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Distributions where share price has dropped


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Everything about this seems wrong to me, but the "trust company" says they do it all the time...

S-corporation sponsors a leveraged ESOP. When the last batch of stock was sold to the ESOP, there was a "price protection" agreement put into place (outside of the ESOP plan document) that said for any participant who terminated employment and received a distribution within 3 years of the sale, that the distribution would be based upon the higher of current FMV at the time of the distribution/liquidation of the shares by the ESOP, or the price per share as of the date the stock was first sold to the ESOP. The purpose, apparently, was to protect retirees in the short term if the stock dropped.

Is this a common thing?

Beyond that, the PLAN DOCUMENT makes no provision for this higher "price protection" distribution. The trust company is asserting that:

1. The Employer can dump into the plan the difference between the current FMV. This will NOT be treated as an "employer contribution" and hence not allocated to all participants. Whether the Employer intends to deduct it or not I couldn't say.

2. The ESOP can then distribute the full "price protection" amount and it will ALL be an "eligible rollover distribution."

They further assert that they have worked with "many top ERISA experts" and have "never had a comment against it."

I'm completely baffled as to how they arrive at their conclusions. But since I'll be the first to admit I'm no ESOP expert, I thought I'd check to see if in fact these are common and accepted practices, and if so, what citation or citations might support it?

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To borrow a comment from a different thread today: This whole thing seems a bit fishy to me.

Maybe the plan has an approved plan document that allows the procedures you describe. <_<

I wonder if those top ERISA experts with whom they have worked are actually aware that they do this (don't ask, don't tell?). It will be interesting to learn what cites they use to justify this clever operation.

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B:

I have seen the price protection guarantee in a few transactions. Mostly in the manner that you illustrate. They do occur and they are complicated. To say that they are routine is a bit much. There is a fair amount of debate in the ESOP community regarding these strategies.

The price protection guarantee, serves as protection for those participants near a disribution event whereby the share price is affected by some sort of financial transaction, that would cause a short term (period of months to a short amount of years) negative impact. For example:

ESOP owns 70% of outstanding shares and enters into an agreement to purchase the remaining or outstanding 30%, in a levaraged deal. The acquistion/the debt causes a drop in appraised value and share price.

This guarantee process sort of replaces tle old days when an "floor" price structure would be built in.

Our firm provides administration services for many ESOP's. In completing a few (very few) recent transactions, we have seen this sort of structure.

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One reason the practice is controversial is that it is difficult to design or reconcile consistent with legal requirements for qualified plans, inclusding ESOPs, especially S corporation ESOPs. To mix metaphors, it is common to hold one's nose to avoid seeing that the emperor has no clothes.

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Although every price protection I have ever seen WAS IN the document. The parameters of the protection, how many years, how to compute the protection and so forth was added by an amendment when the transaction that caused the desire for the protection was done.

So even if it is legit the fact it isn't in the document seems like a problem.

I would strongly urge you to urge your client to find an ERISA attorney who has experience in ESOPs.

Another reason they are controversial is could you be discriminating in favor of HCEs, are you operating the in a way that doesn't reflect the stock's FMV. On the other hand the reason they are mostly done is could the fiduciaries get hit if they allow a transaction to happen that causes their investment to drop. There is no good answer so one needs to be careful with this stuff.

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Ok, a little more information. (P.S. - ordered the brief mentioned by Shot, so if they provide actual citations I'll let you know)

So the ESOP has the funds held in a stock ownership trust by ABC Trust Services, Inc. The sponsoring S-corporation, via a letter/legal agreement signed/agreed to by a Trust Officer of ABC Trust Services, Inc., provides, in relevant part for these "protected distributions" that: "The Price Protected Distributions shall be purchased or funded, as applicable, at a price equal to the greater of (i) the then current fair market value of such sahres as determined under the Trust and in accordance with applicable law, or (ii) the fair market value of such shares (determined underthe Trust an in accordance with applicable law) determined without taking into consideration the impact of then outstanding financing incurred to effectuate the Redemption Transaction."

This is just the formal language for what was discussed already. I don't see that it changes the issues or answers given/discussed previously?

Shot - since you have actually administered such plans, is it your position that the sponsoring S-corp can dump in this extra money to the Plan, not count it as a plan contribution and therefore not allocate to all participants, and turn around and pay it out entirely as an eligible rollover distribution? Do you have any citations for such a position?

Thanks again.

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For example:

ESOP owns 70% of outstanding shares and enters into an agreement to purchase the remaining or outstanding 30%, in a levaraged deal. The acquistion/the debt causes a drop in appraised value and share price.

In this example, the short term price floor gets the deal done, to the benefit of all the participants, assuming the plan has determined that it would be good for the plan to buy the outstanding 30% of shares.

In the OP, the retirees get a 3-year price floor guarantee that is not available to the other, remaining participants. FWIW, I'd look at this sort of arrangement very carefully, and, as ESOP Guy said, consult with an ESOP attorney and put the details into the plan document.

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Belgartha:

I have done this also and I don't see how the money coming into the plan isn't a contribution or a dividend. There is no special rule that money deposited into a plan because of floor price protection is not a contribution or a dividend.

If they are saying it isn't a contribution I would check to see if they are calling it a dividend, or in this case an S corp distribution.

But no you don't get some kind of free pass to pour money into the plan.

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Hi ESOP - yeah, this is how I would have envisioned it. So whatever they dump in must be allocated to ALL participants as per the terms of the document. Therefore if 3 participants have terminated, and are "entitled" to an additional $10,000 each under the price protection agreement (which is not part of the plan) dumping $30,000 into the plan wouldn't then do it anyway, becasue a lot of it would get allocated to other participants, right?

And even if you make the leap that you can dump it in, how is it an eligible rollover distribution? Unless, I suppose, you make a further leap that whatever was dumped in and allocated to only those three participants represents the distribution that they are "entitled" to under the plan - in which case, I suppose it would qualify as an ERD.

Question - have you seen an IRS-approved document that permits such a "dump-in" specifically allocated only to those people eligible for price protection - assuming such price protection is also in the document? So that perhaps all of this is in fact permissible if your DOCUMENT so specifies? So that maybe what they have is an incorrectly drafted document?

I'll be fascinated to see how the brief I ordered addresses all of this, if indeed it does.

I appreciate all of this discussion - it helps to weed out extraneous issues and brings focus to the real questions.

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Just as a formal distribution policy does not have to be part of the plan document, but is formally approved, adopted and operated by by the Plan Trustee or Plan Administrative Committee, so can the price protection guarantee be operated.

In B's example, I believe ABC Trust Services is serving as the Independent or Outside Trustee for the Plan. So the agreement is a written agreement with the Trustee. Or at least it should be.

Any dollars flowing to the Trust must either be a contribution or a dividend as ESOP guy has stated.

Also in this debate, (the part about this program being complicated) I am assuming the appraissal was completed correctly with the appraisers having knowledge of the the price protection, the stock purchase or redemption agreement was executed correctly (which would probably include the price protection language, etc.)

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The brief was informative, but contains no citations whatsoever. With regard to the price protection distribution, they have this (among other things) to say:

"In most situations, this is accomplished by having the company redeem shares from those participants eligible at rthe greater of (1) the price-protected value or (2) the ESOP fair market value. The company then either recontributes those shares to the ESOP (at the current ESOP apparaised price) or retires them as treasury stock. The proceeds from thjis redemption would be eligible for a tax-deferred rollover to an IRA..."

I ask, how is the company purchasing shares for more than their fair market value not a prohibited transaction? What am I missing?

The people writing this brief are obviously bright and experienced in ESOP's, but it sure would be comforting to see some citations supporting all of these assertions and techniques...of course a client must seek legal counsel, but for my own edification, I'd love to feel like I actually understood this!

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The brief was informative, but contains no citations whatsoever. With regard to the price protection distribution, they have this (among other things) to say:

"In most situations, this is accomplished by having the company redeem shares from those participants eligible at rthe greater of (1) the price-protected value or (2) the ESOP fair market value. The company then either recontributes those shares to the ESOP (at the current ESOP apparaised price) or retires them as treasury stock. The proceeds from thjis redemption would be eligible for a tax-deferred rollover to an IRA..."

I ask, how is the company purchasing shares for more than their fair market value not a prohibited transaction? What am I missing?

The people writing this brief are obviously bright and experienced in ESOP's, but it sure would be comforting to see some citations supporting all of these assertions and techniques...of course a client must seek legal counsel, but for my own edification, I'd love to feel like I actually understood this!

If the company purchases/redeems shares from ESOP distributees, there is no ERISA party in interest transaction (as the ESOP is not a party to that transaction). The fact that the company pays more than current appraised fair market value does not make the redemption a transaction subject to ERISA's prohibited transaction rules. The company and the ESOP trustee have agreed (in advance) that the company will pay the higher redemption price at the time the ESOP distributes shares.

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B:

There has been extensive discussions on this topic at both the NCEO and ESOP Annual Conference. Several law firms that work extensively with ESOP's have published articles on this subject as well. The same is true for ESOP consultants and appraisal firms. I am also aware of a few PLR's. In June 2011 there were comments on this issue by the Department of Treasury.

Unfortunately, I do not have handy any sort of electronic version of said documents.

Using your favorite search engine, if you type in the words "ESOP Price Protection" I believe some of that stuff will be available.

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"If the company purchases/redeems shares from ESOP distributees, there is no ERISA party in interest transaction (as the ESOP is not a party to that transaction). The fact that the company pays more than current appraised fair market value does not make the redemption a transaction subject to ERISA's prohibited transaction rules. The company and the ESOP trustee have agreed (in advance) that the company will pay the higher redemption price at the time the ESOP distributes shares."

Hi Shot - thanks for the information. the problem here is that the document PROHIBITS distribution of ESOP stock to the participant, because they are an S-corporation. If no such prohibition existed, I wouldn't have a problem with this. Given that the stock must be purchased from the ESOP, then I believe paying more than FMV is a prohibited transaction?

Yes, I'll do some searches on this.

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