Changing Circumstances: How You Can Change ESOP Distributions

Many companies are looking at changing their distribution policies in light of the economic crisis.
So what can you do?

The first critical rule is “what does your plan allow?” Some companies have their distribution and diversification rules in their plan documents; others have a plan document that allows a designated group (the board or the ESOP admini-stration committee, typically) to develop a written distribution policy that
allows more flexibility. Most commonly, the plan will be written to allow the maximum allowable delay in distribution and diversification requirements, but the written policy will provide for a faster approach. For instance, the company may start distributions three years after termination or pay out everyone with an account balance under $50,000 right away. A company might also allow for earlier diversification on a regular or one-time basis. These policies should have language, however, that states that the company can pay out later than the policy states if doing so would endanger the financial health of the company and can be done in a way that does not discriminate in factor of more highly compensated employees. This exception should be one that is rarely chosen and be for well-documented reasons.

If your rules are hard wired into your plan and provide for earlier than the maximum allowable payout, it is unlikely (and we think inadvisable) that they can be changed without violating ERISA anti-cutback rules, although there are some advisors who take a more flexible approach.

Similarly, plan language will describe whether payouts are in a lump sum or in installments and whether the payout is in cash or stock. Cash distributions are often made in a lump sum; stock distributions are often in installments. Cash distributions can be made all at once or in installments of up to five years with interest. In the latter case, the employee gets one-fifth of the shares each year at their fair market value that year. Here the law does allow more flexibility, and this may be very useful in these circumstances. The form of distributions is not a protected benefit, so you can switch from cash to stock. If your stock price will be dropping, this means your repurchase obligation will as well. This would not be allowable for an employee whose distribution in cash installments had already started, although not all practitioners agree.

If you make this change, though, you may have some unhappy employees, so explaining why it is necessary honestly and with numbers is essential. Don’t just make the change and not explain it because doing so is uncomfortable.

Employees should also be clear that the law allows them two 60-day put option periods to sell back their shares. You can extend that period if you want. This may be very important now. An employee who leaves in 2021 will likely be looking at a reduced share price, but at least have the prospect of a recovery. By waiting, the employee may be better off and the company can avoid a short-term cash drain. You cannot advise people on their financial choice, but you can explain the options and discuss the company’s recovery plans.

A more counterintuitive strategy is to encourage early diversification. Some companies may have the cash to offer this and have employees who are concerned about the current economic uncertainty. Given what may be lower current stock prices, the shares can be repurchased and reallocated to other employees at a lower price. In addition, if the money is put into a 401(k) plan in the company, it is easier for the employee to borrow against this plan or withdraw funds (few ESOPs allow either) to access current cash to meet financial needs.

Special Provisions Under the CARES Act for Employees Affected by the Virus

The CARES Act allows “coronavirus-related distributions” from retirement plans, including ESOPs. Distributions under this act can be made to employees who are diagnosed with SARS-CoV-2 or COVID-19, whose spouse or dependent is diagnosed with the virus or disease, or any individual who experiences adverse financial consequences resulting from quarantine, furlough, being laid off, a reduction in work hours, or being unable to work because of a lack of child care. Unlike normal early distributions, these are not subject to the 10% early distribution tax. The distributions may be made between Jan. 1, 2020, and Dec. 31, 2020. Distributions are limited to the lesser of $100,000 or 100% of the participant’s account balance. The distributions can be repaid to the ESOP or another qualified plan, without interest, within the three-year period starting the day after the participant receives the CARES distribution. If not repaid, the CARES distributions are subject to income tax.

ESOPs companies can choose to implement this plan for their ESOP and/or other retirement plans. If they choose to do it for the ESOP, it could be in shares that can be put back to the company or in cash. It may be difficult to determine at what price the employee would repay the loan if buying back shares as opposed to putting cash in a retirement plan.

Companies can also postpone all required minimum distributions that are scheduled to be made in 2020, and postpone all required beginning dates that would occur in 2020 by one year, i.e., until April 1, 2021. This change needs to be added to your plan language.