How to Make Stock Distributions to Former ESOP Participants
In my prior columns we have explored the reasons that may lead you to make distributions to your former ESOP participants in the form of company stock rather than cash. So how does one go about making this distribution in the form of company stock? Do you have to issue new stock certificates to each former participant and then cancel such certificates when the shares are sold by such former participant? What other issues should you be aware of? This article will focus on the following administrative issues relating to making a distribution in the form of company stock:
- What should be included in the distribution election forms provided to the former participant?
- When do we need to issue new stock certificates?
- How is the Form 1099R reporting different?
Let's look at two different scenarios as we answer those questions:
Scenario A: If the plan sponsor is a C corporation without a bylaw restriction on stock ownership, the participant must actually be given the right to demand his or her distribution in the form of company stock. If the distribution is then made in the form of privately held company stock, the former participant must be offered the right to "put" or sell the stock to the employer. In very general terms, the put option periods are (1) a 60-day period following the distribution of shares and (2) a 60-day period in the following plan year.
Scenario B: If the plan sponsor is an S corporation or has a bylaw restriction on stock ownership, it may be possible to make such a distribution in the form of company stock subject to an immediate sale back to the employer or the ESOP.
Distribution Election Forms
In Scenario A, even if the ESOP were making cash distributions, the distribution forms would need to disclose the right to demand distribution in the form of company stock. If it is predetermined that the distribution would be in the form of company stock, then the distribution election forms should indicate this. The forms should also notify the former participant of the two 60-day put option periods. In addition, a form that allows the former participant to exercise his or her put option and sell the shares should be included as a separate form.
In Scenario B, the distribution forms should notify the former participant that the distribution will be made in the form of the company stock and that such stock must be immediately resold. A separate form that is sometimes called a "stock power form" would also be included. It is this stock power form that will allow the former participant to instantaneously sell the shares.
Stock Certificate Issues
In most cases, the former participant will want the cash value of his or her shares immediately, so even in Scenario A, the put option form is likely to be completed and returned at the same time as the other distribution election forms. If so and if the put option form is properly drafted, there would not be any need to issue a stock certificate to the former participant. The corporation's stock ledger should reflect the distribution of the shares to the former participant and his or her subsequent sale of the shares.
Similarly, in Scenario B, assuming the stock power form is properly drafted, there should not be any need to issue a stock certificate to the former employee. Again, the corporation's stock ledger should reflect the distribution to the former participant and his or her subsequent sale of the shares.
If the ESOP does not purchase these shares, the ESOP's stock certificate will obviously need to be reissued to reflect the reduction in the number of shares it owns.
Form 1099R Reporting Issues
If the distribution to the former participant constitutes a lump-sum distribution and includes a distribution of shares of company stock, then the reporting of such distribution on Form 1099R is different than reporting a cash distribution. (Note: a lump-sum distribution is generally a distribution of the participant's entire account balance.)
Let's assume a lump-sum distribution that is entirely in company stock and that the shares of stock are immediately sold by the participant. The taxable amount of such distribution would be the cost basis of such shares (see my prior column on cost basis determinations). The excess of the current fair market value over the cost basis is known as unrealized appreciation and is taxed as a long-term capital gain. So the taxable amount is reported in Box 2a on Form 1099R, and the net unrealized appreciation is reported in Box 6 on Form 1099R. If the fair market value is lower than the cost basis, then such lower fair market value is the taxable amount of the distribution, and there is no net unrealized appreciation to be reported on the Form 1099R.