As a business owner, you have decided to sell to your employees and implement an employee stock ownership plan (ESOP). Your advisors have helped you structure the deal, the financing is in place, and the last piece to complete is designing the actual ESOP plan and choosing a trustee.
The ESOP plan document needs to meet the regulatory requirements to be considered a qualified plan document by the Internal Revenue Service (IRS). You will want your attorney to assist you in drafting the document to ensure that it follows the IRS rules. We will cover the following areas of the document and specific topics to consider. The trustee can be internal or external. We will discuss both types.
Eligibility to participate in the plan
Items to consider are when an employee would become a participant for both age and service. A key factor to consider here is the turnover of employees as well as the age of the worker. Entry to the plan can be immediate or up to a year of service with a maximum of 1,000 hours. The minimum age cannot be higher than 21 years old. A more generous ESOP will allow entry into the plan upon hire. A company needs to consider their rate of turnover. If turnover is high, from an administrative perspective, a 1,000-hour requirement may be more practical.
Vesting of benefits
Vesting is determined by the years of service at a certain percentage. The participant will receive their vested balance when a distribution is paid out of the plan. Vesting can be a three-year cliff schedule where a participant is vested at 100% at three years.
A graduated schedule beginning at 20% at two years of service where at six years, the employee is 100% vested. Vesting service is based on hours worked in a plan year. One thousand hours worked is the maximum per year. Also, a plan document can exclude years worked prior to becoming a participant as well.
As in other qualified plans, an ESOP allows for payment of small balances up to $5,000 typically a year after termination. If a participant reaches retirement age, passes away, or becomes disabled, these individuals are typically paid out in the subsequent year. For other types of terminations, a distribution can be delayed up to five years after the date of termination.
The next question to ask is how will the participant be paid. Will they receive their entire balance or will they be paid in installments. The method of payment enters into the company’s cash flow needs as well as whether the ESOP is still leveraged or not. Payments can be in the form of cash or stock. However, cash is typically the preferred method of payment.
The definition of compensation is a key component of the plan design. Compensation is a component of allocating contributions to participants as well as the shares. Compensation can simply be gross wages, or you can exclude certain types of compensation such as bonus, commissions, or overtime.
Contribution allocations and share allocations go hand in hand. Contributions and shares can be allocated based on compensation (as defined by the plan). Another option is to use a point formula that is based on compensation and service. This method may be attractive to a company that has a long-standing employee base and they have just implemented an ESOP and want to reward long-term employees. Another option is to place a compensation limit which is below the maximum allowed under the regulatory guidelines. This is viewed as a benefit to those that may be concerned that executives are being rewarded more so than the average employee.
Trustee – internal and external
An ESOP is required to have a trustee. An internal or external trustee is allowed. Before deciding as to what type of trustee to have, it is important to understand the duties of the trustee.
The Employee Retirement Information Security Act of 1974 (ERISA) explains what the fiduciary duties of trustees are for all plan types, including ESOPs, under code section 404.
- Duty of loyalty: the fiduciary must act solely in the interest of plan participants and beneficiaries.
- Duty of prudence: the fiduciary must act as a prudent expert.
- Duty to follow plan/trust terms: the fiduciary must follow the plan and trust provisions, unless contrary to ERISA.
- Exclusive purpose duty: the fiduciary must act for the exclusive purpose of providing benefits.
ESOP trustees are personally liable for plan losses which result from the fiduciary’s breach of duty. They can also be liable for penalties for entering into a prohibited transaction. Common examples of a fiduciary’s breach of duty claims involve breaches of the duty of loyalty, prudence, and failure to follow plan/trust document terms.
If considering an internal trustee, keep in mind that an officer or director of the ESOP sponsor can serve as trustee, plan administrator, or ESOP committee member. The internal trustee may have conflicts of interest as their responsibilities to the company may be a conflict with their fiduciary duty to act solely in the interest of the plan participants and beneficiaries. Also, the ESOP’s general interest may conflict with management’s interests. In addition, the time commitment to be the trustee is significant, and if the officer or director has other demands at the company, they may not have the time commitment to devote to this responsibility. Having an internal trustee is generally more economical.
External trustees have the professional experience and qualifications and will easily meet the prudent expert standard. In addition, this is their profession, and they stay current on the ever-changing rules of ESOPs. External trustees are typical with a larger organization, so more resources are available to them. There is a cost to having an external trustee. Another potential downside is that they do not have as much knowledge of the business.
As you finalize your implementation of the ESOP, keep in mind the above items and work with your outside advisors.