Employee ownership is associated with tax savings, increased production, and higher employee retention rates. However, employee ownership is not always the best fit for some companies. Business owners should be prepared for the possibility that they may have to freeze or terminate an ESOP and revise the plan documents accordingly.
There are a number of reasons why an ESOP may be terminated or frozen. This could occur when the owners want to change the type of retirement plan available, there is a significant change in the industry, or the company is having financial problems. Most often, an ESOP is frozen or terminated when the company is acquired by another company.
An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that invests primarily in a company's own common stock. Employees are plan participants with company shares held in the ESOP trust until the employee retires. When the employee retires or leaves the company, the shares are bought back by the trust or redeemed by the corporation to provide the participant with cash equal to the value of the shares allocated to their account.
If a new owner takes over a previously ESOP-owned company and wants to end or change the benefit plan, the new company could freeze or terminate the ESOP.
If the ESOP is terminated, the ESOP trustee would give each plan participant an interest in the stock sale proceeds based upon their percentage of share ownership allocated to their ESOP accounts. Payouts may depend on the plan documents and how large the ESOP is. Larger ESOPs may have more complicated payout schedules. Depending on the participants' distribution election, the distributions may be taxable immediately to the plan participants. However, plan participants are able to defer being taxed on the distributions if they roll over the funds into another qualified plan or to an IRA.
Alternatively, when an ESOP is frozen, the company stops making contributions to the plan. The ESOP trust continues and the plan participants maintain their interest. The plan does not end unless it is terminated or the last distributions are made. This could mean the frozen ESOP continues for years, with distributions made on retirement or leaving the company, according to the plan documents. Freezing or terminating a plan will cause all participants to immediately become fully vested in their accounts.
There may be a number of reasons for freezing an ESOP, including financial difficulty. If the company can no longer afford to make contributions in cash or stock for the plan participants' benefit, the company could freeze the plan while allowing participants to retain their interests. However, even if the company is no longer making contributions, the ESOP still requires regular annual appraisals and the recordkeeping and the reporting requirements that go along with running an ESOP.
If you have any questions about terminating your company's employee stock ownership plan program, the law firm of Butterfield Schechter LLP is here to help. We are San Diego County's largest law firm focusing its law practice on employee benefits law. Contact our office today with any questions on how we can help you and your business succeed.