As employee owners become eligible for a distribution or diversification, the ESOP Trust is legally obligated to purchase the plan participants’ ESOP shares. How the company meets this obligation can happen multiple ways, depending on the ESOP’s distribution policy.
The ESOP trustee has a fiduciary duty to ensure a repurchase obligation follows plan parameters and ERISA requirements. Likewise, the trustee must be mindful of how a payout could impact company cash flow stability, employee ownership structure, and tax benefits.
Given the potential legal and financial ramifications, how the ESOP structures the repurchase obligation needs to be in the mix of decisions as a company considers selling to an ESOP as well as ongoing administration of the plan. The best course of action is to consult with an ESOP expert to ensure proper strategy, but being aware of your options is valuable as you look into employee ownership.
3 Approaches to ESOP Repurchase Obligations
There are three primary ways an ESOP can handle repurchase obligations:
- Recycle: The ESOP Trust uses cash within the plan to exchange the shares from participants who requested a distribution or are eligible for reshuffling with cash within the plan.
- Redeem: The shares leave the ESOP Trust. Those shares are generally sold back to the company immediately, giving the participants cash and the company shares.
- Redeem and Recycle: A hybrid approach that combines elements of recycling and redemption.
There are distinctions between these simplified definitions, but exploring the advantages and potential drawbacks of each choice helps clarify which best aligns with your goals.
Recycle Strategy: Keep Shares in the ESOP
With recycling, the ESOP trust buys back the shares of participants requesting a distribution or are eligible for reshuffling for the purpose of redistributing them to plan participants with non-reshuffled cash balances. In this scenario the company funds the plan with dividends or cash contributions, so the shares remain within the ESOP. This approach may help ESOP companies manage costs, taxes, and remain committed to long-term employee ownership.
Benefits
- Cash flow predictability: In combination with a distribution policy that creates delays or installments, repurchase contributions can be forecasted and accounted for in the company budget
- Tax advantages: This method requires a cash contribution into the plan. The contribution is deductible, reducing total corporate taxable income
Cautions
- Future cost increases: As 100% of the shares are returned to participant accounts, their accounts may grow quicker than initially predicted and can lead to paying the same shares out over and over again in a short amount of time
- Can create compliance issues: A year in which there is a significant amount of funding needed for distributions or reshuffling can lead to excess participant contributions, going above the maximum deductible limit, and could create a top heavy situation within the plan
Redeem Strategy: Company Purchases and Retires Shares
After the shares leave the ESOP Trust, the company has multiple options for those shares: The shares can be permanently retired (reducing the number of overall ESOP shares), the shares can be contributed back to the plan, or the shares can be re-leveraged (releasing the shares back to participants over time). A combination of these can also be used – an approach that may best serve companies wanting more flexibility in share repurchases.
Benefits
- Flexible cash flow management: Shares can be returned to the plan as a stock contribution (a tax deductible event) or can be returned to the plan with an ESOP note in which the shares are released to participants over time or retired. Retired shares can be contributed to the plan or used to create a new note in the future
- Possibly lower long-term costs: As the number of available shares is reduced, so is the total repurchase liability
Cautions
- Risk of employee ownership dilution if shares are retired: In a company that is not 100% ESOP owned, retired shares increase active plan participants’ ownership percentages, but decrease overall ESOP ownership in the company
- Retiring the shares: Automatically increases the stock valuation, as the number of shares to divide the company’s worth by has decreased
- No tax deductibility: While ESOP contributions offer some corporate tax advantages, redeeming shares is not tax-deductible unless the shares are contributed back to the plan
Redeem and Recycle Strategy: Combined Shares Recycling and Redeeming
This hybrid approach provides flexibility in that the company partially directly buys and retires shares and partially funds the ESOP in order to buy and reallocate shares among eligible plan participants. This approach provides a way for an ESOP company to support and cultivate a culture of employee ownership while also gaining cash flow efficiencies.
Key Benefit
- Cash flow and tax benefit optimization: Choosing to recycle and redeem shares gives companies the latitude to effectively manage share availability to control cash flow. Likewise, the combination offers tax advantages on some of the investment
Key Caution
- Potential future liabilities: Not creating the right balance between redeeming and recycling shares may cause future liabilities related to the change in stock value and shares in participants’ accounts
3 Questions to Ask When Choosing a Strategy
Working with an ESOP expert to answer the following key questions will be beneficial in matching the best strategy to your needs:
- How will repurchase obligations impact our company’s cash flow over the foreseeable short term and long term?
- What is the most tax-efficient way to fund our repurchase obligations?
- How will our repurchase strategy affect long-term ESOP ownership and employee benefits?
Tips for Success
Understanding and managing your ESOP repurchase obligations is essential for maintaining financial stability and ensuring the long-term success of your ESOP.
Our ESOP Repurchase Obligation Tip Sheet is a great reference tool for understanding repurchase strategies, navigating potential financial and tax considerations, and planning sustainability.
