Employee Ownership Q&A: September 2022
Q: We are a professional design firm operating in several states and a new ESOP. One of the states requires that to be licensed in the state, the company has to be owned by licensed professionals. We have an independent trustee for our ESOP. How do other companies deal with this?
A: This issue comes up a lot for architecture, engineering, and design firms. New York just passed a bill that allows ESOPs to qualify under state professional corporation ownership requirements. It had been one of the toughest states for ESOPs in this field.
In many states (now including New York), as long as the trustee is a licensed professional, the company can operate as an ESOP. ESOP attorneys have given us varying advice on what to do in those states where it has been more challenging. For instance, one approach is for the ESOP-owned firm to facilitate formation of a separate licensed-engineer-owned professional corporation (PC) and to pay “manage-ment fees” to the ESOP-owned firm that effectively repatriate revenue to the ESOP-owned firm. Potential pitfalls are payroll paid through the separate PC firm that doesn’t show up as eligible compensation in the ESOP company and orders of magnitude where the non-ESOP firm becomes very significant part of the business relative to the ESOP-owned firm.
A second approach is one in which an engineer licensed in that state owns one share. After a stock split, the engineer who owns the single share, which represents a fraction of outstanding shares, registers the company. Of course, this requires a K-1 and the recognition by the engineer of some amount of income. This same approach may work for an accounting firm that sets up an LLP that contracts the work. Partners in the LLP are assigned some portion of both revenues and costs.
An alternative has been to appoint the engineer(s) licensed in the relevant state(s) as the trustee(s) who register the company in the state(s) involved. The trustee then enters into a delegation agreement with the normal company trustee under which the latter assumes all fiduciary (and in some cases voting) responsibility. The trustee(s) remains the legal/record owner of the stock. The states where this approach has been used (OH and NC) have not objected to this approach.
Q: We have an ESOP that will soon be making diversifications. We don’t have a 401(k) plan. What are our options for diversifying?
A: First, it makes sense to consider adding a 401(k), even if the company does not fund it. You can then use the 401(k) for ESOP diversifications, of course, but another advantage is that employees like these plans and there are many low-cost options to add them. If you do not set up a 401(k), you can just give the cash to employees. They can roll it into an IRA. If they do not, the amounts are taxable (and subject to a 10% penalty if they are 59½ or younger). You can also offer at least three prudent investment options in the ESOP. This will add administrative and reporting requirements that can be costly, however.
Q: Our ESOP provides that we don’t have to start making distributions until our ESOP loan is repaid. It is a 15-year loan and we have seven years to go. So can we wait to make distributions for everyone?
A: Not exactly. The general retirement plan rules state that you have to start making distributions earlier to some people. Distributions must start no later than the 60th day after the end of the plan year in which the later of these events occur: (1) the participant reaches age 65 or, if earlier, the plan’s normal retirement age; (2) the participant’s employment terminates; or (3) the participant reaches the 10th anniversary of participating in the plan. Even though you can wait for other people, it is usually not prudent, especially if your stock price is doing well. You will just end up with a growing obligation and at least some employees who think the ESOP is not all you claim it to be.
Q: We plan to have an outside trustee. We are thinking of making the trustee a directed trustee. Is this a good idea?
A: The idea in having an outside trustee is to reduce fiduciary liability and get expert advice, and having a directed trustee may impede both of these benefits. ERISA assigns fiduciary responsibility to the person or persons who effectively make a decision or cause a decision to be made. In the case of a directed trustee, typically either the board of directors, an ESOP fiduciary committee (usually made up of officers of the company), or, much more rarely, a single officer of the company actually provides directions to the trustee. These decisions involve such matters as voting the shares (expect for any issues where participants have pass-through rights), selecting an appraiser, approving the ESOP valuation, making shareholder decisions on a takeover offer, buying or selling shares, and various plan operational issues.
Courts have also interpreted fiduciary responsibilities to include actions that can cause a directed trustee to take an action even in the absence of a specific direction, such as if the directed trustee is provided improper or misleading information when it reviews a valuation report and makes a recommendation on the fiduciaries. If a directed trustee receives direction from the actual fiduciary that the trustee think is contrary to ERISA or the plan documents, then they are supposed to override the direction. So it is not clear that being directed will prevent the trustee from making a decision you might not like if the issue is controversial. In the meantime, you have taken on more fiduciary responsibility.