Purchasing stock - timing, etc.

[Belgarath]

Not sure if I'll even ask this right, but here goes. Aside from "what does the plan say" I'm more interested in legal/regulatory requirements that might prohibit this, or practical considerations.

Suppose you have a new ESOP. S-corp, leveraged ESOP, 100% of stock. Plan is effective for 2013. Loan doesn't take effect until 2014, with a 10-yer repayment schedule, at the end of each year. Shares will be released as usual, etc., for the second and subsequent plan years as the loan payments are made. (2014 onward)

The first year contribution is cash, and is allocated as such. What happens if they want to, say in June of 2014, take the cash that was contributed and allocated to participants for 2013, and purchase stock with it? Or perhaps to make it simpler - can the Plan Trustees/Administrator/Fiduciaries, at any time, purchase stock with the cash in the plan (assuming not messing with diversification rights or anything like that?)

I'm perhaps making this more difficult than it is, but maybe I'm missing something critical?

[QDROphile]

The only funny part of the post is imagining a 100% ESOP owned company in 2013 when the ESOP apparently owns no stock in 2013.

[ESOP Guy]

I am not sure I fully understand the question. Is it this? There is allocated cash in the plan. Can they use that cash to purchase share within the plan? Example: If someone is terminated and needs a distribution can they take the share from the terminated person and give them the FMV cash for those shares-- then make the payment? Yes

[Belgarath]

Thanks - as I said, I wasn't sure if I was asking it right, and I wasn't.

So the plan is effective 1/1/2013. The company doesn't become 100% ESOP owned until 2014 - loan is first effective in 2014, with first annual payment to be made on 12/31/2014.

The employer just makes a "regular" PS contribution to the plan - participants' cash accounts - for 2013. Can this money then be used to purchase stock out of the ESOP account in, (pick a month) June of 2014? Are there any downsides to this that you see? Is there any particular reason that you know of that this would be beneficial? Any reasons the lender might object? Etc...?

I'm just not sure why in particular someone might want to do this, other than anticipated stock price changes - maybe getting more shares released early in anticipation of a big increase? Or something like that, maybe?

Thanks!

[GMK]

See ESOP Guy's example. The purchased stock goes into the participants' stock accounts, and their cash accounts are reduced by the value of the stock they each got. Same thing if the ESOP purchases the stock from the Company's treasury, if available. And if the ESOP owns 100% of the company, there are no other sources of stock.

This can happen at any time during the year. The recordkeeping (stock and cash account balances) has to track the changes as of the date they happen, which is no big thing. If this is an S corp and you're keeping track of tax basis for NUA purposes, there's a change in the allocations of pass-thru earnings each time the allocated stock totals change, so that's some work.

As long as the lender gets paid on schedule, they shouldn't have anything to object about.

If the ESOP has cash to pay distributions, the company doesn't have to worry about coming up with cash to buy distributed stock (assuming the ESOP is meant to stay the 100% owner of the company). On the other hand, the cash in the ESOP is not available for the company to use as it might wish or need.

[Belgarath]

Ok, thank you very much.

[ESOP Guy]

At risk of stating the obvious but if you are going outside the ESOP you will need an apprsial for that transaction which is the most likely reason people don't do it very often.

[Belgarath]

Ok - but since the loan is in 2014, and there was an appraisal for the loan that pegged the stock price, any reason that value couldn't be used?

[ESOP Guy]

How many months apart are the two events?

If it isn't basically the same date I think you have to get a new appraisal.

Even if it is 5 or 6 months apart I think you have a problem of knowing you are paying FMV.

This comes up in distribution processing. It takes a company until Aug to get the certs out. Now the sponsor want to make payments to people and do it by selling the shares from the trust to the sponsor. Every attorney I know will tell you that you can't use the 12/31 value to know there isn't a PT. You would have to get a new appraisal.

I see no reason why this is different.

(Note the example above is different then if the shares stay in the trust. At which time you can use the prior 12/31 price. I know odd but that is how the PT rules work. The sponsor is a part in interest so you have to pay FMV. The participant I believe is a class exemption to the PT rules.)

[A Shot in the Dark]

B:

I would like to answer your question in the form of explaining a very typical scenario that occurs: For purposes of the scenario the employer is an "S" Corp with a calendar year fiscal year and ESOP Plan Year.

An employer is contemplating an ESOP transaction to take place in 2014, whereby the ESOP will acquire 100% of the outstanding shares of the employer stock from the shareholders. As way to create a 2013 tax deductible contribution and to come with some cash (probably to be used as a down payment) to be part of the 2014 stock transaction, the employer establishes the ESOP for 2013.

The employer contributes cash to the ESOP for 2013. That cash is allocated to the Plan Participants and the plan administration is completed.

In 2014, the Stock transaction takes place. As part of the transaction, I am assuming you will find

• a Stock Purchase Agreement
• Seller Notes
• Loan Administration Agreement
• Initial Stock Appraisal - Fairness Opinion

The transaction calls for the 2013 cash contribution to be a down payment to the seller as part of the overall transaction.

The day of or shortly thereafter, the ESOP issues a check to the Seller in the amount of the 2013 cash contribution.

For the 2014 Plan Year Administration, a transfer from the cash account to the Stock account whereby the amount of shares is based upon the computed share release along with any other contributions made during 2014 that were used to satisfy the seller note payments, etc.

This sort of sequence of events occurs all of the time.

[ESOP Guy]

It isn't' clear it would be wise to purchase a bunch of stock right before a large leveraged ESOP purchase either. Typically the ESOP loan is a reduction of the company's value so the stock price tend to go down by a large amount when the leverage purchase happens. So the plan could be buying shares it knows will go down in value.

[Belgarath]

What about 54.4975-11(d)(5)? (I tried every way I could think of to paste in either the text or a link - won't seem to work - never had this problem before!)

As this isn't a "put" option situation, it would appear that the most recent annual appraisal would be sufficient? Thoughts?

[GMK]

http://www.law.cornell.edu/cfr/text/26/54.4975-11

[A Shot in the Dark]

Perhaps I am being dense about the question and the sort of transaction that is being discussed.

The ESOP as a Qualified Retirement Plan is established the year prior to the year in which the Stock Transaction takes place. For the first plan year a cash contribution is declared, deposited and deducted.

During the second plan year, the stock transaction takes place, As an example, let us use the following dates.

Calendar year Plan year

First Plan Year, 2013

Second Plan Year 2014

For Plan year 2013 a cash contribution of $250,000 is declared, deposited to the ESOP and deducted.

April 22, 2014, the stock transaction is completed with correct documentation and appraisal. The stock purchase agreement outlines the terms the of sale of the stock. In conjunction with the Stock Purchase Agreement the the Seller Loan Note outlines the terms of the payments to seller. As part of the terms, the $250,000 is used a payment to the seller as part of the transaction.

As part of the December 31, 2014 ESOP Plan Administration, the share release is computed based upon the terms of the Plan Document, the Stock Purchase Agreement and the Seller Loan Note. And, of course another appraisal is completed for the Plan Year End.

For the first year of of an ESOP there are almost always two appraisals completed. The initial appraisal for the transaction and the standard appraisal for the plan year end.

The initial cash contribution to the ESOP and the use of that cash as part of the Stock Transaction has nothing to do with Suspense Accounts, etc. and the cash contribution is not being used to purchase stock prior to the initial stock transaction.

[Belgarath]

Hi Shot - thanks for the response. Your post is right on up to the part where you say that the $250,000 is used as a payment to the seller as part of the transaction. It isn't. Hence my puzzlement as to why someone might want to do this.

So the question remains, is it acceptable to use the initial stock valuation done, in your example, on April 22, 2014, and in June, or July (or whenever they decide to use the $250,000 to prepay part of the loan and release shares to the participants' accounts) as the basis for the share release? Or, must they do a new appraisal? It seems to me that they can use the April valuation.

Thanks again!

[ESOP Guy]

What about 54.4975-11(d)(5)? (I tried every way I could think of to paste in either the text or a link - won't seem to work - never had this problem before!)

As this isn't a "put" option situation, it would appear that the most recent annual appraisal would be sufficient? Thoughts?

Once again I am confused by your comment. To quote the referenced rule:

In the case of a transaction between a plan and a disqualified person, value must be determined as of the date of the transaction.

If the ESOP is buying shares from a disqualified person the value "must be determined as of the date of the transaction". The fact set you are describing isn't doing that but using an appraisal that is months old. The only way I seem that I could be wrong is if the seller isn't a disqualified person for some reason. I have been assuming the seller is the plan sponsor based on the question. Let me know if that assumption is wrong.

Strangely you can use the prior annual valuation when you are doing the standard put option transaction. That transaction goes like this:

Step 1: Distribute the shares to the former employee

Step 2: Have sponsor buy shares from former employee per the Put Option. You will note there are no disqualified persons as the plan isn't involved. The whole buy/sell is between the company and one of its shareholders. (Even if they are only a shareholder for 1 second.) So if the two agree to the transaction at the prior annual stock price no problem.

[Belgarath]

Thanks ESOP. Well, maybe I'm reading that section wrong.

I agree that it says that for transactions between the plan and a disqualified person, value must be determined as of the date of the transaction. But, the proposed transaction isn't between the plan and a disqualified person. The plan already owns the shares, and the cash already in the plan participants' accounts that represents the 2013 contribution is proposed to be used to prepay some of the loan, and shares will be released accordingly to the participants.

So the quoted regulation goes on to say that for all other purposes under this subparagraph (5), value must be determined as of the most recent valuation date under the plan.

Maybe my initial terminology was incorrect. Maybe it should be a "release" of shares rather than a "purchase" of shares?

[GMK]

Is this correct?

The ESOP took out a loan in 2014 and used the loan money to buy shares at a price determined early in the year, and these shares are in the suspense account in the ESOP.

Now the ESOP wants to use the $250k that was contributed in 2013 to pay off some of the loan, which would result in the release of some number of shares from the suspense account to the participants' accounts.

And the question is whether or not the valuation/price determined earlier in the year can now be used for determining how many shares are released by the $250k in June or July.

[A Shot in the Dark]

B:

Sorry, I guess I am dense. I get your question now. So, using my same example but addressing your question.

On April 22, 2014, the Stock Transaction takes place with the same set of documentation. Except the stock purchase agreement and seller loan note might state something like this:

The ESOT shall make a payment of $250,000 on or before July 31, 2014 and another payment of $__________ on or before October 31, 2014. The principal balance remaining after those two payments shall then be amortized over a 10 year period with the first installment due on January 1, 2015 and remaining payments shall be equal annual installments of principal and interest.

To satisfy the payment requirements of the seller note, the company must deposit contributions at least equal to the payment requirements.

The share price on which to compute the release of shares is based upon the initial appraisal. But remember the share release may very well be based upon a different computed release price depending if the share release is principal only or principal and interest.

An appraisal is not required each time a contribution or opposing payment is made.

In my example, for the Plan Year End December 31, 2014 all of the payments (contributions if the same) would be added up to compute the share release on the plan year end date, which is the valuation date for most ESOP's. In most ESOP's, the share release calculation and allocation occurs one time a year at the plan year end regardless of the number of payments (contributions) made.

[ESOP Guy]

If all you are asking is can you use the money put into the plan as a contribution for the PYE 2013 to make a payment on the loan in 2014-- yes you can.

The FMV is irrelevant. You compute the release per the document which is the ratio of loan payments over total loan payments. As Shot says you have to look to the paperwork to know if you use Prin+int or just Princ on that calc.

FMV just doesn't change how many shares are release.

As Shot says you would really compute the release at an allocation date which in an ESOP would normally be once per year. I suppose you can have quarterly allocation (for example) but that would be very rare.

I am not trying to be mean here but if you are a TPA that doesn't normally work on ESOPs you might want to work with one that does. If you are a company that is trying to work your own ESOP you might want to get help from a TPA that does ESOPs for a large part of their business. The firm I work for makes good money every year fixing ESOPs that good 401(k) TPA providers or company's thinking how hard can this be and they end up in VCP.

[Belgarath]

Thanks to all for your responses.

First, I'd like to say that all of this is in fact a hypothetical question, not a "real life" situation. We were having a discussion about this issue, and weren't sure, so I thought I'd get some opinions here and as always, the discourse has been very helpful.

Shot, FWIW, I wasn't envisioning a situation where there is any formal agreement in the loan note, seller agreement/stock purchase agreement. Merely a situation that would be purely discretionary - using cash in the plan to prepay the loan and release shares.

GMK and ESOP - yes, that's precisely the situation we were discussing here.

Again, this has been very helpful, and I thank you. Observations from experienced people like you who have actually been in the trenches are far more valuable to me than textbook discussions generally are. I find ESOP's to be a somewhat daunting subject, and all the ERPA and QPA, etc. coursework pretty much glosses over them, so I'm trying to learn more about them from other sources. The regs and all the legal/compliance information is fine, (although tough sledding at times) but that stuff doesn't address these types of common, real life questions. I'm not sure there is any substitute for actual experience!

[ESOP Guy]

For what it is worth I find a lot of course work in the retirement field lacking in term of many common day to day problems. I remember back in the early '90s when I was first learning 401(k) plans. You learned about all those refunds you might have to make with gains. For the longest of time it never struck anyone to make it clear what you did if the plan had a loss. Maybe it was obvious to everyone less but it wasn't to me. It seems like now you see it written more clearly. That is just one of the many examples I remember.

The only places you can go and get a good education about ESOPs are ESOP Association and NCEO conferences in my opinion. There you will hear speaker that do ESOPs for a living.

[GMK]

ESOP Guy has given you some good notes, and he's right about where to get more information. Running an ESOP is another way to get educated in a hurry, but don't try it without a really good ESOP attorney advising you. When ESOP questions arise, you will regularly hear, "There is little guidance, so ..." which means that you need someone who is immersed in the ESOP world and can give informed advice. And, as with other topics, BenefitsLink can be a good resource.

We've seen some very good 401(k) people struggle with the ESOP. For example, simple schedule differences are important. With once a year valuations, there's a push to get account allocations and other paperwork completed pretty fast after the first of the year, so we can process distributions timely. And we've seen people who had to be reminded every year that waiting until the 5500 deadline doesn't cut it.

Now, on to celebrating Ricky Nelson's birthday and my wife's birthday. Party time.