Article by Judy Kornfeld

Planning for the repurchase obligation (also called the "repurchase liability") is an important issue for employee stock ownership plan (ESOP) companies whose stock is not publicly traded. Section 409(h)(1)(B) of the Internal Revenue Code of 1986 (Code) requires that such companies be prepared to buy stock back at the then fair market value from participants who receive stock distributions from the ESOP. Such companies are also required to provide liquidity when ESOP participants choose to exercise their diversification rights between ages 55 and 60. These repurchase and liquidity obligations can represent a significant cash drain for companies whose ESOPs own a substantial portion of the company stock, particularly if the value of the stock is appreciating.

Ideally, the planning process should begin before the ESOP plan document is adopted. The distribution provisions of the plan can have a significant effect on the timing of repurchase obligation liquidity needs, but once the plan has become effective the ability to change plan provisions is limited. Taking maximum advantage of the ability to delay distributions to terminated participants and to make installment rather than lump-sum payments can often make the liquidity requirements much more manageable. Conversely, if the stock is appreciating rapidly, delaying distributions may have the opposite effect, and methods to accelerate distributions, such as in-service distribution provisions in the plan, can be effective in managing the magnitude of the repurchase obligation over time.

The thought process about the repurchase obligation is complex because several interrelated issues are involved. Conceptually, the repurchase obligation involves elements of return on shareholder equity, ownership succession planning, and employee benefit planning. In addition, the method of handling the repurchase obligation can affect the value of the company and the distribution of value among the owners.

ESOP distributions are the major way that ESOP participants receive a return on their shareholder equity. The main reason for owning stock in a corporation is to realize a return on the investment through dividends or appreciation in the value of the stock that can be realized upon its sale. The repurchase obligation imposed on an ESOP company in a sense forces the company rather than a third party to provide a market for the stock. (Indeed, in many closely held ESOP companies, ownership of the stock is restricted to the ESOP and employees.) The company must be able to provide a cash return to its shareholders equal to the repurchase obligation. Whether this cash expenditure is a problem will depend on the demographics of the employee population, the cash flow generated by the business, and the capital required to sustain the business. To the extent that the value of the company may be affected by repurchase obligations associated with the ESOP, large repurchase obligations may be made more manageable by the negative effect they could have on value. One could argue that repurchase obligations should not be a problem over the long term, because the affect on the value of the stock will make the problem self-correcting. (One could also argue that the valuation of company stock should not be affected by repurchase obligations, but that valuation should instead be based on the fair market value of the business to a third party who would not face repurchase obligations.) No matter how the valuation issue is viewed, substantial variations in repurchase obligations from year to year, particularly in smaller companies, can create short-term funding problems.

The repurchase obligation also resembles the ownership succession problems for which all closely held businesses ideally should plan. Often, for succession planning in a closely held corporation, the company's shareholders will negotiate a buy-sell agreement under which the corporation or the other shareholders will acquire the stock from a departing shareholder. The repurchase obligation is analogous to a mandatory stock redemption buy-sell agreement. The main difference between a buy-sell agreement and the repurchase obligation stemming from an ESOP in a closely held business is that the ESOP transactions are smaller and more frequent, which typically makes them more manageable.

ESOPs are also a form of employee benefit. Participants in an ESOP realize their retirement benefits at least in part through the liquidation of their employer stock. The repurchase obligation thus should also be viewed in the context of the company's overall employee benefit expenses.

ESOP companies meet liquidity needs for their repurchase obligations in a number of ways. The most common include:

• Cash flow from current operations;
  
• Sinking funds (in the ESOP, the corporation, or corporate-owned life insurance (COLI));
  
• Debt; and
  
• Third parties (sale of the business, public offering of stock, or internal markets).

In most situations, the best solution will involve some combination of these. The challenge is to determine the optimal combination.

This article presents a step-by-step approach to developing a comprehensive plan for managing and funding the repurchase obligation. It attempts to present a framework for a systematic analysis of the funding options and to identify the advantages and disadvantages as well as the appropriate uses of each option.

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