ESOP Operational Issues
Distributions to Former Participants in Company Stock (Part 1)
October 7, 2009The topic of my last column touched on the subject of tracking the cost basis of shares owned by an ESOP. The determination of cost basis is relevant when a distribution is made from the ESOP to a former participant in the form of shares of company stock. Perhaps that column led you to wonder why a distribution might be made in shares of company stock instead of cash, especially if your company is an S corporation. I will attempt to answer that question in general terms. There are a myriad of legal and other issues that you would want to review in detail with your ESOP advisors if you like the idea of distributing in the form of shares of stock.
One of the general rules applicable to ESOPs is that a participant has the right to demand that his or her distribution be made in the form of company stock. There are exceptions to this general rule. If the charter or by laws of the company restrict ownership of substantially all of the stock to employees and the ESOP or if the company is an S corporation, then the ESOP can distribute in cash and the participants do not have the right to demand company stock. Unless one of the exceptions applies, the participants in your ESOP have the right to demand the distribution be made in the form of company stock. (Note, if a person chooses a distribution in the form of company stock and such stock is not readily tradable, he or she must be provided with the option to put (i.e., sell) the shares back to the company.)
Even if one of the exceptions is available, there may be situations where it is desirable to distribute in the form of company stock, even if your company is an S corporation. As outlined in my last column, the taxation of a distribution in shares can be advantageous to the former participant so that might be one reason to allow share distributions. More typically, the desire to distribute in shares is part of a strategy for dealing with the ESOP's repurchase obligation and/or a have vs. have nots situation.
If a cash distribution is made from the ESOP, then such shares are recycled back among the accounts of former participants. A cash distribution also requires the existence of cash within the ESOP at the time of the distribution. One strategy for dealing with the ESOP's repurchase obligation is to retire the shares as opposed to recycling them. This may be done to minimize the future obligation by removing those shares from the ESOP. Or it may be done because there is not sufficient cash in the ESOP to recycle all such shares and the company is not able to contribute enough cash due to the contribution limitations.
So a possible solution that may be proposed is to have the company buy shares directly from the ESOP as this may be perceived as preferable to distributing shares to former employees. However, the prohibited transaction rules come into play because this would be a transaction between a qualified plan and a related party. In order to qualify for the exemption to the prohibited transaction rules allowing this type of transaction, the value of the stock must be determined as of the transaction date, not as of the most recent valuation date. Also, certain S corporations may not be able to buy shares back from the ESOP without triggering a prohibited transaction even if the valuation is determined as of the transaction date.
So to avoid the cost of an interim valuation of the company stock or for those S corporations that may be prohibited from buying stock from the ESOP, an alternative solution may be to distribute shares to the former participants. In certain cases, these distributions can be made subject to the requirement that the former participant immediately sell the shares to the company. The result is that the objective of retiring the shares can be realized.
There are other strategies and issues that should be considered; I plan to address them in my next column.