP cash conversion strategy (also called ESOP reshuffling) for terminated participants
A distribution policy is built on a foundation of these minimum requirements. From there, it’s built to meet ESOP goals and company objectives, manage cash flow, and control the level of benefit to employees.
Because of the RO’s impact on cash flow, it’s important to consider multiple scenarios when developing the policy.
Developing Your ESOP Repurchase Obligation Forecast Assumptions
A solid forecast starts with accurate assumptions. For an obligation that affects company cash flow, employee morale, and retirees’ futures, spitballing or guessing doesn’t cut it. Consider these key factors that impact the repurchase obligation:
1. Participant groups — Account for compensation, vesting, turnover rates, and employee growth rates. Some companies group employees by job classification or hourly vs. salaried, but groups based on the characteristics listed above tend to get more accurate results.
2. Stock growth rates — This is the most important factor in the study, and the most difficult to predict. The values used should agree with enterprise values used by your appraiser and in your corporate and strategic planning. A best practice is to include the appraiser in the repurchase study process.
3. Employee and eligible compensation growth rates — How many net new participants will be added each year as a result of hiring? At what rate will your eligible compensation increase? Projecting these rates separately is a best practice, and projections should agree with corporate and HR projections.
4. Termination rates — One of the most accurate ways to project future termination rates is to use employment history. Adjust to remove terminations due to retirement, death, and disability to avoid double counting, and account for circumstances that inflate or deflate the projected rates. Consider multiple years and use a weighted average.
These rates should be projected for separate employee groups, as termination rates can vary significantly.
5. Retirement rates — Project when active employees will retire from the company. Many plans use the retirement age of the plan, but it is important that this age comes close to the actual age that most employees retire. The retirement age for key individuals with large balances may need to be adjusted accordingly.
6. Diversification rates — If your plan is less than 10 years old, diversification may be the first major repurchase obligation for the company. Does your plan use the statutory minimum requirements or does it provide more liberal rules?
Many companies assume 100% diversification, but this typically overstates diversification distributions in the short-term and, assuming a continuing growth in stock price, understates the long-term repurchase liability.
A best practice is to monitor the diversification rate from year to year and make regular adjustments.
7. Death and disability rates — Usually, the rates of death and disability are statistically insignificant to an RO study. As an alternative, you could apply a fixed percentage or other actuarial assumptions.
8. Contribution rates and timing — While a loan is outstanding, contributions are made to the plan for loan payments. When the plan pays distributions, a decision will have to be made as to whether shares are recycled or redeemed, and this decision will impact the plan contributions projection.
This discussion becomes even more important when the loan is paid, and leads to a strategic question: what is the target employee benefit level (EBL) that the company wants to provide employees in the long-term?
9. Significant events — Major corporate events such as acquisitions, dispositions, and layoffs affect forecast assumptions.
10. Future share activity, ESOP transactions, synthetic equity — If the plan is not 100% ESOP owned, a study would be incomplete if it didn't account for future share activity inside and outside the ESOP, as well as any other significant draws on equity such as synthetic equity and deferred compensation.
Along with the forecasting assumptions, it’s critical to consider how ESOP-related tax savings and any loan repayment for a leveraged ESOP (including amortization, interest, and release of shares from the suspense account) impact company financials.
Repurchase Obligation Study is a Key Business Planning Tool
The health of your ESOP contributes to the ongoing success of your company. The confidence that comes with knowing you can meet your repurchase obligation can improve leadership effectiveness, increase employee morale, and deliver a range of holistic advantages to business operations.
To address fiduciary concerns and develop reliable RO forecasts, ESOP Partners offers a proprietary ESOP administrations system, ESOP PROS™, which includes in-depth forecasting to accurately project your RO well into the future. That enables our clients to better visualize the RO’s impact on their businesses, and more effectively plan their companies’ futures. Just click the link below to request your consultation and learn more.