ESOP Distributions

[Belgarath]

C corporation has an ESOP. Their corporate charter/bylaws whatever restrict ownership to employees or plan only, so a stock distribution is not allowable. So when a participant is about to retire, (let's say they are entitled to $50,000 at current appraised stock value) I'm wondering what options are available. There were two that were brought up, and as I don't know much about ESOP's, I was wondering if one is "better" than another or if both are even allowable options:

1. The corporation makes a deductible contribution to the plan of $50,000. This cash is paid to the terminating participant, and the participant's stock is then allocated amongs the eligible plan partiicpants just like any normal plan contribution. This seems perfectly normal and acceptable. Is it?

2. The corporation contributes $50,000 to the plan to pay out the participant, but it isn't a deduction. Instead, they retire the stock. Is this allowable? Does it have any effect upon the stock price of the remaining shares in the plan? It would seem that this would be a "wash" and therefore a neutral transaction in terms of stock value (?), but is it even allowable?

[ESOP Guy]

Both are allowable.

Which is better is a more difficult question.

You need to talk to someone who has some experience with the question and knows your plan. It would seem like your TPA ought to be able to give you better guidence.

Here is the short of the two:

Cont leave shares in plan:

pros:

keeps allowing current employees to increase their ownership, or if new employee start owning the company. If having broad based ownership is a major goal you want to do this.

You are using pre-tax dollars to fund the payments as cont are deductable

the are other pros but that is the big one and I want to keep it short

cons

the level of contribution tends to be dictated by people leaving not your business plan (althought there are way to manage this) By this I mean one year you might put 5% of comp into the plan next year 15% the next 1%. If the ESOP is an employee benefit you might want to better manage your costs for example

Taking shares out of the plan

pros: like any share buy back it will casue the share price to go up, although with less shares the total value will not change.

You don't ever have to buy those shares from employees ever again. In theory the two methods should get the same repurchase obligation as one has high share price and the orther has more shares, the effects are the various people are different. If you go to ESOP conferences you can find people who have projected out the differences.

cons on of the differences newer employees don't get shares, so the rising share price only benefits current shareholders, which is typically older employees. So the newer employees are working and not sharing in the benefit of the company profits

You are using after tax dollars to fund distributions as this is not deductable

You can only buy shares from the ESOP for so long. Someone has to own the company so you can't buy 100% of the shares.

This is the very short version. I have a whole power point presetation I use for your clients as they enter this phase of the ESOP's life. You ESOP TPA should be able to help you get all the factors in front of you for an informed decision.

Another thing to look at there are ways to use dividends to get funds into the plan and under the right conditions the dividends can be deductable which isn't normally the case with a C corp.

You don't have to answer this, but have you looked into changing to an S corp ESOP?

[Belgarath]

Thanks!

[QDROphile]

Neither approach is necessarily preferable. The second can be particularly troublesome because of prohibited transaction issues. Are you interested in another way or are you somehow confined to the options you have suggested?

[GMK]

With an S corp owned by the ESOP, the Plan Doc can specify that the ESOP can distribute shares of stock if that distributed stock is automatically and immediately purchased by the company. The distributee (participant, beneficiary, rollover account) never has possession of the stock. The check is ready when the stock certificate is created and immediately cancelled.

A similar arrangement might work for a C corp where the automatic and immediate buy back applies only to distributions to non-employees. Employees receiving distributions in stock would still have the choice to keep it or use a put option to get cash. You would need to get your ESOP attorney's advice on all of this.

[ESOP Guy]

Bel I assumed you were the ESOP company not the TPA, but based on your comment on loan interest it appears you are the TPA.

You might want to think about the NCEO webinars coming up on repurchase obligations. Of note the May 16 webinar. You will note the webinars cost $150 which seems high. That is the NCEOs way of getting your to join. You can have a single person join for $90/year and that person can go to the webinars for free. But the 16th one talks about way to fund the obligation, which is a fancy way of saying paying out distributions.

This might help build your knowlege base.

http://www.nceo.org/main/meetinglist.php/id/1

[Belgarath]

ESOP - we are a TPA, but not for the ESOP. And by the way, thanks for the webinar info. I have no experience with ESOP's, but this was a question that came up in discussion. Seems like another one of these tricky little pension "niches" all on its own. QDRO, I wondered about the PT issue, which was why I asked if it was allowable - didn't know if there was a specific exemption that allowed it.

[QDROphile]

GMK described the distribution procedure that avoids the problems that you can have with #2. Under #2, the $50,000 is not really contributed to the plan. The plan is selling shares to the sponsor. The sale is OK, but to be exempt from the prohibited transaction proscription, the sale must close at the value of the stock at the time of the closing and most plans do not want to get a valuation opinion at the time of every distribution. The approach described by GMK allows the sale of the shares to the sponsor under the presumption that the most recent regular valuation is still valid.

I don't think that the automatic buy-back arrangement is limited only to distributions to non-employees, so I invite GMK to elucidate. The authority for the arrangement is indirect, so some details are not settled.

[GMK]

In the OP, employees and the plan can own stock. My example was based on a situation where no one but the ESOP can own stock (which I should have said).

If the plan doc says that the company MUST automatically and immediately buy any stock the ESOP distributes, that would take away the option for current employees to own stock distributed from the ESOP (which I don't think they want).

So, I suggested that the auto and immediate buy back only apply to shares distributed to non-employees.

[RLL]

GMK described the distribution procedure that avoids the problems that you can have with #2. Under #2, the $50,000 is not really contributed to the plan. The plan is selling shares to the sponsor. The sale is OK, but to be exempt from the prohibited transaction proscription, the sale must close at the value of the stock at the time of the closing and most plans do not want to get a valuation opinion at the time of every distribution. The approach described by GMK allows the sale of the shares to the sponsor under the presumption that the most recent regular valuation is still valid.

I don't think that the automatic buy-back arrangement is limited only to distributions to non-employees, so I invite GMK to elucidate. The authority for the arrangement is indirect, so some details are not settled.

See IRC section 409(h)(2)(B). The mandatory cash-out provision (including the distribution of stock subject to immediate redemption) may apply to distributions to employees, former employees and beneficiaries if so provided in the plan document, so long as the employer is an S corp or if the corporate charter/bylaws restrict ownership to employees and the ESOP.