ESOP Operational Issues
Distributions to Former Participants in Company Stock (Part 2)
November 9, 2009Another situation that may lead a company to decide to make stock distributions from its ESOP is if the company is concerned about a haves vs. have-nots situation within its ESOP. The haves vs. have-nots situation exists when the longer-term employees have significant share balances but newer employees do not have many shares in their accounts. This typically occurs because the original securities acquisition loan(s) have been paid off and there is no longer a pool of shares to allocate each year.
The company would like to recycle the shares of the former participants but would like to have the reallocation of the shares occur over a period of years rather than all in one year. This will allow future participants to take part in the reallocation of these shares. This may also result in a more sustainable level of benefits to the ESOP participants (e.g., annual allocations of 5% of compensation instead of 20% of compensation) .
One way to accomplish this is to have the ESOP borrow the funds needed to buy such shares from the terminated accounts. However, the IRS regulations on such securities acquisition loans provide that the purpose of the loan must be to either (1) acquire shares or (2) repay an existing securities acquisition loan. If the ESOP is acquiring shares, there is an assumption that such shares were not already owned by the ESOP. In other words, a loan made to the ESOP to allow it to make cash distributions to former participants may not be a securities acquisition loan since the ESOP never relinquished ownership of such shares. The shares should leave the ESOP trust, even if for only a moment, for the ESOP to be able to reacquire such shares with a loan.
The distribution in the form of company stock accomplishes that result. The former participants receive their distributions in the form of company stock and then such former participants sell those shares back to the ESOP. The ESOP incurs a loan for the amount of the purchase. Thus, the ESOP has become leveraged again. As the ESOP makes its payments on the loan, the shares will be released and allocated. The result is that there is a new pool of shares that can be allocated to all participants, including new participants who may not have been employed at the time of the initial securities acquisition loan(s).
This strategy may also help with the ESOP's repurchase obligation as it slows the reallocation and hence the need to repurchase the shares again.
As usual, you should check with your ESOP advisors before implementing this strategy as there are some legal issues that should be considered. For example, if a former participant is a "related party" under the prohibited transaction rules, then the sale by such related party to the ESOP would be a prohibited transaction unless the conditions of the exemption are satisfied (i.e., the stock is valued as of the date of the sale to the ESOP). For this reason, this strategy may not work as well with diversification distributions as the recipient of such distribution could very well be an employee and as a result be a "related party."