Blue Ridge ESOP Associates

What we call “repurchase obligation” is a fact of life for privately held ESOP companies[1]. Even as the ESOP Trust may initially provide a market for shareholders’ stock, the company itself must provide a market for stock that has been distributed to participants from the Trust. Unless a participant chooses to retain the stock[2], every distribution must be converted into cash according to distribution rules provided by the Employee Retirement Income Security Act of 1974, as Amended (“ERISA”)[3], special rules set forth for ESOPs by the Internal Revenue Service (“IRS”)[4] and the distribution provisions of the plan document itself. This chapter sets forth those events that require cashing in company stock, and explores the effect certain distributions and timing can have on a company’s total repurchase obligation and cash flow.

Repurchase obligation is triggered by any event that requires turning stock into cash, e.g. any event in which a participant receives a distribution from the ESOP, whether in cash or stock (in the latter case, assuming said participant requests to receive cash for stock). Structuring distribution payments to minimize repurchase obligation is an important task for ESOP companies as they mature. A major component of repurchase obligation is whether the share value is going up or down, not always a known factor. If the share value is going up, a company may want to turn stock into cash as quickly as possible; if it is going down, it may make sense to string out the payments as long as possible. In either case, it is hard to know which direction and for how long the share value is going to change. In order to maximize planning repurchase obligation to fit with a company’s cash flow, a reliable repurchase study should be done, which is the subject of another chapter in this publication.

Each of these events carries specific rules concerning the timing and manner of payment. Some of these provisions are flexible according to both ESOP law and a specific plan document; all are subject to the general ERISA rules, except for required minimum distributions, which are governed by the Tax Code.[5]

Also factored into the distribution process is a law stating that no participant may be forced to take a distribution without his/her consent if the vested benefit is greater than $5,000.[6] Consent is not required if a participant has reached age 62 or, if greater, retirement age under the plan; nor is it required of a beneficiary pursuant to a death payment. Generally, participants are happy to take their distributions, especially as no taxes are incurred so long as they roll over their payments to IRAs or other qualified plans.

A plan document may specify “Normal Retirement Age”, so long as it is no later than, the later of, age 65 or 5 years of plan participation.[7] Special ESOP rules state that, in the event of a participant’s retirement, payments must begin no later than the end of the plan year following that in which the event occurred.[8] Payments may then be made in installments over a period of five years, extended one year for each $170,000 over $850,000.[9] Again, payments may be made faster, but not slower, than allowed for by the special rules. Keep in mind that, when a participant reaches normal retirement age under the plan, he/she automatically becomes 100% vested, under ERISA and the Internal Revenue Code (“Code”).[10] Many plans also provide that a participant will receive an allocation for the year in which he/she retires, if such allocations are made.

Retirement is probably the most predictable of the events causing repurchase obligation, as it is easy to see which employees are reaching the magic age. The exception would be if participants have the right to keep on working after reaching retirement age, thereby putting off their distributions until some unknown later date. If the share value is increasing, it may make sense to put in an in-service distribution rule for those who are still working after retirement age, so that the company may begin paying them immediately, thereby funding its repurchase obligation with fewer dollars.

Plan documents tend to provide the same distribution rules for death as for retirement. The special ESOP rules pertaining to termination due to death require that payment must begin no later than the close of the plan year following that in which the event occurred. As with retirement, payments may be made in installments, no slower than annually, over a period of five years. ERISA says that payment must be paid in full within five years of the date of death, so plan administrators need to watch for this deadline, and make all payments prior to reaching it. In fact, most plans pay for termination due to death as quickly as possible. Although not required by law, many plans provide for a participant to receive an allocation for the year in which he/she dies (if such allocations are made) and may also vest the account 100% at that time.

Unlike retirement, terminations due to death are not easy to predict. The only control a company has over death payments is whether to pay immediately, wait a year, or pay in lump sum or installments. Whatever the decision, the ERISA requirements mentioned above must be met.

Disability
Participants who “retire” due to a disability are often treated as having the same privileges as a person who has reached normal retirement age under the plan. ERISA does not address disability as a separate category, but the ESOP special rules do, requiring that payment begin no later than the close of the plan year following that in which the event occurred. As with retirement and disability, payment may be made in lump sum or installments over a period not to exceed five years, or a combination of the two. The extended payment rule, as stated in Footnote 9, applies. Although not required by law, many plans provide for a participant to receive an allocation for the year in which he/she becomes disabled (if such allocations are made) and may also vest the account 100% at that time.

As with death, disability is hard to predict; fortunately, disability is the least of the events causing repurchase obligation unless a company is in an extremely high-risk industry. It is a good idea to define “disability” clearly in the ESOP document; without clear guidance, it can be difficult to decide what exactly constitutes disability.

Termination for Other Causes
Participants who leave the company for any reason other than death, disability or retirement fall under the basic ERISA rule and under the ESOP special rules. As always, the plan document may give less restrictive (to the participant) instructions that still fall within these more general rules. The special rules state that payments must commence no later than the end of the sixth plan year after the year in which the participant terminates (often written as in Footnote 4). Then payments may be made in lump sum, installments or a combination of the two. The extended payment rule, as stated in Footnote 9, applies.

Payments to these participants will depend largely upon the general turnover in the company. If it is very great during the first few years, fewer participants will become vested and thus will not be entitled to distributions. On the other hand, the greatest turnover may occur after enough years to vest everyone 100%, which will increase total repurchase obligation.

A good repurchase study will take turnover and stock value into account. Studies on very large populations can result in reasonably accurate turnover predictions based on historical evidence, but studies on smaller populations are generally less reliable. Again, the chosen payment schedule should fit the company’s cash flow management scheme, taking into account whether the share value is likely to increase or decrease.

Exception for Exempt Loans
In a C-Corporation, payments to terminated participants (except retirement and death, which are subject to ERISA rules) may be held until the loan that bought the stock in question has been repaid in full. (Other tranches must be paid according to the timing of the ESOP special rules unless they, too are subject to a separate exempt loan exception). Again, this may help or hurt your repurchase obligation depending upon whether the share value is going up or down.

It is unclear at the present time whether S-Corporations can legally take advantage of the exempt loan exception.

Annuities
Most ESOPs are exempt from the requirement that they pay in the form of Joint and Survivor Annuities, so long as the plan document names the spouse as primary beneficiary, and certain other conditions are met by the plan.[11] For various reasons, however, an ESOP may be required to offer an annuity as an optional form of benefit, or even as the primary form of benefit. In these cases, if an annuity is chosen by the participant, the effect on repurchase obligation is the same as paying a lump sum in accordance with the special ESOP rules. The plan trustee would then use the vested account balance to purchase an appropriate annuity for the participant within the commencement deadline prescribed by the special ESOP rules.

Statutory Diversification
ESOP law provides that certain participants have a chance to diversify their investment in company stock.[12] When a participant has been in the ESOP for ten years and has reached the age
of 55 or over, that individual has the right to elect to invest up to 25% of his/her company stock balance in something else. There is no requirement that a participant elect to diversify; indeed, in some cases, company stock may be outperforming other qualified investments, so no eligible participant will choose to diversify. After qualifying to diversify in the first year, the participant has four other chances, in the four succeeding years, to elect to re-direct the investment of up to 25% of company stock ever allocated to his account. Diversification applies only to company stock, and only to shares which have not been previously diversified. In the sixth year after diversification starts, a participant can elect to bring the level of diversified investments to 50% of the company stock ever allocated to his/her account.

Diversification is often the “big bulge” in an otherwise streamlined repurchase obligation scenario. Unless previous history dictates otherwise, it is a good idea for a company to predict the worst-case scenario (assume 25%-50% for all eligible participants) when forecasting its repurchase obligation. Once again, the important assumption is the value of company stock. This is a good reason why even a new ESOP company should perform a study that takes its ESOP at least one or two years into the beginning of the time when the plan must provide statutory diversification.

Other In-Service Distributions
It is not uncommon for ESOPs to have in-service distribution provisions other than statutory diversification. For example, as a motivational and retention tool, an ESOP may provide for participants to have access to a certain percentage of their account balance every so many years. A provision of this sort can hasten the repurchase obligation for the company, similar to that caused by increased turnover. Whether it increases the total amount that must be ultimately paid for repurchase depends on the rate of increase of the stock price relative to the company’s effective cost of funds. Again, the timing and probable size of these payments must be factored into the cash flow projections for the company.

Another provision sometimes seen in ESOPs is the hardship withdrawal, often having attached itself to the ESOP through consolidation with a previous qualified plan. Hardship withdrawals have the same effect that any distribution would have, and are difficult to predict. In general, such provisions function as more of a hardship to the ESOP than as an incentive to plan participants. If an ESOP has to have such a provision,[13] it is wise to have a very clear definition of what constitutes a hardship, so that such withdrawals can be kept to a minimum.

Early Retirement
Plans may contain an early retirement provision, usually accompanied by a years of service or plan participation requirement, such as age 55 and 10 years of service, or age 60 and 20 years of service. If there are age and service provisions, and a departed participant has completed the service requirement, his benefit must be made available to him at such time as he reaches the specified age.[14] Any such provision may increase the rate at which a company has to pay its repurchase obligation and should be figured into a repurchase obligation forecast.

Required Minimum Distributions (“RMD”)
If a plan participant who is still employed at the company reaches age 70 ½, he/she may trigger repurchase dollars if allowed to elect an in-service distribution; otherwise, if terminated, such a participant must by law begin receiving distributions. If any participant who owns more than 5% of the stock of the company reaches age 70 ½, that person is required by law to begin receiving payments from the plan regardless of whether he/she is still employed. Generally, the repurchase obligation caused by RMD’s is small, but it could be significant if an aging employee has a large vested balance in the ESOP. In any case, the amount of each payment is calculated according to actuarial tables based on the participant’s projected life span.

End of the Year Share Exchange
Although not technically a distribution, and not addressed in the Code, some plans provide an “end of the year exchange” so that all stock held in terminated participants’ accounts is exchanged for the cash in active participants’ accounts after the allocations are completed for the plan year. If there is not enough cash in the ESOP to complete this exchange, and money must be put in from the company, the transaction has the effect of adding to the repurchase obligation in any year for which it is done. The effect is the same as paying departed participants a lump sum for their Company Stock. Similarly, in plans which “cash out and segregate” terminated participants’ stock, thereby turning their shares into cash, whether or not the balances are paid immediately, the effect is the same as paying a lump sum, and it should be factored into any repurchase obligation forecast.

Because of the number and variety of events that may trigger distribution payments, it is a safe course for plan sponsors to write a distribution policy that applies equally to all plan participants; indeed, many plan document have language requiring the creation of such a policy. As a rule, such policies may be changed if there is a valid business reason for doing so, although it is generally accepted that it should not be changed too often. A good rule of thumb might be no more than every three years, unless there are special circumstances. A good policy will state the circumstances under which it can be changed.

Statutory diversification and required minimum distributions have deadlines that are set by law and are therefore addressed in the plan document; they do not need to be included in the policy unless the company wants to make them less restrictive to participants.

The policy may take into account the size of individual account balances, so long as the same rule applies to everyone. Attorneys vary in their opinions as to whether these amounts should be written into the plan document. For example, if a company can see that their largest account balances are in the accounts of participants who will undoubtedly leave employment due to retirement or death, the policy can be written to extend payments for those two events to minimize the impact on the company cash flow.

Summary
The events that trigger distribution payments to participants, whether departed or still employed, are the same ones that trigger the obligation to turn participants’ shares into cash. Most of these events are dictated by law, although a few are at the discretion of the Company. Most of them are permanent once they are adopted (with the exception of hardship withdrawals and most voluntary in-service distributions). A thoughtful and detailed repurchase forecast, done with several scenarios, can help project these future cash payments and fit them to the projected cash flow of the sponsoring company.

¹ The stock of a publicly held ESOP company is traded on a public exchange, and so does not necessarily require any involvement from the company to turn the shares into cash, e.g. no repurchase obligation exists unless the company chooses to redeem shares distributed.

² Only C-Corporations must give participants the right to retain company stock distributed from the ESOP. S- Corporations may distribute in cash without allowing the right of demand. A C-Corporation may also distribute in cash if its corporate charter or by-laws restrict ownership of “all or substantially all” of its stock to employees and the ESOP Trust. The term “all or substantially all” has never been specifically defined.

³ Both ERISA §206(a) and IRC §401(a)14 provide that a distribution must commence within 60 days after the close of the plan year in which occurs the later of, termination from service, attainment of age 65, or ten years of plan participation.

⁴IRC §409(o), referred to in this article as “special ESOP rules,” states that, in general, distributions must commence not later than one year after the close of the plan year in which the participant separates from service by reason of attainment of retirement age under the plan, disability or death OR one year after the close of the plan year which is the fifth plan year following the plan year in which the participant separates from service.

⁵IRC §401(a)(9).

⁶ Treas. Reg. §1.411(a)-11(c)(3).

⁷IRC §411(a)(8)(b) / ERISA §3(24)(A).

⁸IRC Sec. 409(o). A plan may begin payment earlier if the document allows.

⁹IRC § 409(o)(1)©(ii). Amounts are indexed for cost of living increases. These are the figures for plan years beginning in 2005.

¹⁰IRC §411(a) / ERISA §2003(a).

¹¹IRC §401(a)(11)(B)(iii).

¹²IRC § 401(a)(28)(B).

¹³ A hardship withdrawal provision is not a protected benefit under the law, Treas. Reg. §1.411(d)-4, Q&A-2(b)(2)(x). Its elimination does not violate IRC §411(d)(6).

¹⁴IRC §401(a)(14).