In the first article on this subject that we recently posted, we
considered the administrative and fiduciary issues that arise when an
ESOP sells company stock to the company to fund its benefit
distributions. The fiduciary issues under the
Employee Retirement Income Security Act of 1974, as amended ("ERISA")
include the need to obtain a new valuation opinion letter from the
ESOP's appraiser updated to the date of the sale. This
updated opinion letter is required for the sale to be exempt from the
prohibited transaction rules of under Section 4975(c)(1)(A) of the
Internal Revenue Code of 1986, as amended ("Code") and Section
406(a)(1)(A) of ERISA. In this second article,
we consider alternative methods for handling benefit distributions
which avoid (or at least reduce) the administrative and fiduciary
issues associated with the sale of company stock and the updated
valuation opinion. We assume the company's objectives are: (1) to make ESOP distributions in the form of cash in order to avoid having former employees retain stock in the company, (2) to
make no additional ESOP contributions to fund this obligation and (3)
to preserve stock ownership for ESOP participants who are active
employees.
Stock Distributions with Mandatory Company Buyback
If the ESOP sponsor is a company that restricts
ownership of substantially all of its stock to active employees and the
ESOP (as contemplated by Section 409(h)(2) of the Code) through its
Articles of Incorporation or By-laws, or for a company that is an S
corporation for federal tax purposes, the ESOP may distribute shares to
ESOP participants subject to the requirement that the shares be
immediately and automatically resold to the company. The Treasury regulations that define an ESOP would permit this repurchase to occur at the most recent prior year end value. An updated valuation would not be needed (unless the distributee was a "party-in-interest" under Section 3(14) of ERISA).
If the ESOP sponsor does not have an ownership restriction on its
stock and is not an S corporation, then an ESOP participant who
receives company stock in a distribution is not obligated to sell the
shares to the company. He may retain the shares and become a long term shareholder.
Use of Secured Promissory Notes
If an ESOP sponsor is an S corporation or has a stock ownership
restriction as described above, the ESOP could make distributions in a
lump sum in the form of company stock. The
purchase price for the mandatory buyback of the stock could be made in
installments using a secured promissory note, as contemplated under
Section 409(h)(5) of the Code. Former employees would then become creditors rather than shareholders of the company. The company's future payments on the promissory notes would not be contributions.
By following this procedure, the company could prevent former employees from becoming shareholders. Also, the company would avoid making additional contributions into the ESOP. Note
that the IRS has made clear that momentary ownership of S corporation
stock through ESOP distributions to an ineligible person or individual
will not affect the company's S election.
Temporary Suspension of New Contributions
If the desire to avoid additional contributions is temporary, the
ESOP could make distributions in the form of company stock and
repurchase the shares from participants using the proceeds of a new
ESOP loan from the company at the prior year-end fair market value. (However, if the former employee is a party in interest under Section 3(14) of ERISA an updated valuation may be needed). The
shares acquired by the ESOP would be credited to an ESOP loan suspense
account, and would be released only as payments are made on the ESOP
loan. Contributions to the ESOP to repay the
loan could be minimized (using an interest-only loan for awhile), with
principal amortization to begin once the company can again begin making
substantial contributions to the ESOP. This alternative would defer, but not eliminate the need for future ESOP contributions. Also,
distributions of stock could be subject to an immediate and automatic
repurchase by the company so long as the company had an ownership
restriction on its stock or is an S corporation.
Alternatively, the company could assist the ESOP in funding cash
distributions by using an interest free loan, as contemplated under DOL
Prohibited Transaction Class Exemption 80-26. The ESOP would use the proceeds of the interest-free to make benefit distributions. Then,
in the next year or two, the company would make contributions large
enough to allow the ESOP to repay the principal balance of the loan.
Installment Distributions
A company may find that it is willing and able to make continuing
cash contributions into the ESOP, but not contributions which are large
enough to fund all benefit distributions. In this case, the
ESOP could choose to make cash distributions in annual installments
from the ESOP over a period of up to five years (see Section
409(o)(1)(C) of the Code), reducing the amount of new cash needed each
year by the ESOP (relative to the cash needed to make lump sum
distributions). So long as the company
maintained an ownership restriction on its stock or was an S
corporation, all distributions could be made in cash and not in company
stock. Under this approach, participants would retain a declining balance of equity in the company over the installment period. Therefore,
two of the objectives stated above of (i) avoiding distributions in
company stock and (ii) avoiding additional contributions to the ESOP
are met. However, former employees remain
partially invested in company stock during the installment period
(although they do not receive distributions of stock) and additional
contributions are required in order to fund the installment payments.
Conclusion
A company may wish to fund ESOP benefit distributions without
allowing former employees to remain invested in company stock and
without permitting former employees to become long-term shareholders. If
the company does not wish to make current cash contributions to the
ESOP to fund these distributions, the company and the ESOP should
consider a distribution policy that avoids the need to have the ESOP
regularly sell company stock back to the company. These
sales create both administrative and fiduciary issues that may be
avoided by choosing one of the alternative methods of distributions
described in this article.
Editor's note: this posting is based in part on an article that appeared in The ESOP Report of The ESOP Association several years ago.
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