Freezing or Terminating an ESOP

Each year, 3% to 4% of all employee stock ownership plans (ESOPs) are terminated; an unknown percentage are frozen, usually because the sponsor wants to create a different kind of benefit plan, wants to recapture some of the ESOP's ownership or, more rarely, has financial problems. Terminating or freezing a plan is a decision that can be made by the plan sponsor, but, in both cases, there are special considerations that need to be taken into account.

Freezing an ESOP

In a frozen plan, further contributions stop, but the plan continues to operate. Employees receive their distributions according to the rules of the plan document. Theoretically, the plan could continue until the last participant receives a distribution. As in all ESOP matters, the ESOP committee or other fiduciary should be careful to document and justify all decisions.

Plans are often frozen in situations where the plan was set up to buy out one or more owners. Once this is accomplished and any loans are repaid, there may be no additional shares to repurchase. Usually, companies recirculate shares repurchased from employees and make further cash contributions to the ESOP. In some cases, however, a company may choose to retire the shares or make them available to other buyers. The ESOP would be frozen to accommodate this. In other cases, a plan may be frozen because the company cannot afford further regular contributions.

At first blush, it may seem that freezing the plan is the simplest step when a company wants to wind down its ESOP. There are, however, a number of problems freezing can create. First, the plan must still be administered, with annual reports to participants and the government. In closely held companies, there must be an annual valuation. Top-heavy rules must still be met. Remaining participants still get to partake in any stock appreciation. Any improprieties in the plan could lead to lawsuits. These additional costs and risks may more than offset the benefits from simply terminating the plan, as discussed below.

Terminating an ESOP

When a plan is terminated, all participants become fully vested and distributions must begin as soon as administratively feasible, generally within a year of the plan's termination. If the stock is put back to the company, however, payouts for the distributions can be made in equal installments with adequate security over five years (or more in cases of distributions over annual benefit limit, which was $975,000 in 2010). It is difficult to obtain such security, however, so this would be very rare. Participants must have the right to receive their distribution in stock if they so choose unless the plan calls for cash distributions and all or substantially all the company's stock is owned by employees. Alternatively, the company can effectively terminate the ESOP by merging it into a successor plan in the current company or an acquiring company, such as a 401(k) or profit sharing plan.

ESOPs are merged into another plan by combining the assets for each account balance into a new account balance in the surviving plan. The surviving plan can retain company shares, subject to the fiduciary requirements of the new plan. Generally, this requires a stricter standard of prudence for holding shares. There are several requirements that must be met when an ESOP is merged into another plan:

1. The sum of the account balances in the plans must equal the fair market value of the assets of the surviving plan on the date of the merger or consolidation;
2. The participants' balances in the plans that survive right after the merger must be equal to the sum of the participants' account balances (individually determined) in the plans just before the merger;
3. Special rights attached to the ESOP shares for distribution options must be maintained, including the right to demand distribution in shares for that portion of the account balance and the put option. Voting rights, however, would not have to transfer.

Terminating a nonleveraged plan or a leveraged plan where the loan is fully paid is usually relatively simple. The amounts that are allocated are paid out directly to participants or rolled over into a successor plan. One possible complication occurs if the seller has used the tax-deferred rollover provisions or the lender has used the interest income exclusion provisions. Excise taxes may apply in these cases if plans are terminated too soon.

In any termination there are fiduciary issues. The plan sponsor has the right to terminate the plan, but fiduciaries must decide at what price and on what terms. Shareholders or corporate insiders have a clear conflict of interest situation if they or their employer are repurchasing shares or selling the company. Either an outside trustee should be appointed or, at the very least, qualified, independent advisors should be enlisted. A new valuation should be performed, one that might change some of the assumptions in the previous valuation. For instance, if the buyer will obtain control by buying ESOP shares, a control price may now be appropriate. Marketability discounts may no longer apply as well.

Terminating a leveraged plan where the loan has not yet been repaid is more complicated. To repay the loan, the company must reacquire the shares or sell them to another buyer. If the shares are not at a price that repays the remaining amount, the company makes up the difference; if selling the shares results in more cash than is needed, a more complicated situation arises. An amount equal to the basis paid for the shares divided by the proceeds of sale, multiplied by the excess after the loan is paid off, must be allocated to employee accounts on the basis of their relative share balances. In other words, any windfall from the shares goes to employee accounts.

Termination or freezing a plan is not a decision to be taken lightly. This article has only touched on some of the basic legal issues. Competent legal advice is a must.

For more detailed information on this topic, see our publication Terminating an ESOP: Valuation and Fiduciary Issues.