Whether you have a new or mature ESOP one thing is for sure, at some point you’ll have to process distributions. You often hear the phrases such as recycling ESOP shares or redeeming ESOP shares. What’s the difference? Can I do one versus the other? Most Plan Documents will give you flexibility to pay out stock or cash distributions. There are some key things to note.
With the redemption method, when a participant is eligible for a distribution, shares leave the ESOP trust and are purchased by the company. It’s important to consider how the transaction is structured. If the Company makes a contribution to the ESOP to purchase the shares, the purchase must be done at the fair market value of the shares on the day of the transaction and comply with other requirements to avoid running afoul of prohibited transaction rules. As such, it will be necessary to have the valuator involved to help the Trustee determine the value on the day of the transaction. Alternatively, if the shares are distributed from the ESOP and purchased by the Company outside of the ESOP, it is treated as a stock distribution from the ESOP and the value of the shares distributed can be determined based on the most recent fair market value (taking into account any events that may have occurred since the valuation date that could impact share value). Once the shares leave the ESOP they will usually be retired and treated as Treasury shares. Opposed to retiring the shares, you also have the option of re-contributing the shares to the ESOP or re-leveraging the shares. By re-contributing some or all of the shares, you can decide what kind of benefit level you would like to provide to your participants. Re-contributed shares are allocated based on the ESOP’s allocation formula. On the other hand, if you re-leverage the shares you now have shares available for current and future participants based on the terms of the loan and the formula used to determine the number of shares released from the suspense account as the loan is repaid.
With the recycling method, the shares never leave the ESOP trust. Therefore, your outstanding shares will remain the same. For distribution purposes, typically a cash contribution will be made to the Plan. Distributions are paid from that cash and the shares the participants once had are reallocated to other eligible participants. You can also use existing cash that is already in the Plan, or you can fund the distributions with dividends in the case of a C Corporation or S Corporation income distributions.
Longer term participants with larger stock balances will typically benefit the most from redemption of stock if the shares are retired since, all things equal, share value should rise as the number of outstanding shares decreases. The same can be held true for recycling if the funding is done by dividends or S Corporation income distributions as longer-term participants are likely to have more shares allocated to their accounts and dividends and S Corporation income distributions are allocated based on shares.
You can decide to switch from redeeming to recycling from year to year. Similarly, if you redeem shares you can decide to retire them, recontribute some or all of the shares or releverage some or all of the shares. There are several factors that need to be considered when considering the various approaches and commonly involve input form the valuator, tax advisors and legal counsel. Your Blue Ridge plan administrator is also available for questions.