Article by Judy Kornfeld

The ability to delay distributions to ESOP participants who have terminated employment is one of the tools that closely held ESOP companies can use to manage their repurchase obligations. However, many ESOP companies who delay distributions to terminated participants do not want them to share in gains or losses in the value of company stock after they terminate employment. To accomplish this, some companies create a segregated investment account that is invested in conservative vehicles. Company stock allocated to the participant's account is cashed out at the appraised value at the end of the year in which termination occurs and is placed in the segregated investment account until it is time for distribution. This protects the participant, but requires that the company come up with cash as though it were making immediate lump-sum distributions. Are there any other techniques that can be used to achieve the same goal? This article explores the question of when and at what price closely held ESOP companies can cash out ESOP participants who are entitled to receive distributions from the plan.

The Legal Framework[1]

The ESOP plan document governs the timing and form of distributions that are permitted under the plan, and the plan document must comply with certain ESOP distribution rules contained in the Internal Revenue Code of 1986, as amended (the Code). These rules require that distributions due to death, disability, or retirement must begin no later than the end of the plan year following the year in which the triggering event occurs.[2] Distributions due to termination of employment for any other reason must begin no later than the end of the sixth plan year following the year in which employment terminated (unless the participant does not consent to a distribution before normal retirement age).[3]

Distributions, once they begin, may be made in a lump sum or installments. If they are made in installments, they must be at least as rapid as equal annual installments over a five-year period or, in the case of large account balances, may be extended up to an additional five years.[4]

Distributions may be made in cash or company stock, or some combination thereof. Unless the company's bylaws or corporate charter limit ownership to employees only or to a trust that is qualified under section 401(a) of the Code, a participant who is entitled to receive a distribution may demand that it be made in whole shares of company stock (with payment for fractional shares made in cash).[5] If the stock is not readily tradable on an established market, a participant who receives a distribution in company stock has a "put" option that may be exercised during the 60 days after the distribution is received or may be exercised for a 60-day period during the next plan year after the participant receives notice of the updated valuation.[6]

Many companies choose to have the ESOP plan document delay distributions as much as permitted by these rules. Delaying distributions gives a company a longer planning and funding horizon for the repurchase obligations associated with the distributions. Furthermore, many companies do not want employees who quit to receive their distributions immediately. They believe that immediate distributions of account balances may encourage employees to quit in order to get access to these otherwise inaccessible funds.[7]

Alternative Methods of Handling Account Values Pending Distribution

When distributions are delayed, when and at what price should terminated participants be "cashed out" of company stock? There is no authority in either the Code, the Employee Retirement Income Security Act of 1974, as amended (ERISA), or the regulations thereunder that provides guidance concerning how ESOP account balances that are being held pending distribution should be handled. This leaves room for some flexibility in drafting the relevant provisions in the ESOP plan document. As a practical matter, there are several ways that this issue is being handled.

Method One: Leave the Account Invested in Company Stock

The first method is to simply leave the account invested in the number of shares of company stock that had been allocated to it before the participant's termination of employment. Many ESOP companies object to this method because they do not want former employees to be affected by gains or losses in the value of the company's stock after they terminate employment. They consider it unfair for former employees to benefit from increases in value that are created after they have left the company, or, conversely, to be harmed by decreases in value that occur after they have left. Another objection to leaving account balances invested in employer stock, particularly when the stock price is increasing, is that the repurchase obligations the company will face may ultimately be much higher if the employees' accounts are not cashed out of company stock until distributions begin.

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Notes

1. This discussion is intended only to provide a brief overview of the distribution rules. For a detailed discussion of these rules, see Ronald L. Ludwig and Laurence A. Goldberg, "ESOP Benefit Distribution Rules," Journal of Employee Ownership Law and Finance vol. 6, no. 4 (fall 1994). [return to text]
2. Code Section 409(o)(1)(A)(i). [return to text]
3. Code Section 409(o)(1)(A)(ii). Distributions due to termination of employment of stock acquired with an acquisition loan may be postponed until the loan has been repaid. [return to text]
4. Code Section 409(o)(1)(C). [return to text]
5. Code Section 409(h)(1). [return to text]
6. Code Section 409(h)(4). [return to text]
7. This concern may make it desirable to provide for in-service distributions so that employees can reach a portion of their account balances while still employed. An ESOP that is not a money purchase pension plan may permit distributions of funds accumulated under the plan after a fixed number of years (no fewer than two), the attainment of a stated age, or upon the prior occurrence of some event such as layoff, illness, or some other hardship. Rev. Rul. 71-295. The IRS has also ruled that a plan could permit participants with no less than five years of participation to withdraw all employer contributions (including those made within the last two years). Rev. Rul. 68-24. [return to text]

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