Should ESOP Trusts Hold Cash?

The Internal Revenue Code, which along with ERISA is one of the main laws that govern ESOPs, requires that ESOPs be “primarily” invested in company stock. ESOPs typically hold assets other than company stock. Sixty-one percent of the companies responding to the NCEO’s 2023 ESOP repurchase obligation survey have cash in the ESOP trust. At most of the surveyed companies with cash in their ESOPs, that cash represents less than 5% of the ESOP’s assets, although 13% of respondents said that cash represented over 20% of the value of their ESOP.

There are a variety of reasons the trust might have cash investments, not just company stock:

• The company is or was less than 100% ESOP-owned. If a company is less than 100% owned by an ESOP and is an S corporation, it normally will make distributions to non-ESOP shareholders so they can pay their share of taxes on company earnings. By law, the company must make pro-rata distributions to all shareholders. That includes the ESOP trust even though it pays no taxes. The trust keeps these distributions and allocates them to employee accounts.
• The company has paid off its ESOP acquisition loan and wants to make a uniform annual contribution to the plan: In a mature ESOP, the ESOP may own all the shares. The only shares going into the loan for new employees come from repurchased shares from terminated employees. Some companies set a target percentage of pay to use as the annual contribution to the plan. If the repurchased shares are not enough to meet this, the company can contribute additional cash.
• The company pays a dividend: Some companies want to pay a cash dividend to the ESOP trust as an added ESOP benefit. The dividends are allocated to employee accounts.
• Employees have opted to diversify: Once an employee reaches age 55 and has 10 years in the plan, the employee must be able to diversify at least 25% of the shares in their account. This increases to a cumulative 50% five years later. The company can just pay that out, but it has adverse tax consequences for the employee. Instead, the money can be moved into the employee’s 401(k) or kept in the ESOP and invested in prudent investments. Some companies offer voluntary early diversification as well.
• Companies segregate accounts at termination: Many ESOPs purchase employee shares when they terminate but do not make a distribution until the distribution becomes applicable sometime later. This is done because the company only wants current employees to be owners, wants to diversify accounts for more senior employees who have terminated, or wants to limit its repurchase obligation if the share price is rising quickly. Segregation has been approved by the IRS.
• Companies want to prefund repurchase obligations: Many companies want to build up some cash reserves so there are funds for future repurchase needs. In a C corporation ESOP, contributions to do this are tax-deductible.

Having cash in the plan is not per se a good or bad policy in an ESOP but rather a facts, circumstances, and corporate philosophy issue.

How the cash is managed depends on a variety of factors. If it is being used for short-term needs for buying stock from former participants, then a conservative approach makes sense. If some or all of the money will not be needed for the mid- to long-term, then a more balanced posture makes sense. If the money is being used in part or in whole to provide more diversification, then it should be managed like any other assets would be in a 401(k) plan. If there is a substantial amount of cash, it is a good idea to create an investment policy and work with an investment advisor.