The COVID-19 pandemic has had a significant impact on most, if not all, of our clients, with many businesses needing to close their doors to comply with the local, state, and federal government responses to the pandemic. A company, like yours, that sponsors an employee stock ownership plan (“ESOP”), faces various issues unique to ESOPs that need to be considered in administering the ESOP both during and after the pandemic.
Several of our ESOP clients have already contacted us with various questions about administering their ESOPs during this crisis. As a result, we wanted to provide all of our ESOP clients with a summary of some of these issues that should be discussed among your management team, your board of directors and your ESOP trustee(s) as you navigate your ESOP-owned company through this pandemic.
Impact of Coronavirus on ESOP Stock Valuations
The COVID-19 pandemic’s impact on ESOP stock valuation has become a particularly hot topic in the ESOP community over the past several months. ESOP companies are required to have their shares appraised as of the plan’s year-end for administrative purposes, which for most ESOP companies that value their stock annually was December 31, 2019. That appraised value would typically dictate the share price for transactions occurring over the following plan year, including determining the value of shares allocated to plan participants as a result of ESOP loan payments during the prior plan year and distributions and diversification elections made during the plan year.
However, we are now living in a world that is VERY different from December 31, 2019, and the full economic ramifications of the COVID-19 pandemic have yet to be realized. This presents a critical administrative issue for many ESOPs if the 2020 stock allocations, plan distributions, and diversification elections are based on the December 31, 2019 stock valuation that does not take the effects of COVID-19 into account.
Many of our ESOP clients have already asked us if their December 31, 2019, ESOP valuation can be revisited to consider the effect of COVID-19 on the value of the company. The short answer is no. The reason for this is because the standards governing the appraisers that value ESOP stock dictates that when estimating a private company’s value, an appraiser can only consider the information regarding the company and market data that was known or knowable as of the established date of the valuation.
However, an ESOP Plan Administrator (typically the company sponsoring the ESOP) may have the option of setting an interim valuation date to determine the value of an ESOP’s assets for plan administration purposes during 2020. By establishing an interim valuation date, a plan administrator can cause an ESOP trustee to determine the value of the company stock and other assets held by the ESOP as of a date other than the last day of the plan year. The ESOP trustee(s), in turn, would have to determine the value of the ESOP’s assets as of the interim valuation date which would be used to fix the amount of any 2020 stock allocations, distributions, or diversification elections paid after the interim valuation date.
The legal standards to which the Plan Administrator is held requires the Plan Administrator to discharge their duties in accordance with the plan documents. An ESOP plan document typically is either (1) silent on whether or not an interim valuation should be considered in light of compelling circumstances (i.e., requires judgment) or (2) may explicitly state that interim valuations are permissible, yet not required (again, requires judgment). If the ESOP plan document does not currently permit the Plan Administrator to establish an interim valuation date, it will need to be amended before doing so.1
Assuming the ESOP plan document already allows for interim stock valuation or is subsequently amended to allow it, the Plan Administrator and ESOP trustee(s) must carefully consider whether to do an updated mid-year stock valuation. There should be compelling reasons, such as canceled or suspended contracts, significant layoffs, a substantial decline in cash flow, or solvency concerns. Merely suspecting that your company’s value has been impaired since the year-end appraisal may not be enough. If the decision is made to conduct an interim valuation, then the interim valuation must consider all facts known or knowable as of the interim valuation date, which certainly would include the impact of COVID-19.
If the ESOP Plan Administrator elects to conduct an interim valuation, the next question would be what the new valuation date should be. There is still a great deal of uncertainty about what the future holds, the stock market continues to be wildly volatile, and it is difficult to know when and how these guideline company values will settle. Company forecasts and budgets for 2020 and beyond prepared in December or January are almost certainly out the window now, but it may still be too soon to know to what extent they should be revised. Because of the current uncertainty, an ESOP company electing to conduct interim valuations should wait to choose an interim valuation date when they will have a better understanding of how revenue and earnings are tracking and markets have settled, especially since the economy is beginning to open again in many states across the country.
What Should You Do Now?
Review your ESOP plan documents to see if an interim valuation is permitted and under what circumstances or decide whether to amend your plan documents to allow for an interim valuation.
Reach out to the ESOP trustee(s) and their appraiser to determine the potential additional cost of obtaining an interim valuation. Most ESOP trustees should require a fulsome update to the prior valuation report and not simply ask for an updated stock price without a full valuation analysis considering revised forecasts and market data.
Talk with your HR staff and third-party administrator to determine how to communicate the delay issuing participant statements and the processing of distributions and diversification elections to allow time to conduct the interim valuation and when that process can occur after the interim valuation is completed.
Analyze the financial viability of the company and determine whether there is a sustainability issue if the 2020 distributions and diversification elections are processed based on the December 31, 2019 stock price that does not take the COVID-19 into account and consider changing your 2020 distribution policies to account for this instead of or in addition to doing an interim valuation (see discussion below).
Modification of ESOP Distribution Policies as a Result of COVID-19
The events which trigger a right of an ESOP participant to receive a distribution of their ESOP account balances is the death or disability of the participant, the participant’s attainment of a “normal retirement age” (specified in the ESOP plan document and is most often age 65) and the participant’s termination of employment with the company sponsoring the ESOP (whether voluntary or involuntary). Also, a participant may elect to defer the distribution of their ESOP account balances even though they may otherwise be eligible to receive distributions from an ESOP. However, an ESOP may provide that distribution must begin by normal retirement age (or later termination) and if it does not require commencement then, the law requires distribution to begin the calendar year after the attainment of age 72. 2
The specific rules governing ESOPs require that participants eligible for distribution be permitted to elect to take a distribution from the ESOP no later than one (1) year after the participant retires, dies or becomes disabled or the fifth (5th) year following the plan year in which the participant ceases to be employed by the company sponsoring the ESOP for any other reason. Once a participant is eligible and elects to receive a distribution of their ESOP account balances (or is otherwise required to take a distribution from the ESOP), their ESOP account balances may either be distributed in one lump sum or distributed in installments over a period generally not exceeding five (5) years (or even longer for very large balances). The ESOP plan document must specify when distributions should commence as well as how they are paid.
Many of our ESOP clients have already asked us if their current distribution policies can be revisited to consider the effect of COVID-19. While qualified plans are generally subject to strict limitations on making distribution options less favorable to participants, ESOPs are allowed more flexibility if the changes are “non-discriminatory.” Therefore, an ESOP company that may be facing liquidity constraints due to the downturn of their business should be able to modify their ESOP distribution policies for 2020 and beyond, as long as the changes are non-discriminatory.
What Should You Do Now?
Review your ESOP plan document and stand-alone distribution policy (if you have one) to make sure they explicitly permit the current distribution provisions to be amended.
Contact your third-party administrator to see which ESOP participants are eligible for distributions in 2020 to determine if there are liquidity issues in honoring the distribution requests under your current distribution policies to decide whether a modification of your current ESOP distribution rules will be necessary.
Model out various potential changes to the distribution policies to ensure they can be implemented in a non-discriminatory manner.
Talk with your HR staff to determine how to communicate any changes to your distribution policies best.
Partial Plan Terminations
Large-scale reductions in force may have unintended consequences for your ESOP. Under the tax code, a “partial plan termination” occurs when there is a sharp decline in the number of participants in a retirement plan. Whether a plan experiences a partial termination is a question of facts and circumstances. However, the IRS has indicated that there is a rebuttable presumption that a partial termination will have occurred if the plan sponsor terminates at least 20% of a plan’s participants from employment within a specific period.
If the plan sponsor cannot provide sufficient evidence to show that the turnover rate was routine or was not the result of employer-initiated severance from employment, the presumption of a partial termination will stand. The participants who are terminated by the plan sponsor during the partial termination “measurement period” (and potentially including those who voluntarily terminated during the partial termination “measurement period”), must be fully vested in their account balance on the date of the partial plan termination for the plan to continue to be qualified under the Code. The IRS has not yet issued any guidance about whether an exception may be carved out for layoffs or furloughs resulting from the COVID-19 situation. However, if a layoff or furlough of employees is temporary and the affected employees resume active participation in the plan, those employees should not count toward determining whether a partial plan termination has occurred.
What Should You Do Now?
If you plan a significant workforce reduction or if a layoff or furlough turns into a permanent workforce reduction, you should work with LP and the third-party administrator to determine whether the ESOP will have a partial plan termination, and if so, which participants’ account balances must be fully vested.
Additional Administration Issues
In addition to the issues discussed above, ESOP plan sponsors and fiduciaries may need to consider many other ESOP administration issues, including the effect of employee headcount reductions on ESOP loan amortization requirements (i.e., if ESOP stock remains leveraged), potential investment changes in connection with the ESOP’s other investments account which is not invested in ESOP company stock and furlough and leave of absence issues under existing plan provisions including allocation of future contributions. Also, for ESOP companies which are S corporations, the plan sponsor needs to consider the effect the potential reduction of stock on compliance with Section 409(p) testing requirements.
What Should You Do Now?
Model out your projected payroll for 2020 to ensure you will have enough eligible compensation to cover the contributions required to repay any ESOP loans during 2020.
Determine if your investment policies for non-stock investments in the ESOP need to be adjusted based on the current state of the stock market.
Ask your third-party administration to run Pro-forma 409(p) tests considering the potential reduction of the stock price during the 409(p) testing period applicable to your plan.