Take Stock of Your ESOP Distribution Policy

It’s plain and simple: if your company’s Employee Stock Ownership Plan (ESOP) lacks a distribution policy, there may be no defined rules for when and how participants are paid from the plan. A distribution policy is a key component of an ESOP and should include timing, method, and form of payment.

Committee of Stakeholders

Developing an ESOP distribution policy begins by gathering a committee of company stakeholders – representatives from the executive team, human resources, shareholders and trustees. This policy group should focus on developing a well-written ESOP distribution policy that considers the employee benefit, ownership and corporate objectives, and their relative importance. An ESOP distribution policy:

  • Provides details for distribution to participants
  • Ensures adherence to legal requirements outlined in the plan document and the Internal Revenue Code (IRC)
  • Ensures the method of payment is nondiscriminatory and nondiscretionary
  • Simplifies administration of the plan
  • Aligns distributions from the plan with the company’s financial objectives
  • Supports the company’s philosophies and ESOP culture 

Ultimately, the committee will set rules related to when and how ESOP participants will be paid from the plan.

Take Stock of Your ESOP Distribution Policy

Timing of Payment

As the committee weighs the timing of ESOP benefits, one of the guiding factors should be based on the company’s overall goals and objectives. Deferring payments until the required deadline:

  • Allows for a longer planning horizon
  • Slows the reallocation of shares and repurchase obligation
  • Reduces the incentive participants may have to quit in order to gain access to their ESOP benefit

The committee may choose to provide immediate payment of ESOP benefits to participants who have terminated employment. Immediate payment allows the organization to:

  • Remove stock from accounts of terminated participants
  • Allocate shares to newer employees sooner, which addresses “have/have not” concerns typical in more mature ESOPs
  • Ease administration of the plan

Whether the committee opts to defer ESOP benefit payments or make them immediately upon the participant’s termination, it’s important to follow IRC regulations (IRC §409(o)) for ESOPs which set specific rules for distributions due to death, disability or normal retirement, as well as termination for any other reason.

In the event of death, disability or normal retirement, participants are entitled to ESOP benefits no later than one year after the end of the plan year in which the event occurs. A participant who retires in 2020, is entitled to payment of their ESOP benefit before December 31, 2021.

For participants who terminate employment for any other reason, benefits must be provided no later than six years after the end of the plan year in which the event occurs. A participant who terminates employment in 2020, is entitled to their ESOP benefit before December 31, 2026.

There are additional ESOP distribution rules (IRC §401(a)(14)) that must also be applied, including:

  • Age 65 or the plan’s normal retirement age (if earlier)
  • 10th anniversary of the date the participant entered the ESOP

In some instances, a participant’s request to delay an ESOP payment may be permissible. For example, an employee may wish to delay receiving their payment under the IRC’s required minimum distribution rules (i.e. attainment of age 72), instead of age 65. Rules addressing these delays should also be addressed during the formulation of the distribution policy.

Method of Payment

The ESOP distribution policy establishes the method of payment for the benefit: lump-sum, installments or alternative options based on the participant’s account balance. In accordance with IRC §409(o), installment payments should be:

  • Substantially equal payments
  • Made at least once per year
  • Fully paid within a five-year period (large balances can be paid over an additional five years)

The policy may also provide an option to make lump-sum payments for balances that are below a certain threshold (e.g. $10,000 or $20,000) and installments for balances above the threshold.

The committee should consider the company’s objectives as it chooses the ESOP payment method.

Installment Payments:

  • Help spread the overall distribution funding requirements over a longer horizon
  • Contribute to smoother plan benefit levels

Lump-Sum Payments:

  • Limit terminated participants from receiving future S-distributions/C-dividends
  • Help concentrate the shares held in the plan to primarily active employees

Form of Payment

The ESOP distribution policy should also define the form of payment – cash, stock or a combination. IRC 409(h) provides specific distribution rules for ESOPs, including participant rights to demand distribution in the form of employer securities and (if not readily tradable) have the employer repurchase the shares at a fair valuation.

Mandatory cash distributions are permissible in certain instances:

  • S Corporation ESOPs
  • When an employer’s charter or bylaws restrict substantially all ownership to the ESOP or current employees
  • Bank ESOPs

Just as the timing and method of the ESOP payment align with the company’s objectives, the form of payment should also be set with the organization’s goals in mind. When payments are made in stock:

  • Shares are distributed and redeemed by the company (Payment is either a lump-sum payment or installments backed by a promissory note, which must be adequately secured by the company)
  • Participants may be eligible for capital gains treatment on the difference between the market value and their cost basis (net unrealized appreciation (NUA))

If cash is the chosen form of payment, the distribution funding will typically consist of employer contributions to the ESOP or through S-distributions/C-dividends.

Other Considerations

While the ESOP distribution policy committee will focus primarily on the timing, method and form of payment, the group should also address these topics which may impact plan distributions:

  • Account segregation
  • Qualified Domestic Relation Orders (QDROs)
  • Events after termination
  • Forceout distributions
  • Diversification

Questions about ESOP Policy Distribution? Contact the Findley consultant you normally work with or Aaron Geibel in the form below.

Published June 3, 2020

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Copyright © 2020 by Findley, Inc. All rights reserved.

The DOL and ESOP Trustee: There’s No Love Lost

If you eavesdrop on any conversation between an ESOP-experienced ERISA attorney and an ESOP trustee, you’ll likely hear this question: “When do you think the DOL will let up?” The truth is that the end is not in sight. For most of the last decade, the DOL has outpaced ESOP participants to the courthouse.

In this environment, what is an ESOP trustee to do? Many ESOP experts will tell you that understanding the recent court judgments and settlement agreements is the most important next step. These documents are where an ESOP trustee will find nitty-gritty guidance regarding the ERISA fiduciary process that the DOL apparently expects of ESOP trustees. Never mind that these judgments and agreements are supposed to bind only the DOL and the particular ESOP trustee involved. Never mind that this same guidance cannot be found in applicable regulations. ESOP trustees and attorneys report that in recent DOL audits, trustees have even been asked whether their process follows the “GreatBanc Agreement”. In effect, the DOL is regulating via litigation and investigation.

The impact of DOL settlement agreements

Since the DOL and GreatBanc Trust Company disclosed their settlement agreement in the summer of 2014, other agreements have followed, each adding their own wrinkles. The DOL’s public disclosure of these agreements announces the fiduciary processes it expects of ESOP trustees not only in a transaction setting, but also in annual valuations conducted in routine plan administration.

The protocols outlined by these agreements focus on (1) the valuation advisor’s independence, (2) the qualifications of the valuation advisor and (3) the valuation report. While the categories are broad, the requirements enumerated are detailed. And it is these detailed requirements that have caused ESOP trustees and advisors to significantly alter their practices.

Required independence of the valuation advisor

The agreements establish new requirements to ensure the independence of the valuation advisor,  include prohibiting an ESOP trustee’s use of a valuation advisor who had previously worked for any other party to the transaction other than the ESOP or the trustee. The prohibited work includes preliminary valuations for a company thinking about establishing an ESOP.  ESOP trustees must now document an exhaustive fiduciary due diligence process to evaluate valuation advisors, not only for their qualifications, but also in light of their own history and the history of every party to the transaction to demonstrate that there are no conflicts of interest.

Documenting the evaluation and selection of the valuation advisor

The agreements set out requirements for a formal, documented due diligence process for evaluating and selecting the valuation advisor, including the requirement to produce a detailed written report of how a particular valuation advisor was chosen. The analysis expected by the DOL must include:

  • The reason for the selection of the valuation advisor,
  • Who else was considered,
  • A discussion of the valuation advisor’s qualifications,
  • A list of at least three references,
  • Whether the valuation advisor was the subject of prior criminal, civil or regulatory proceedings, and
  • Why the selection was prudent.

If an ESOP trustee chooses to use the same valuation advisor in a subsequent transaction, the evaluation and selection process must be repeated if the last documented selection process is more than 15 months old (as stated in the GreatBanc agreement), or if the selection process was prior to the calendar year that precedes the new selection (as stated in the First Bankers Trust agreement).

The valuation report

With respect to the ESOP trustee’s oversight of the valuation itself, the agreements contain a long list of required reporting and disclosure for any valuation report relied upon by an ESOP trustee. The list includes:

  • Identifying the individuals responsible for providing projections and if they may have had any conflicts of interest as to the ESOP transaction,
  • Documenting why the projections, and all assumptions used in the projections, are reasonable in light of the ESOP sponsor’s five-year financial history,
  • Documenting if any of the metrics used to determine the projections were ignored,
  • Describing any adjustments applied to the ESOP sponsor’s historical or projected financial statements,
  • Describing how the plan provisions and demographics of the ESOP sponsor’s employees affect the prospective repurchase obligation,
  • Describing the risks facing an ESOP sponsor that could cause the company’s financial performance to fall short of the projections,
  • Analyzing whether the terms of any loan received by the ESOP in connection with the transaction are at least as favorable as any loans given to the ESOP sponsor’s executives by the company in the two years prior to the transaction, and
  • Explaining the differences between the current valuation and the most recent valuation of the ESOP sponsor performed within the prior 24 months by any valuation firm for any purpose.

These DOL expectations described in the agreements will likely drive up the cost for a compliant valuation report and limit the ESOP trustee’s choice of a valuation advisor, which may in turn raise the cost of the ESOP valuation significantly.

Documenting the valuation report review

The lessons from recent DOL lawsuits and agreements provide additional guidance for ESOP trustees — and additional work – in evaluating projections used in the valuation and the determination of other factors affecting the valuation.

This means that ESOP trustees must ensure that every aspect of a valuation report’s description of projections is reasonable. Merely following every provision of the agreements concerning projections may not be enough. The DOL wants to see that ESOP trustees are challenging the assumptions used and projections to make sure they are solid, which means documenting their thorough review and understanding of the report. The ESOP trustee must also scrutinize all other factors, including the valuation advisor’s assessment of control value, the potential dilution created by synthetic equity, and the choice of public companies that are truly comparable peers if they were used in establishing the valuation.

The bottom line is that ESOP trustees must now not only hire competent valuation advisors, they must challenge their valuation reports. The DOL expects to see an ESOP trustee engage with the valuation report and advisor and to document that engagement. Such engagement lengthens the timeline for an ESOP transaction or a routine annual valuation. Again, the costs of the transaction and the valuation will likely be higher, reflecting the significant additional work now required.

What’s in store for ESOP trustees

There appears to be no end to the DOL’s national enforcement initiative targeting ESOP trustees. In an environment in which ESOP trustees are under increasing DOL pressure to be omniscient (when it comes to all of the players in an ESOP transaction) and prescient (when it comes to the future financial health of the ESOP sponsor), it is little wonder that some ESOP trustees are considering hanging up their ESOP fiduciary hats. That result would be a shame for good companies that want to transition ownership to their employees and provide for their retirement benefits at the same time. The DOL’s actions appear to be resulting only in fewer ESOP trustee options, higher costs and, ultimately, discouraging employee ownership.

Recommended action steps for ESOP trustees in light of DOL actions

  • Arrange for an audit of your processes as a trustee:
  • Determine whether trustee meetings are appropriate in frequency and length,
  • Determine whether the minutes from trustee meetings are sufficiently detailed to assure the DOL that you meet their standards,
  • Confirm that interactions with valuation advisors, legal counsel and other service providers, outside of meetings, is documented and the notes retained,
  • Confirm that your valuation advisor receives complete, accurate and current information from the company necessary to value the employer securities, and
  • Confirm that the examination and acceptance of valuation reports are documented in detail, including any trustee questions and advisor responses
  • If you haven’t already done so recently, revisit the qualifications of your valuation advisor:
  • Document your current knowledge of its qualifications and experience,
  • Require written confirmation of no conflicts of interests,
  • Require written confirmation of (or absence of) prior criminal or regulatory proceedings,
  • Arrange for peer review of valuation reports, if the advisor is less well known, and
  • Confirm that the advisor is familiar with the DOL’s standards for ESOP trustees, and is prepared to comply with your requirements

Posted August 21, 2018

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Main Street Loves ESOPs . . . And So Does Congress!

The Main Street Employee Ownership Act (MSEOA), signed into law on August 14, 2018 (as part of the John S. McCain National Defense Authorization Act), eases the way for small companies to establish employee stock ownership plans (ESOPs). The Act allows the Small Business Administration (SBA) to loan a company up to approximately $5 million for purposes of establishing an ESOP. The company in turn would loan the SBA-guaranteed funds to its newly established ESOP to purchase company shares. As much as 85% of the loan can be guaranteed by the SBA. In addition, the Act empowers the SBA to assist small business owners in establishing the ESOP through outreach and training programs.

At this point, it is unclear how many small businesses can, and will, take advantage of this new resource. What is clear is that Congress has sent a strong message that it endorses employee ownership through an ESOP. This is welcome news in light of recent concerns that the Federal government might see ESOPs as a source of revenue, by limiting the tax advantages offered to these plans. The National Center for Employee Ownership notes that the Main Street Employee Ownership Act “is the most significant change in employee ownership law since the series of laws that allowed ESOPs to be shareholders of S corporations in the late 1990s and early 2000s.” ESOP companies have emphatically made the point to their Congressional representatives that ESOP companies are generally more profitable than non-employee owned companies, and provide meaningful employment.

Even though MSEOA (the Congressional acronym people needed to do a better job on this one) may entice banks to offer loans to smaller companies to set up an ESOP, we continue to advise business owners to perform careful due diligence before entering into any ownership transition arrangement, including an ESOP. A company whose success hinges on a key employee or one major client faces huge risks in establishing an ESOP, and these factors should be reviewed carefully with competent ESOP counsel. While the flexibility provided to the Small Business Administration by the MSEOA can be a powerful tool for companies considering an ESOP, and may sway a decision, it should not be the primary consideration in establishing an employee stock ownership plan.

For more information, contact Alex Grasser at 502.253.4636 or Alex.Grasser@findley.com; Sheila Ninneman at 216.875.1927, Sheila.Ninneman@findley.com; or the Findley consultant with whom you normally work.

Posted August 21, 2018

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ESOPs: The Good, the Bad, and the Ugly

Employee Stock Ownership Plans (ESOPs) are unique among retirement plans. An ESOP merges the tax benefits of a qualified retirement plan with corporate finance, and aligns employees’ retirement benefits with corporate goals. This combination of tax favored employee and corporate benefits is complex, but with planning and an expert team of advisors, it can be a win-win scenario for both employees and employers.

This paper examines the benefits of ESOPs to both the employer and the employee.

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ESOPs: The Good, the Bad, and the Ugly

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