ESOP does not have cash to pay participants

[Lori H]

1) have the company buy the shares from the plan, thereby reducing the number of shares?

2) leverage the ESOP?

The plan did not make a contribution for calendar year 2009.

Suggestions?

[RLL]

Distribute benefits in shares and have the company repurchase the shares from the distributees.

[JRN]

There are several ways for the Employer to get cash into the Plan so that the Plan can make cash distributions. All assume that the Company has cash. Your note indicates that the ESOP does not have cash, but I think presumes that the Company does have cash.

First, of course, the Company can make a cash contribution. The cash contribution is allocated among all active participants (i.e., current employees) in proportion to compensation (presumably). Cash and shares can then be "reshuffled" (to use IRS terminology) among current and former emloyees so that cash distributions can be made to former employees.

Second, the Company can redeem shares from the ESOP. Redemption must be structured to meet ERISA 408(e) exemption.

The third option -- assuming the Plan permits distribution of Company stock (e.g., not an S corp ESOP, no prohibition of outside ownership in Company bylaws) -- is to distribute shares to the former employees and then have the Company purchase the shares back under the Plan's put option provisions.

Leveraging the ESOP is, as you've noted, an option too. Caveat: Loan proceeds must be used to acquire shares. ESOP already owns the shares. You'll need to work thru that procedurally. Also, leveraging allows you to allocate these shares over time -- while options 1 and 2 would require allocation of the shares in current year. Need to weigh this.

[GMK]

Good replies.

One minor point is that an ESOP can even distribute S corp shares with ownership restrictions IF the plan provides for this form of distribution and IF the company immediately and automatically buys the shares when they are distributed. Again, this assumes the company has some cash available.

An advantage of stock distribution is that if the participant takes a lump sum distribution (entire account balance paid, not rolled, following a triggering event, like separation from service, disability, or death; and all within a single tax year), then only the basis is taxed as regular income. The NUA is taxed at long term capital gains rates, even though the participant sells (the company buys) the shares immediately and no matter how long the plan held the stock.

Basis is the value of the shares when the plan acquired them (which is an interesting calculation for forfeitures) plus (for an S corp) pass-through earnings.

These links give some info on NUA:

http://www.bogleheads.org/wiki/Net_Unreali...reciation_-_NUA

http://financialducksinarow.com/2354/mistakes-with-nua/

Participants should get investment and tax expert advice before electing a lump sum distribution with NUA treatment.

[Lori H]

Second, the Company can redeem shares from the ESOP. Redemption must be structured to meet ERISA 408(e) exemption.

The third option -- assuming the Plan permits distribution of Company stock (e.g., not an S corp ESOP, no prohibition of outside ownership in Company bylaws) -- is to distribute shares to the former employees and then have the Company purchase the shares back under the Plan's put option provisions.

Leveraging the ESOP is, as you've noted, an option too. Caveat: Loan proceeds must be used to acquire shares. ESOP already owns the shares. You'll need to work thru that procedurally. Also, leveraging allows you to allocate these shares over time -- while options 1 and 2 would require allocation of the shares in current year. Need to weigh this.

Thanks for your reply.

Can you elaborate on the difference between the second and third option? By redeeming do you mean they buy back from the plan as opposed to buying from the terminated participant in your third option? By redeeming they don't technically make a contribution, they just fund the plan with the necessary amount to purchase the shares, am I thinking right? Also, you mention with options 1 and 2 allocation of the shares in current year would be required. I understand that with just a regular contribution to the plan, but in Option 2, if the company was to buy the shares outside the plan from terminated participants would this not just retire the shares? Meaning the plan has less shares of stock?

[Lori H]

This plan only has like $20K in cash and some of the participants have account balances of $200K and up that they will have to pay in the near future. Can the company buy additional shares from the plan at one time to plan for these future pay outs? It is about a 2 and a half hour process each time they have to go into their mainframe to change the stock list.

[GMK]

Can the company buy additional shares from the plan at one time to plan for these future pay outs?

I don't know of anything that would prevent this, but I would plan to do it once a year, not once for the next, say, 5 years.

Having a lot of extra cash in the ESOP for a long time may not be a prudent investment of the ESOP's assets, especially now with interest rates so low.

For what it's worth, we generally distribute the (S corp) shares from the ESOP, and the company immediately buys them back. Most years, it's only one or two times into the mainframe. Yes, this reduces the number of shares in the ESOP, but the company usually makes its contributions in shares. Contributions do not necessarily equal the number of distributed shares, but they bring the number of shares in the ESOP back up and increase the share balances of active participants.

[Lori H]

thanks for the replies, two last questions

1) is the basis on a stock distribution the cumulative amount allocated as a contribution or is it the current price of stock? For example, if i was a participant in the plan for 3 years and received an allocation(contribution/forfeitures) in year one of $2,000 as well as years two and 3, my basis would be $6000. my balance is $8000. The $6000 would be taxed at ordinary rate and the NUA would be $2000 and taxed at long term rates. This would be rather difficult for a participant in the plan 20 years plus.

2) if the participant took a distribution in shares, this could not be rolled over into an IRA? Would the proceeds from the purchase of the shares outside the plan be an eligible rollover distribution?

[GMK]

1) The basis is the cumulative total of value of the stock at the time the plan acquired the shares. In your example, the basis is $6000, and the NUA is $2000, and would be taxed as you described.

2) If you roll over the stock to a taxable investment account, you get to use NUA tax treatment (assuming a lump sum distribution following a triggering event), but you'll be paying the taxes on the distribution. For example, see this link:

http://www.dinkytown.net/java/StockRollover401k.html

If you do a rollover to an IRA, you lose the NUA option.

You have to run the numbers, but in most typical cases, a rollover is better in the long run, because the money that you otherwise would have paid in taxes goes into your rollover account to generate additional earnings.

Check with a financial advisor about whether a rollover or NUA is better for you in your situation.

[RLL]

This plan only has like $20K in cash and some of the participants have account balances of $200K and up that they will have to pay in the near future. Can the company buy additional shares from the plan at one time to plan for these future pay outs? It is about a 2 and a half hour process each time they have to go into their mainframe to change the stock list.

It's better to avoid having the company buy shares directly from the ESOP. In order for the PT exemption under ERISA section 408(e) to be satisfied, the purchase price must be no less than the fair market value of the shares on the purchase date. In a closely held company, determining compliance with the fmv requirement on an up-to-date basis can be a problem. On the other hand, when shares are distributed to participants by the ESOP and then the company buys the shares from the distributees, the purchase price may be determined as of the prior year end.

[Lori H]

This plan only has like $20K in cash and some of the participants have account balances of $200K and up that they will have to pay in the near future. Can the company buy additional shares from the plan at one time to plan for these future pay outs? It is about a 2 and a half hour process each time they have to go into their mainframe to change the stock list.

It's better to avoid having the company buy shares directly from the ESOP. In order for the PT exemption under ERISA section 408(e) to be satisfied, the purchase price must be no less than the fair market value of the shares on the purchase date. In a closely held company, determining compliance with the fmv requirement on an up-to-date basis can be a problem. On the other hand, when shares are distributed to participants by the ESOP and then the company buys the shares from the distributees, the purchase price may be determined as of the prior year end.

so if the company bought the shares from the plan, they would have to do a separate valuation, which would be an added cost to the plan?

[GMK]

so if the company bought the shares from the plan, they would have to do a separate valuation, which would be an added cost to the plan?

Yes, but the company can write the check for the valuation.

Just my opinion, but it seems ill advised to spend a few thousand on an evaluation when you have other, more cost effective options. As discussed previously, the company could simply contribute cash to the ESOP, or the ESOP could distribute shares to participants and have the company buy them, for example, using the put option.

[RLL]

so if the company bought the shares from the plan, they would have to do a separate valuation, which would be an added cost to the plan?

A "separate" valuation may not be needed. An updated opinion from the appraiser, stating that the purchase price is not less than fair market value as of the purchase date, would be sufficient. There would likely be an added cost for such an update. If the company's financial situation and the state of the capital markets are such that value is declining, the use of the most recent year-end valuation should be OK, but the opinion update would still be required. If value is rising, the appraiser would have to determine an updated fair market value for the purchase price. If a higher value is used, there is an issue as to whether the distributees are entitled to receive the increased value. In either case, it is preferable for such a transaction to occur as soon as possible after the year-end valuation.

For these reasons, it's much better for the company not to purchase the shares from the ESOP.

[Lori H]

so if the company bought the shares from the plan, they would have to do a separate valuation, which would be an added cost to the plan?

A "separate" valuation may not be needed. An updated opinion from the appraiser, stating that the purchase price is not less than fair market value as of the purchase date, would be sufficient. There would likely be an added cost for such an update. If the company's financial situation and the state of the capital markets are such that value is declining, the use of the most recent year-end valuation should be OK, but the opinion update would still be required. If value is rising, the appraiser would have to determine an updated fair market value for the purchase price. If a higher value is used, there is an issue as to whether the distributees are entitled to receive the increased value. In either case, it is preferable for such a transaction to occur as soon as possible after the year-end valuation.

For these reasons, it's much better for the company not to purchase the shares from the ESOP.

The company is wanting to buy the shares from the plan. They have a participant with a large balance who was taking installments, but is now wanting all her money due to the fact the last valuation(12/31) was lower. Is there a section of the code that references the need for a an updated opinion?

Thanks much!

It would seem that if the plan distributed the shares to the participants and then the company bought the shares, you would have to go back several years and determine the participants basis in the plan. That would be an additional cost as some of that information is ancient history and would most likely be in storage somewhere. What if the plan's records did not go back that far? There would be no way to determine a participants basis.

[GMK]

Here are a couple of articles on the subject:

http://www.esoplawblog.com/2008/03/article...gations-part-i/

http://www.esoplawblog.com/2008/04/article...ations-part-ii/

It appears that you need the valuation as of the date of the sale, and the plan has to consider other fiduciary concerns, such as, is it in the best interest of the participants to sell the stock rather than distribute it?

You only need to know the basis if the participant takes a lump sum payment to her. If she rolls it over to an IRA, NUA is not a factor. As noted before, after some number of years a rollover is the better choice, but you have to run the numbers in each case to see how long that takes.

Going back through the records, even if you have them, to calculate basis is a big job, especially if there were forfeitures credited to her account along the way.

Good luck.

[Lori H]

Thank you kindly, GMK. Have a great day