How ESOP Companies Handle the Repurchase Obligation

From "The ESOP Repurchase Obligation Study"

In any kind of forecast, it is very helpful to reorganize the data into groups in some way that makes tracking possible.

Since this method is a largely statistical process, some sort of grouping methodology is a good idea in order to make the data more manageable. We have found it useful to group employees on the basis of the factors that best predict their eventual account balances in the ESOP-the interaction of compensation level and length of service.

The mechanics of this process start with the assignment of a relative score between zero and one (basically a percentile ranking) to each active employee in the population on each of the two characteristics (i.e., vesting service and compensation). So if your highest-paid employee has eligible pay of $200,000 and your lowest has eligible pay of $20, on a scale of zero to one, the $20,000 employee is 0 and the $200,000 employee is a one. A $50,000 per year employee would be approximately a 0.25. On service, if your tenure pattern for participants ranges from one year to 25 years, service of 15 years would be approximately 0.6, while service of five years would be about 0.2. If you use Excel, or something like it, the program provides an automatic function that will provide these rankings. In any case, the resulting scores are then combined so that you have a score for each employee in your census that falls between zero and two.

From "The ESOP Repurchase Obligation in S Corporations"

This tax advantage affects the repurchase obligation of S corporation ESOPs through both participant balances and the funding options available to the company. With regard to participant balances, to the extent that the company retains tax savings as cash or uses them to invest in the growth of the company, the fair market value of the company's stock will increase above the growth it would have otherwise experienced. Since the repurchase obligation for any particular year is based on the value of shares that must be distributed, this increase in value increases the repurchase obligation.

The second way the S corporation election can affect the repurchase obligation differently than a C corporation election is the creation of two categories of participants, the "haves" and the "have nots" (or, at least, the "have much lesses"). Without careful planning, two classes can easily form in mature ESOPs that own less than 100% of the sponsoring S corporation, as well as in some 100% S corporation ESOPs. S corporations typically distribute funds to non-ESOP shareholders so that those shareholders can pay income taxes due on the S corporation income attributed to them. Such S corporation distributions must be paid in the same per-share amount to all shareholders. In a mature ESOP, all of the stock has often been allocated, so the S corporation distributions are allocated only to participants who already possess stock balances, with the majority going to long-term participants. Furthermore, since an often-significant amount is flowing from the company to the ESOP as S corporation distributions, once the ESOP is no longer leveraged or no longer acquiring shares through cash contributions, the company often reduces or eliminates employer contributions to the ESOP. Contributions are generally allocated based on compensation and, consequently, go to both new and long-term employees. In the absence of such contributions, the only assets allocated to new participants are reallocated forfeitures. Even if cash contributions are not eliminated, barring any of the approaches discussed below, more junior employees will only have shares that are reallocated from plan participant forfeitures or from shares repurchased and reallocated by the plan. S corporation distributions may still end up largely bypassing these employees.