ESOP's and Sub S Distribution windfalls

[Guest Alan Stonewall]

It is my understanding that sub-s distributions paid on unallocated shares in a leveraged ESOP are treated like any other investment gain. That is, they are allocated to participant accounts. So, if only 20% of shares have beeb released to participant accounts, the participants will get 5 times the normal sub-s distribution on their shares because 100% of the sub-s distribution must be allocated as investment gain.

In many leveraged ESOP's, the sub-s distribution on unallocated shares is used to pay down the ESOP loan, but to the extent they are not, the above seems to hold.

Am I missing something? Can the sub-s distribution on unallocated shares be used in other manners?

[jpod]

Clearly, the distributions are plan earnings.

You're right: normally, plan earnings would be allocated to participant accounts.

But, what do the loan documents say? Do they not require all cash distributions/dividends with respect to encumbered securities to be used to pay down the loan, or to remain encumbered?

[Guest Alan Stonewall]

The loan documents do not require that sub s distributions be used to pay down the loan. It is the absence of that language that led to their current issue.

What I did not mention earlier is that the company pays out a substantial sub s distribution each year, so 5 times substantial equals a really big number! Hence their question, "Is there anything else we are allowed to do with the sub s distribution on unallocated shares."

The problem will eventually go away, but in the interim, the results seem unreasonable.

[RLL]

Hi Alan Stonewall ---

Assuming that the ESOP documents include appropriate provisions, the S corporation distribution attributable to the suspense account (unallocated shares) could be used for ESOP loan payments, could be used to acquire additional shares of available company stock, could be accumulated in cash or other investments, or could be "passed-thru" currently to ESOP participants and beneficiaries. In all events, the S corporation distribution will inure to the benefit of the ESOP participants and beneficiaries (except, perhaps, to the extent applied to loan interest payments that do not "release" shares for allocation to participants" accounts).

Why is it "unreasonable" for a shareholder (the ESOP) to receive its pro-rata share of corporate dividends (the S corporation distributions)?

An owner of rental real estate that is subject to debt is still entitled to receive the entire net rental proceeds as long as he/she makes debt payments as and when due. An owner of income-producing property (including an ESOP) is entitled to receive the income generated by that property. Where's the "windfall" ?

If this is of such great concern, why didn't someone think about it while the ESOP transaction was being structured?

[Guest Alan Stonewall]

The unreasonableness comes from the comparison of two individuals who own stock. The individual who owns one share of stock outside the ESOP receives an annual sub s distribution (dividend) of $5. The individual who owns one share of stock in his or her ESOP account will be credited with a $25 sub s distributioin this year, $20 next year, $15 in the third year, $10 in the fourth year, and $5 each year thereafter based on a five year term for the loan. If you are a non-ESOP participant share holder, it sure looks like the participants are getting a windfall.

The employer is prepared to live with this result, they are simply asking if there is any other approach they can consider. What I am hearing is confirmation of my understanding that one way or the other, the sub s distributions on unallocated stock earned this year (like any other investment gain) must benefit current participants.

I appreciate the input I have received thus far. Thanks.

[RLL]

Alan ---

The ESOP is the owner of all its stock...both allocated and unallocated shares. If the ESOP owns 50% of the company's common stock, it's entitled to 50% of the dividends. This is not a "windfall" to the ESOP participants.

Would one suggest that the unallocated shares in the ESOP are not entitled to receive dividends? Would it be a "windfall" if the company decided to make an extraordinarily large ESOP contribution one year? Is it fair that the direct shareholders currently receive their dividends, but the ESOP participants may not? Is it fair that ESOP does not have tax liability on its dividends, but other direct shareholders do?

Actually, one other approach may be to use dividends on unallocated shares to pay administrative expenses of the ESOP (to the extent agreed to by ESOP fiduciaries and permitted under the ESOP documents and ERISA).