Segregation, also referred to as “reshuffling” or “conversion,” is defined by the IRS as “the mandatory transfer of employer securities into or out of plan accounts, not designed to result in an equal proportion of employer securities in each account.” Segregation is often used in ESOPs to convert the accounts of terminated participants out of stock and into cash until such participants are paid a full distribution of their vested plan balances.
How Does it Work?
An ESOP must have a written provision in the plan document in order to implement segregation. Based on the terms of the provision and generally on an annual basis, all or a portion of stock held in the accounts of terminated participants will be exchanged for cash from active participant accounts. At the same time, the active participants will receive the stock from terminated accounts in exchange for their cash. As a result, stock is “reshuffled” between terminated and active accounts in the Trust.
For Example:
Before Segregation:
|
Status |
Cash In Account |
Stock in Account |
Price per Share |
Total Account Value |
|
Participant A - Terminated |
$1,000 |
100 |
$5.00 |
$1,500 |
|
Participant B - Active |
$2,000 |
50 |
$5.00 |
$2,250 |
After Segregation:
|
Status |
Cash In Account |
Stock in Account |
Price per Share |
Total Account Value |
|
Participant A - Terminated |
$1,500 |
0 |
- |
$1,500 |
|
Participant B - Active |
$1,500 |
150 |
$5.00 |
$2,250 |
Why Segregate?
By removing all or a portion of stock from terminated participant accounts, these participants will no longer share in any future appreciation in the value of company stock. Instead, active employees will see more of the benefit from any share price increases and dividends, if applicable. Segregation may also alleviate a plan’s have/have not issue where long term employees hold a majority of the stock. By utilizing cash in the accounts of all active participants, including newer employees, to fund a segregation transaction, these newer hires have more opportunity to accumulate a share balance.
Things to Consider
-
- Segregation should be nondiscriminatory and written in the plan document.
- The plan document language should detail how segregation will be administered including when the transaction will take place, what share value will be used, which participants will be affected, and what to do if there is not enough cash in active accounts for full segregation.
- Where will the cash in segregated terminated accounts be held until those participants are paid distributions from the plan? It may be prudent to design an investment policy for this cash.
