United States

The devil is in the details

The ins and outs of ESOP distributions


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Plan documents are drafted to provide specific rules on employee stock ownership plan (ESOP) distributions covering: when they are made, how they are made, whether the put option applies, if shares are put, how the put option works, etc. The plan rarely covers the detailed mechanics on how, when and what value is used for each of these steps, depending on whether the party on the other side of the transaction is or is not a party-in-interest (PII) or disqualified person (DQ), with respect to the ESOP at the time of the sale. The following information addresses that issue.

Why does PII or DQ status matter?

A plan is allowed to enter into transactions with persons who are not a PII or DQ under any terms that are in the best interests of the plan and its participants. If the person involved in the transaction is, however, a PII or DQ, the law requires that specific protections be in place before such a transaction can take place. With respect to a purchase or sale of employer stock, one of those protections is that the plan may not pay more or sell for less than the fair value on the date of closing. Thus, the use of the most recent annual valuation may not be appropriate if the plan is buying stock from a PII or DQ. Similarly, if the plan is selling stock to a PII or DQ, the price paid may not be less than fair value on the date of closing. So again, the most recent annual valuation report for the ESOP may not be an appropriate price for such a transaction. Also, if the plan is purchasing shares with a note from a PII or DQ, specific terms are required to be included in such a note.

Who is a PII or DQ when we are discussing the events surrounding distributions?

This is where it gets tricky. First, let’s discuss why there are two terms. Retirement plans are enforced by two governmental units for this purpose. These are the Internal Revenue Service (IRS) and the Department of Labor (DOL). Each of those entities has different duties when it comes to these transactions, and they have separate definitions of the party over which they have concerns. The DOL uses the term PII. For purposes of the normal issues associated with distributions, it is important to know that the employer, any director, any direct or indirect more than 10 percent shareholder and any employee are considered to be a PII.

The IRS uses the term DQ. For the IRS, the definition includes only highly compensated employees, not all employees. This is not the traditional definition of a highly compensated employee. It is limited to persons who earn 10 percent or more of the total wages of the employer. In other words, all employees are subject to the restrictions on such transactions for the DOL, but very few employees other than officers, directors or non-ESOP shareholders would likely be subject to these standards from the IRS perspective.

This means that if the plan makes stock distributions and the plan is subsequently repurchasing that stock, generally that distribution would have been made to a former employee or their beneficiary, because the employee has separated from employment before the distribution. That person would not be a PII or a DQ, unless they are otherwise a shareholder or director. But if the distribution was made under the diversification provisions of the plan to a current employee, a repurchase of those shares from the participant is subject to these restrictions on PII transactions. This is because that person is still a PII under the DOL rules, due to their continued employment. This conclusion would also apply if the stock is being repurchased from an individual who has terminated employment, but is a director of the employer or is, directly or indirectly, a more than 10 percent shareholder at the time of the transaction.

Similarly, if the plan is making cash distributions by selling shares back to the plan sponsor to provide the cash to fund the distribution, these restrictions will apply, as the plan sponsor is always both a PII and a DQ. Also, it is important to note that where the plan sponsor is an S corporation that is controlled by someone other than the ESOP, additional restrictions apply.

What are the restrictions on these transactions with a PII or DQ?

Where the plan purchases stock from a PII or DQ, the price the plan pays cannot be more than fair value on the date of the transaction. Similarly when the plan sells stock to a PII or DQ to provide cash for distributions, the price paid cannot be less than the fair value on the date of transaction. Since ESOP distributions are typically made many months after the end of the plan year, the annual valuation may not be a reasonable measurement of fair value at the time of distribution or repurchase. For example, in a recent DOL investigation, the DOL concluded that a valuation for a date three months prior to the transaction date was stale, and an updated valuation was required as of the transaction date. Generally the appraiser is able to roll the valuation forward to the transaction date with relatively little additional work, unless significant changes have been made in the business since the valuation date. But this need should be discussed with the appraiser as part of the planning of the engagement. The put option requirements permit the use of the immediately preceding valuation date for purposes of what is required to be paid to the participant. But this requirement does not supersede the requirements for a PII or DQ transaction. The put option rules simply define what the participant has the right to receive.

Where the plan is purchasing distributed shares with a note, some conditions apply to any note given from the exercise of the participant’s put right. Additional loan terms will apply if the individual is a PII or DQ. All put option loans, whether between the plan and the individual or the corporation and the individual, are required to bear a reasonable interest, be adequately secured and be payable over a five-year period, with the first payment made at the beginning of the note and payments not less frequently than annually thereafter. If the loan is between the individual and the ESOP, and the seller is also a PII or DQ, the terms of the loan will have additional restrictions in the event of a default on the loan, and must contain specific terms as to collateral release.

What happens if these requirements are violated?

If the DOL requirements are violated, the result is a nonexempt transaction reportable on Schedule G of the Form 5500 and the requirement to correct the violation. That might mean making an additional payment to the plan to correct for an underpayment for purchased shares or an overpayment for sold shares, plus lost earnings. Correction may simply require a revision to some wording on documents, or obtaining evidence that the price paid was appropriate.

If the IRS rules are violated, an excise tax applies of 15 percent of the amount involved for each year or part of a year that the error was outstanding. For a purchase or sale of securities, the amount involved is the difference between the price paid and the fair value. For a loan, the amount involved is the interest on the loan for each year until corrected. This tax, however, is only due on transactions with DQs, not PIIs. Thus, it applies to transactions with the company, officers, directors and direct or indirect more than 10 percent shareholders. This tax is reported on Form 5330. There is a possibility of a 5 percent excise tax on transactions with employees who are not a DQ under the DOL provisions. But to date, we have never seen this tax apply.

What are recommended practices to avoid these problems?

The good news is that all of these issues can be avoided with well-designed, effective controls over the distribution process. Consider the following:

1.  Read the distribution language of the plan, summary plan description, distributions forms and notices and any other communications with participants. Make sure that such documents are consistent with intent, each other and practice. If noted, rework such documents and procedures to make them consistent. On this step, remember that the tax law puts certain restrictions on the ability of the plan sponsor to make changes in distribution rights.

2. Consider the cash flow capability of the plan sponsor and the timing of available cash flow, if that is a constraining factor.

3. Consider the employee benefit objectives—is the goal to make the ESOP broader, to maintain the current levels of ownership or to reduce the percentage of ESOP ownership?

4. Discuss with the appraiser the ability to roll forward the year-end valuation to the actual transaction date.

5. Where shares are to be distributed, a distribution of stock with a put option to the company will never create an issue under these provisions. It is important to remember that even if the goal is to increase or maintain the percent ownership of the ESOP, these distributed shares may be immediately contributed to the plan subject to the limitations on deductible contributions.

6. If cash is to be distributed and it is not available from contributions, dividends or other sources within the ESOP, a couple of options are available.

a. The plan sponsor may make an interest-free advance to the plan to cover short-term liquidity needs under an existing DOL class exemption. This rule has its own set 
of specific requirements. Such an advance can be converted to a contribution or repaid by the plan from other available resources.

b. The valuation can be rolled forward to the transaction date, and the employer can make a single, cash purchase of all distributable shares from the ESOP, unless some other restriction applies, such as loan covenants or the more rigorous PII or DQ rules applicable to certain controlled S corporations.

7. If the plan only has sufficient cash to fund part of the distributions, consider using that cash for diversification distributions first, as those distributions are usually made 
to active employees who are PIIs, and thus, trigger all of 
the complexities.

8. Establish procedures to raise a red flag in the event a participant requests a departure from your normal distribution practice, so that you stop and verify that such action will not create a problem.

If you have any questions on how to implement good distribution practices within your ESOP, reach out to your RSM client service representative.