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What is an ESOP?

An ESOP can be a highly effective liquidity and diversification strategy for business owners, while also providing additional employee incentives and sustaining local operations. The ESOP lawyers at Devine Millimet are uniquely qualified to assist owners of companies in assessing the feasibility of ESOPs in light of their personal objectives and the financial capability of their company. We counsel businesses in all industries to understand the benefits, the pros, and the cons of establishing an ESOP. Additional benefits of entering into an ESOP can be significant federal tax advantages to the owners and to the underlying company. 

ESOP transactions require extensive understanding of the tax and business considerations, rules, and regulations.  Our experienced Team has guided many companies and their owners throughout New England and across the US with their personalized ESOP investigation, feasibility, and transaction process. 

The Devine Millimet Team also has extensive experience representing both individual and institutional ESOP trustees in connection with their fiduciary role in an ESOP’s sale or purchase of company stock and with ongoing decisions. In a time when there is more focused attention by the regulatory agencies that oversee ESOPs, it’s important for ESOP trustees to have access to experienced ESOP legal counsel.

Beyond the flexible nature of the ESOP as an ownership transition strategy, the ESOP serves as an additional retirement benefit plan for employees participating in the ESOP. Our Team can assist companies ensure the ongoing compliance of the ESOP to ensure it remains a qualified retirement plan eligible for tax deferral.

Please call a member of the Devine Millimet ESOP Team today to explore whether an ESOP might be the right ownership transition solution for you!

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            Common Questions About ESOPs

            Q:  The CARES Act made certain changes to retirement plans available to help employers provide access to funds of participants. What are those options?
            A:  Although it is not mandatory for employers, the CARES Act allows you to permit plan participants to withdraw up to $100,000 from an eligible retirement plan (IRA, 401(k), ESOP, etc.) and upon doing so, the participant would not have to pay the 10% penalty as he or she otherwise would upon early withdrawal, even if he or she is not 59½ years old; however, the participant can only withdraw funds from a retirement account if he or she has a “coronavirus related distribution.”  To be eligible to make such a withdrawal, the retirement plan participant or his or her spouse or dependent must have been diagnosed with COVID-19, or the participant must have experienced adverse financial consequences due to COVID-19 as a result of being quarantined, a layoff, furlough, reduction in hours, the inability to work due to lack of childcare caused by COVID-19 or, for business owners, the loss of business.

            Withdrawing from an eligible retirement plan account under these conditions will trigger the participant’s payment of income taxes on the distribution; however, he or she will be able to pay the ordinary income taxes on such distribution spread over three years.  Additionally, to avoid such payment of income tax, the participant has three years from the date of the distribution to pay it back to his or her retirement account- if the participant chooses, which would defer the tax payments.

            Additionally, the CARES Act permits employers to allow increased loans from qualified retirement plans (including ESOPs) made from the plan to a participant from March 27, 2020 to September 23, 2020, but again, plan sponsors must elect to amend the plan to include the additional CARES Act provisions.  The applicable provisions of the CARES Act work to enhance existing loan rules by increasing the loan limit to the lesser of 100% of a participant’s vested account balance and $100,000. Generally, participants who take out a loan from the retirement plan must repay the loan within five years, but under the CARES Act rules, the date that triggers repayment is delayed for one year, giving borrowers six years to pay back the loan; however, interest continues to accrue during the additional year.


            Q:   In regards to the in-service withdrawal/distribution options and loan provision options – do those only apply to our 401(k) plan and do not apply to our ESOP plan?
            A:  No.  These provisions of CARES Act apply to an “eligible retirement plan” as defined in Section 2202(a)(4)(c) of the CARES Act, which defines eligible retirement plan to mean those plans given such term by Section 402(c)(8)(B) of the Internal Revenue Code.  That section defines eligible retirement plans to include, among other things, a qualified trust.  An ESOP is a qualified trust, such that in-service withdrawal options, loan provision options and waiving of early withdrawal penalties apply to ESOP plans in addition to 401(k) plans and certain other retirement plans. However, the expanded in-service withdrawal/distribution option and enhanced loan provisions are not mandatory and ESOP plan sponsors should carefully consider the implications of adding such features to plans that hold primarily (or solely) company stock.


            Q:  Do any of the CARES Act changes to retirement plans apply to ESOPs without the sponsor making an affirmative election?
            A:  Yes.  The CARES Act suspended (or temporarily waived) all required minimum distributions (RMDs) from retirement accounts for calendar year 2020.  This is a benefit to the company and retirees in that it does not take away from already diminished plan assets and it allows retirees to potentially see gains in their ESOP accounts once the economy recovers. If a retiree has already taken his or her 2020 RMD and the distribution was within 60 days, then the CARES Act allows such retiree to consider the distribution an eligible rollover distribution, and put it back into his or her account. There are more nuances to the 60-day rule that should be discussed with your professional advisors. 


            Q:  If we elect to adopt any of the options offered by the CARES Act to our retirement plans (i.e., ESOP, 401(k), etc.), will we need to make any formal amendments to our plan documents?  And if so, by what date?
            A:  Yes.  Election of any of the options offered by the CARES Act will require amendments to the applicable eligible retirement plan.  Plan amendments to which the applicable sections of the CARES Act related to the options listed above (excluding the automatic RMD suspension) currently must be made on or before the last day of the first plan year beginning on or after January 1, 2022.  For calendar year plans, that means amendments must be done by December 31, 2020.  We will communicate the plan for such amendments to our client’s plans in the future, as no current amendment is necessary.


            Q:  Due to the impact of COVID-19 on the value of our company stock, can the valuation of the stock as of December 31, 2019 be revised?
            A:  No.  Because COVID-19 and its impact was not or could not have been known at the time (as of Dec. 31, 2019), valuations completed as of December 31, 2019 cannot be modified for the impacts of COVID-19.


            Q:  My company has made the difficult decision to lay-off employees due to the impact of COVID-19 on our business.  This may have material impacts on the repurchase obligation of the company both currently and in the future.  Specifically, we know the value of company stock has declined since December 31, 2019 due to the impact of COVID-19 and to pay out distributions and diversification elections at the December 31, 2019 value would put the ongoing operation and sustainability of the company at risk.  Can the company use a different valuation of the company’s stock to make distributions and diversification elections during 2020?
            A:  It depends on the terms of your Plan, but for many Plans the answer is yes.  Many Plans give the Plan Administrator (i.e. Board of Directors in many companies) the discretion to utilize an interim valuation when necessary.  An interim valuation is a new valuation completed by the Plan’s trustee and valuation firm as of a date between January 1, 2020 and December 31, 2020.  The interim value of the stock is then used to value the distributions and diversification elections during the 2020 plan year.  This is something your company can consider in light of COVID-19 and its impact on the viability of your company.  If you are interested in discussing interim valuations, Plan amendments and other options for your particular situation, please contact Tabitha Croscut at (603) 695-8542.


            Q:  Other than considering an interim valuation, are there other ESOP related items that we should be considering due to the significant impact that COVID-19 has had on our company’s operations and financial capabilities?
            A:  Yes.  In addition to concerns regarding the value of company stock for purposes of 2020 distributions and diversifications, ESOP companies should consider other features of their ESOP’s operation that will impact cash flow during 2020 and beyond, including, for example, the following: (i) potential changes to the 2020 distribution policy; (ii) potential changes to the 2020 allocation requirements due to the potential reduction in hours of service of some employees; (iii) the impact of reduced payroll on the maximum contribution limitations (i.e. 25% of payroll); and (iv) the inadvertent occurrence of a partial plan termination during 2020 resulting from the involuntary termination of approximately 20% or more of ESOP participants.  Every company will need to consider its own circumstances and review how those circumstances may or may not be impacted by how the ESOP currently operates.  Companies should be proactive and discuss with their legal counsel and third party administrators any changes that may be applicable as soon as possible to avoid certain cut-off times, after which certain changes to the plan will not be permitted.


            Q:  One of our employees is seeking a divorce and they have asked for a distribution to their ex-spouse of 50% of their vested ESOP account value.  Can we transfer 50% of the ESOP account value to the ex-spouse?
            A:  Generally a participant’s ESOP account is not assignable, meaning it cannot be transferred; however, a qualified domestic relations order (QDRO) is an exception to the antiassignment rule which permits the ESOP to pay benefits to someone other than a participant pursuant to the terms of the QDRO.  In the absence of a QDRO or if the domestic relations order is not qualified, any payment of benefits to someone other than the participant results in disqualification of the ESOP and possible fiduciary liability.  A DRO must meet a list of requirements to be considered qualified and every ESOP should have QDRO procedures.

            Q:  An employee is filing bankruptcy and is concerned about access to his/her vested ESOP account balance.  Is a participant’s ESOP account excludable from his/her bankruptcy estate under Bankruptcy Code section 541?
            A:  Yes, the Supreme Court has held that the antiassignment provision in ERISA Section 206(d) is enforceable, which results in the exclusion of the ESOP benefit from the bankruptcy estate of the plan participant.


            Q: Can an ESOP participant’s account be assigned or levied against?
            A:  An ESOP participant’s account as a qualified plan accrued benefit is protected from assignment or alienation under IRC Section 401(a)(13)/ERISA Section 206(d).  The two exceptions to this are a Qualified Domestic Relations Order and a federal tax levy.  The IRS may enforce a tax levy against a participant’s ESOP account; however, the IRS generally can’t demand payment from the ESOP until the time the participant is entitled to a distribution from their ESOP account.  This exception does not extend to state tax levies.
            The ESOP account is also protected from the company’s creditors because the ESOP assets are held for the exclusive benefit of the participants and their beneficiaries and are not part of the company’s general assets.


            Q: Why does the independent trustee in an ESOP transaction need separate legal counsel?

            A: The ESOP Trustee’s attorney is serving the role as Buyer’s counsel in a typical M&A transaction – the ESOP is the Buyer (or seller in some cases).  The Trustee’s attorney will review and negotiate the transaction documents on behalf of the Trustee and should be engaged in a review of the legal due diligence information.  When we serve as Trustee’s legal counsel we prepare a lengthy diligence memo for the Trustee and also ensure that all formal meetings of the Trustee are documented in minutes.  Trustee’s counsel should have sufficient experience and knowledge to be awareness of the requirements and expectations that the Department of Labor and Internal Revenue Service have regarding the Trustee’s process and assist the Trustee in procedurally complying with those requirements and expectations, which will enable the Trustee and the Company to provide acceptable responses in any audit post-closing.
            Depending on the attorney’s billing rate, it would be very difficult to adequately complete a transaction as Trustee’s counsel for $25,000, and there are very few ESOP lawyers that will fix the fee due to the number of unknowns that are out of their control, such as what information will be uncovered during the due diligence review process.


            Q: As an ESOP plan sponsor, can I change the allocation eligibility requirements of my ESOP to add or remove requirements after the ESOP is adopted?

            A: Yes.  An ESOP can require an employee to be employed on the last day of the plan year and/or to complete at least 1,000 hours of service to receive an annual allocation of employer contributions or company stock for the plan year, provided the legal coverage requirements are satisfied.  These are referred to as the allocation eligibility requirements and are separate and distinct from the participation eligibility requirements. Generally, new ESOPs will define the plan’s allocation eligibility requirements when the ESOP is first implemented, and those requirements are not changed for the life of the ESOP; however, the allocation eligibility requirements can be modified prospectively.  For example, if the ESOP’s current allocation eligibility requirement is only completion of 1,000 hours of service during the applicable plan year, the plan sponsor could later decide to add the requirement of employment on the last day of the plan year  to future plan year allocations. 

            Adding an allocation eligibility requirement in a current plan year could result in a reduction of participants’ accrued benefits (i.e., a participant has worked 1,000 hours by August 1st and the sponsor adds a last day of plan year employment requirement to the plan on August 30th; if the participant terminates prior to year end, the participant loses the allocation for that plan year), which would be a violation of the anti-cutback rule.  Thus, it is much harder to change the eligibility requirements for a current plan year.

            Another feature of the allocation eligibility requirements that ESOP sponsors consider at the outset is how to treat death, disability and normal retirement age terminations during a plan year.  Should those categories of terminations be excluded from the 1,000 hours of service requirement?  Should they be excluded from the last day of plan year employment requirement? Or should they be excluded from all allocation eligibility requirements and automatically receive an allocation no matter what?  Additionally, some ESOP sponsors decide to treat the three categories differently.  For example, the normal retirement age terminations may not be required to meet the last day of plan year employment requirement, but they must still have 1,000 hours of service during the plan year; whereas, the death and disability terminations might be excluded from both requirements.  Again, these are features of the allocation eligibility requirement that can be modified prospectively.

            A couple common questions asked about these requirements deal with certain categories of employees.  First, what happens when you have seasonal layoffs.  If the ESOP has a last day of plan year requirement, will those employees never receive an allocation in the ESOP?  The answer depends on the treatment of seasonal layoffs.  Most companies do not remove those employees from payroll and consider them terminated, but rather they are temporarily laid off and remain on payroll to return to active employment in the next plan year.  If that’s the treatment of such seasonal employees, then they will meet a last day of plan year requirement by remaining on payroll as an employee of the company.  Second, what if you have employees that move from union to non-union, how does that impact the participant where there is a last day of employment requirement and they might be a union employee on the last day of the plan year?  Whether the participant is categorized as union or non-union, the employee would be considered to meet the last day of plan year employment requirement so long as he or she is an employee on the last day of the plan year.


            Q: Is my ESOP plan required to regularly be submitted to the Internal Revenue Service (IRS) for confirmation that it remains qualified as an employee stock ownership plan?

            A: Effective January 1, 2017, the IRS changed the submission requirements and eliminated the five-year remedial amendment cycle system for all individually designed plans, including ESOPs.  Prior to January 1, 2017, ESOPs were required to submit determination letter applications every five years within their “cycle” based on the plan sponsor’s EIN.   The IRS now accepts determination letter program submissions for individually designed plans for ONLY initial plan qualification (e.g., newly adopted ESOPs) and qualification upon plan termination.  There is no longer a requirement for ongoing ESOPs to regularly submit to the IRS for a determination letter.  However, each year the IRS issues a Required Amendment List, which establishes required changes and the applicable period of time within which those changes must be made to plans, referred to as the remedial amendment period.  There were no items included on the 2018 Required Amendment List.  It is important for qualified plans to stay in compliance with the required changes established by the annual Required Amendment List to ensure in the event of an audit that the plan sponsor will not be assessed a penalty fee for noncompliance. 

            Additionally, the IRS has indicated in guidance that determination letters issued to sponsors of an individually designed plan (e.g., an ESOP) on or after January 4, 2016, will not include an expiration date.  Such guidance also confirmed that expiration dates included in determination letters issued prior to January 4, 2016 are not operative.