Foster Swift Employment, Labor & Benefits Quarterly
Companies that maintain ESOPs are legally required to provide enough cash to the ESOP to meet the distribution and diversification requirements of the ESOP (referred to as "Repurchase Obligation"). A company should implement a strategy to review the Repurchase Obligation and begin to fund for the Obligation to avoid any unpleasant financial surprises.
Upon a distributable event (i.e., death, disability or severance from employment), the company will ultimately be responsible for providing enough cash to the ESOP to equal the value of the company shares held in a participant’s account. There are two general mechanisms to deal with Repurchase Obligation. First, a company may contribute cash to the ESOP, which, in turn, is used to make a distribution from the ESOP to the participant. Under the "recycle approach", the amount of outstanding shares held by the ESOP remains constant.
Second, the employer may redeem (i.e., purchase) shares of stock held by the ESOP. The ESOP utilizes the cash from the sale of stock to the company to make a distribution from the ESOP. This redemption ultimately lowers the percentage ownership by the ESOP, but is done with after-tax dollars. Other than an S Company owned 100% by an ESOP, the "after-tax" element of Repurchase Obligation needs to be carefully taken into account by an ESOP company.
There are many methods available to an ESOP company to soften the financial impact of its Repurchase Obligation. For example, the timing and form of distributions should be reviewed. In addition, leveraged ESOPs should strongly consider structuring any ESOP loan (not the bank loan) for a longer period of time than the bank loan. This will result in a slower release of shares from the unallocated suspense account to participants’ accounts.
The legal obligation to fund these Repurchase Obligations lies with the company, not with the ESOP trustee. However, the ESOP trustee should be reviewing the company’s Repurchase Obligation and bring any issues to the attention of the company’s Board of Directors in order to properly discharge its fiduciary obligations to the participants. Both the company and the trustee must carefully review the ESOP valuation to ensure that it accurately reflects the per share value of the company held by the ESOP. In addition, there is now a discussion among ESOP appraisers regarding whether and to what extent the financial impact of Repurchase Obligation should be reflected in the annual valuation.
Companies should periodically review their Repurchase Obligations and fund their ESOPs accordingly. Failure to do so could result in creating or enhancing a potential financial problem to the company and could ultimately result in litigation if improperly handled.
Please contact your Foster Swift employee benefits professional if you have any questions.