Back to Basics: An Overview of ESOP Repurchase Obligations

One of the main purposes of an ESOP is to provide benefits to the participants. Because an ESOP holds assets that consist primarily of stock of the sponsoring company, there must a mechanism for participants to realize the value of the stock that is held on their behalf or the benefits would be meaningless. If the stock is publicly traded, this mechanism exists in the public securities markets. If the stock is not publicly traded, then Section 409(h) of the Internal Revenue Code (the "Code") requires that the company sponsoring the ESOP must buy the stock back from participants who receive distributions from the plan. This is accomplished by a "put" option, which entitles participants to require that the corporation buy back the stock at fair market value as determined by an independent appraiser. The put option can be exercised during a 60-day period that begins on the date of distribution, or during a similar 60-day period one year later.

An additional requirement for ESOPs, designed to protect participants from the investment risks of lack of diversification, is that participants have the right to diversify a portion of the company stock allocated to their accounts beginning at age 55, with 10 years of participation in the ESOP. (See Code Section 401(a)(28)(B); a participant can diversify up to 25% of his or her company stock account during the five years beginning when the participant reaches age 55 and has 10 years of participation in the plan. At age 60 [with 10 years of participation] the participant can diversify up to 50% of his or her company stock account.) The obligation to honor the "put" option and the obligation to provide cash to the ESOP when participants exercise diversification rights are usually referred to together as the ESOP "repurchase obligations."

The timing and magnitude of a company's repurchase obligations depends upon the provisions of its ESOP plan document, the demographics of its employee population, and the value of its stock.

The plan provisions that have the greatest impact on repurchase obligations are those relating to the timing and form of distributions from the plan, and the vesting schedule. Ideally, the impact that plan provisions will have on repurchase obligations should be considered at the time the plan document is being drafted, because there are certain limitations on the changes that can be made after the plan has become effective.

The Code requires that distributions made because of retirement, death or disability begin no later than the end of the plan year after the year in which the event occurs. Distributions due to termination of employment can be delayed for an additional five years or until an ESOP loan used to acquire the stock has been repaid, if later. (See Code Sections 401(o)(1)(A) through (C).)

Distributions can be made in installments over a five-year period (or longer, for certain large accounts). An ESOP plan document can provide for distributions to occur sooner than required by the Code. For example, the plan can provide for immediate distributions and for lump sum payouts instead of installments, but this will accelerate the repurchase obligations. Distributions that are made when a participant elects diversification rights must always be made in a lump sum and cannot be delayed.

Unless the corporation's bylaws limit stock ownership to current employees, a participant has the right to demand that he or she receive distributions in company stock. The participant can then exercise the "put" option and sell the stock back to the company. If the distribution was made for reasons other than the exercise of diversification rights and the stock was distributed in a lump sum, the company can pay for the stock with an interest-bearing installment note, which must be adequately secured. If the bylaws restrict ownership of the stock, or if the participant doesn't demand that the distribution be made in stock, the distribution can be made in cash. To provide the liquidity needed for the distribution, the company can contribute cash to the ESOP, or the company can buy shares back from the ESOP trustee. There are a number of factors that should be considered in deciding the best way to handle these mechanics, which have been the subject of prior columns.