ESOP - 4 years and no appraisal or stock purchase

[Guest rhkesop]

The firm where I am employed established an ESOP in calendar year 2008. Since then, the firm has directed its 3% safe harbor 401(k) contributions into the ESOP.

However, the firm has not yet had an appraisal, and no stock has been purchased. Our safe harbor contributions have been sitting in a cash account since the end of 2008 earning almost zero interest, with substantial expenses related to plan administration eating away at the cash (we're probably really too small to be doing an ESOP, but that's another story).

Since the purpose of an ESOP is to buy company stock, how long can this go on without the ESOP purchasing stock, before the IRS or DOL decides this isn't a real ESOP? I should add that this is a closely held small company, where the primary owner has been reluctant to sell, as the value of the company is probably way less than in 2008, and the owner seems to be holding off on selling to the ESOP in the hope that the company value will increase.

[ETA Consulting LLC]

The firm where I am employed established an ESOP in calendar year 2008. Since then, the firm has directed its 3% safe harbor 401(k) contributions into the ESOP.

However, the firm has not yet had an appraisal, and no stock has been purchased. Our safe harbor contributions have been sitting in a cash account since the end of 2008 earning almost zero interest, with substantial expenses related to plan administration eating away at the cash (we're probably really too small to be doing an ESOP, but that's another story).

Since the purpose of an ESOP is to buy company stock, how long can this go on without the ESOP purchasing stock, before the IRS or DOL decides this isn't a real ESOP? I should add that this is a closely held small company, where the primary owner has been reluctant to sell, as the value of the company is probably way less than in 2008, and the owner seems to be holding off on selling to the ESOP in the hope that the company value will increase.

There are several apparent fiduciary breaches that would fall under the DOLs purview. You should contact your local DOL office and provide them your fact pattern.

Good Luck!

[ESOP Guy]

Can I suggest talking to the owner before you get the government involved?

I mean really the only real problem to you here is the cash is invested poorly. And even there it was free money to you.

I mean even if it isn't an ESOP in fact it would simply become a profit sharing plan. Maybe you can get him to amend the plan to rename and brand it as a profit sharing plan and get a better mix of investments. And if at some time in the future he decides to do the ESOP he can add that component back to the plan.

[ETA Consulting LLC]

Can I suggest talking to the owner before you get the government involved?

I would normally agree, but the system is designed to ensure the employees interests are protected; especially in situations where the employees aren't skilled enough (or versed in the rules) to ensure their interests are being protected. When you have a right to something, but fail to benefit from that right due to someone keeping you misinformed, then there are implications. The government has some enforcement mechanisms to ensure employees are protected when they do not have the authority (or background) to protect themselves. In fact, a large percentage of the "random" audits are a result of situations where employees request DOL involvement where they feel they aren't being treated fairly. If you feel the employer has set up an ESOP, refused to sell the shares to the ESOP in anticipation of the growth in value, and left amounts invested in a Stable Value fund since 2008 when markets have doubled since that time, there is no negotiation (because you're saying you were screwed by your employer). Are you being unreasonable? I don't know, but your fact pattern suggests that you believe you were.

Good Luck!

[Marcus R Piquet]

Wow, I've got to say that I think ERISAtoolkit.com appears to be way off-base here.

What rhkesop seems to be describing is, sadly, not that uncommon of a situation. Allow me to present the perspective of the Company in all of this:

- A company establishes an ESOP in good faith with the goal of using it to buy out an owner.

- Rather than doing a completely leveraged ESOP transaction, the Company plans to prudently "pre-fund" for the anticipated ESOP transaction by making contributions to the plan for a few years.

- Most unfortunately, a couple years into this plan, the Company is unexpectedly severly impacted as a result of the worst recession in our lifetimes. The owner sees the value of his investment fall precipitously, perhaps as much as 40% to 90%. How excited to you think he is about the prospect of selling his Company to the stock when it is at an all-time low?

- "Prefunding" within an ESOP for a future transaction is not at all uncommon. However, IRC §4975(e)(7) defines an ESOP, in part, as a plan which is "designed to invest primarily in qualifying employer securities" (see also §54.4975-11(b) ). This raises a difficult issue - clearly the ESOP is "designed" to ultimately be invested in employer securities, but how many years can the plan really go without actually acquiring employer securities before that "design" can be called into question? In my professional experience, we all start to get nervous about this after three to five years. In the case of the most severe recession of our lifetimes, would it be reasonable to stretch that out? Seven years? Ten? I'm not sure. ESOP Guy is spot-on here - what's the worse that could happen? The IRS could contend that the ESOP isn't really an ESOP but rather a profit-sharing plan. So what? That means that it would be more difficult (but not impossible) to use those funds in a future ESOP transaction.

- Regarding the nature of the plan investments and the administrative costs of the plan - remember that the current owner(s) is hoping to receive these plan assets in the future as consideration for his/her shares in a future ESOP transaction. His interests are aligned with the plan's - he wants to protect that nest egg and grow it prudently if possible so that the funds will be there at transaction time. I suppose it's possible that he's just stupid and likes to give his money away to service providers, and yes, that could constitute a fiduciary breach, but I think it's unlikely.

ESOP Guy is absolutely right. Talk to the employer first before talking to the government. I see no reason to assume that the employer is doing anything imprudent. To the contrary, it seems obvious that the owner is experiencing a lot more pain than the participants are. Getting the DOL involved prematurely probably wouldn't help anyone.

[A Shot in the Dark]

I agree with Marcus and ESOP guy.

To blatanly state there has been some level of fiduciary breach is not a factual statement.

[Guest rhkesop]

Thanks to those of you have responded so far. Appears to be some disagreement on how to proceed. I have heard that 3 years, while not cast in stone, is the period after which the government begins to get skeptical about the actual intent of the ESOP.

I think Marcus's description of the owner's frame of mind is fairly accurate, and I sympathize with the dilemma. However, I would disagree that the owner's interests in increasing value now are directly in line with the ESOP's interests. The ESOP would benefit more from buying the shares now at current value and then adding value. In other words, any value the employees add right now accrues to the owner, rather than the ESOP/employees. If the point of an ESOP is to give the employees a stake to motivate them, the fact that the owner is trying to build value first is kind of a demotivator.

A second point is that there has never been a statement that we are waiting to build up a cash reserve rather than do a loan. I think originally the intent was that there would be a loan to allow a purchase, that would be paid back with the annual contributions. In other words, the delay in purchase was never related to building up enough cash. Furthermore, I could come up with e-mails from several points in time demonstrating intent of the owner to sell a few months in the future (as indicated by plans to get appraisal, etc.). Then it simply never happens.

Also, at current values, there is probably enough cash to buy the 30% share the owner wishes to sell initially. There is no reason to wait anymore to do a cash transaction. Of course since there has been no valuation, who really knows?

When I have questioned the investment strategy, the answer has been that the funds needed to be kept liquid in order to be available for the upcoming stock purchase. That only makes sense as a short term strategy.

On the other hand, if the owner would have had their act together in 2008 when the ESOP was first set up, we would have bought stock that would be worth a lot less today. Compared to that, the low interest account looks pretty good.

[ETA Consulting LLC]

If I, personally, am part of a plan where I feel my rights as a participant aren't being enforced, then I would not hesitate to contact the DOL. The DOL investigators I've worked with tend to be very knowledgeable and proficient in their craft; and seldom let their emotions guide their decisions. To my knowledge, prudence is a fiduciary standard under ERISA that does not yield to any plan type. There may be flexibility, but how much? So suggesting that since the value is at an all time low the owner isn't excited about selling would appear to place the owner's interest (as an individual) above my interest as a Participant in the plan. I could be way off base, but I though that's what the Prudent Man Rule was design to prevent. These are determinations that may differ based on whose being affected; which is why I would've contacted the DOL a long time ago. If nothing else, they are objective (I do give them that much credit).

Good Luck!

[ETA Consulting LLC]

To blatanly state there has been some level of fiduciary breach is not a factual statement.

"Like". I wholeheartedly agree. Which is why I, typically, refrain from blatantly stating anything. "There are several "APPARENT" fiduciary breaches" was my attempt to avoid making blatant statements. I see that at being much different from saying "There are several fiduciary breaches" or "There are several obvious fiduciary breaches".

Good Luck!

[Guest rhkesop]

The downside of calling in the DOL is the standard whistleblower problem. This is a very small firm, and anonymity in making a complaint would be nearly impossible. A similar problem exists relative to actually talking to the owner, in being labeled as a troublemaker. Unless somebody knows how I can trigger an audit without the audit being indicated as being related to a particular complaint.

Yes, I suppose there are rules in place that would protect me if I complain, but my guess is their practical utility is limited in my situation. It's not only a small firm, it's in a small industry, such that I can't just go find another job if I get a troublemaker label stuck on me.

One thing I am not sure I made clear, the firm has a 401(k) plan in place that is not tied to the ESOP, except that the employer has chosen to make the 3% safe harbor contribution, and starting in 2008 that contribution has been directed to the ESOP. I am wondering, if the ESOP is found to be bogus, if it might mean that the whole 401(k) is not in compliance, which I presume would have ugly tax and other ramifications for me. The ESOP contribution is peanuts compared to what I have done as an employee contribution in the 401(k).

[ESOP Guy]

rhkesop:

Allow me to add to Marcus' employer perspective. The idea of a prefunding an ESOP is very common in ESOPs of small companies. The reason for this is there is a limit to how much money that can be contributed to any type of qualified plan. That limit is tied to compensation eligible for a contribution. Many small companies simply don't have a large enough payroll to support a contribution that can make the loan payment. So they in effect prefund a "down payment" for the purchase. I suspect this was the plan until the economy took a dive.

I would add most likely the owner doesn't want to sell 30% of the company. That will greatly reduce the amount he will receive for his stock. When they appraise stocks for these kinds of sales there are a number reasons they will apply a discount to the first number they determine as fair market value (FMV). One of them is the discount for minority ownership. If the ESOP will end up as a minority owner it has less say over the direction of the company then the majority owner. So its position is in fact worth less then if it were to buy a majority position on a ratable relatinship. Or put another way a 70% owner still controls 100% of the board of directors for example so a in many situations a 30% ownership is the same as a 0% ownership. Obviously, that isn't true in all cases. The 30% owner still gets 30% of the dividends (if any). But hopefully you can see how a 30% ownership is worth less then 30% of the full FMV. So most likely the owner wants to sell all or at least 50.1% of the company to the ESOP so he doesn't take a hit for the discount on the sale price.

I would tend to disagree with the idea that the owner has a fiduciary duty to sell while the share price is low. The fiduciary has an obligation to pay no more then FMV. But FMV is the price of a willing buyer and seller. At this point there is no willing seller so one can't determine FMV. The owner can solve the conflict of interest problem by hiring an outside trustee to represent the plan when he is ready to sell.

So I will go back to my first recommendation. Talk (nicely!) to the owner and see if you can either come to understand his position or if he is willing to be more accommodating regarding how the plan assets are invested. At this point in my opinion all you are out is the investments income and expenses haven't been as good as they could have been. Even after setting up the ESOP the stock is his to keep or sell. A business owner is never obligated to sell his business to the ESOP.

You situation is unfortunate as if you had been able to direct the Safe Harbor contribution it sounds like you would have a larger balance. But life not going according to plan and an action to get the DOL in someone's life aren't the same thing.

[John Feldt ERPA CPC QPA]

Or prehaps your situation is fortunate that the stock was not all purchased in 2008. Assuming it has declined in value since that time. Cash earning very little may be better than an investment that is declining in value.

[Guest rhkesop]

rhkesop:

Allow me to add to Marcus' employer perspective. The idea of a prefunding an ESOP is very common in ESOPs of small companies. The reason for this is there is a limit to how much money that can be contributed to any type of qualified plan. That limit is tied to compensation eligible for a contribution. Many small companies simply don't have a large enough payroll to support a contribution that can make the loan payment. So they in effect prefund a "down payment" for the purchase. I suspect this was the plan until the economy took a dive.

I would add most likely the owner doesn't want to sell 30% of the company. That will greatly reduce the amount he will receive for his stock. When they appraise stocks for these kinds of sales there are a number reasons they will apply a discount to the first number they determine as fair market value (FMV). One of them is the discount for minority ownership. If the ESOP will end up as a minority owner it has less say over the direction of the company then the majority owner. So its position is in fact worth less then if it were to buy a majority position on a ratable relatinship. Or put another way a 70% owner still controls 100% of the board of directors for example so a in many situations a 30% ownership is the same as a 0% ownership. Obviously, that isn't true in all cases. The 30% owner still gets 30% of the dividends (if any). But hopefully you can see how a 30% ownership is worth less then 30% of the full FMV. So most likely the owner wants to sell all or at least 50.1% of the company to the ESOP so he doesn't take a hit for the discount on the sale price.

I would tend to disagree with the idea that the owner has a fiduciary duty to sell while the share price is low. The fiduciary has an obligation to pay no more then FMV. But FMV is the price of a willing buyer and seller. At this point there is no willing seller so one can't determine FMV. The owner can solve the conflict of interest problem by hiring an outside trustee to represent the plan when he is ready to sell.

So I will go back to my first recommendation. Talk (nicely!) to the owner and see if you can either come to understand his position or if he is willing to be more accommodating regarding how the plan assets are invested. At this point in my opinion all you are out is the investments income and expenses haven't been as good as they could have been. Even after setting up the ESOP the stock is his to keep or sell. A business owner is never obligated to sell his business to the ESOP.

You situation is unfortunate as if you had been able to direct the Safe Harbor contribution it sounds like you would have a larger balance. But life not going according to plan and an action to get the DOL in someone's life aren't the same thing.

The owner does only intend to sell 30% originally, I think that's the minimum that provides some of the tax shelter, and with some finessing will allow him to maintain majority control (there are two other owners, and the majority owner only owns 80% of the company). But he might not be aware that there are valuation issues (you might be starting to get the idea this whole ESOP hasn't been thought through so well....). How does that work, is the valuation done with a particular sale in mind? What if there is just an annual appraisal that doesn't take into account an actual sale of a certain size?

[ESOP Guy]

There needs to be an appraisal done just for the sale. That appraisal should take in to account all the factors of the sale like if there is a discount for minority interest or not. Just about every new ESOP of any size gets a DOL and they will always make one justify the sale price.