Information and Frequently Asked Questions for Employee Stock Ownership Plan (ESOP) Participants

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1 Information and Frequently Asked Questions for Employee Stock Ownership Plan (ESOP) Participants An Opportunity to Take Part in Your Company's Success If you ve been invited to participate in your company s Employee Stock Ownership Plan (ESOP), congratulations. An ESOP is an opportunity to take part in the growth potential of your company. As an ESOP participant, you may play a greater role in your company s operations. For one, an ESOP account gives you a window into the financial performance of your company. Furthermore, you may be invited to participate in committee work in support of your ESOP. We encourage you to take advantage of this opportunity. After all, there s nothing like the feeling of helping to control your company s future--and your own. What is an ESOP? An Employee Stock Ownership Plan (ESOP) is a qualified, tax deferred retirement program created under the Employees Retirement Income Security Act of 1974 (ERISA). An ESOP provides a vehicle for sharing company ownership with employees. An ESOP can be created only by an employer, and the employer is the plan sponsor. The employer can use the ESOP to acquire ownership from a prior owner or can contribute shares to an ESOP in order to give a portion of company ownership to participants. In either case, the shares of company stock are placed in a trust that is the responsibility of a trustee. The shares of company stock in an ESOP are owned by the trust for the beneficial interest of participants and not directly by the participants. What is an SPD? A summary plan description (SPD) is a plain English summary of the major provisions of a retirement plan document. Every participant is entitled to a copy and should read it. Participating in an ESOP There is much that you can do as a participant in an ESOP that will make a difference for your company, for yourself and for fellow employees. Committees If you have the opportunity, join the ESOP committee. Participate in committee activities. Set an example for other employees. You can make a difference. Relative performance Quarterly measures of performance have been maintained and compared for 10 years for smaller companies. ESOP companies often perform better that their non-esop competitors. Representation The ESOP Association and the National Center for Employee Ownership each hold periodic conventions and seminars at different locations around the country. Volunteer to represent your company at one or more of these meetings. You

2 will learn from the experience and others will learn from your participation. Be creative There are many ways to create and maintain enthusiasm for an ESOP within a company. You can volunteer to be a part of making the ESOP a success at your company. Participant Rights The following is a brief summary of your general rights under an ESOP. For additional details on these and other rights, please refer to your Summary Plan Document (SPD), which is available from your employer. Rights regarding share distributions When you qualify for a distribution from the plan and your company is a C Corp, you have the right (with some exceptions) to receive shares of company stock from the plan. There are potential tax benefits to receiving and holding shares of stock instead of receiving a cash distribution. If your company is closely held, there may be agreements that limit who can own company stock. In this case you may be required to immediately sell your shares back to the company or the ESOP. Rights regarding diversification At age 55, if you have been a participant for more than ten (10) years, you may be entitled to diversify some of your ESOP account out of company stock and into other investments. There are specific rules regarding the time period in which you may diversify, and the diversification options available. For details, please refer to your SPD. Rights regarding the voting of shares The shares of company stock in your company s ESOP are actually owned by the ESOP trust. Therefore, you do not have the right to vote directly. In some cases, however, participants are entitled to direct the trustee on how to vote the shares that are allocated to them. This is called pass-through voting because the shareholder vote is passed-through to participants and they are entitled to direct the trustee on how to vote the shares allocated to them. Some ESOP plan documents give this opportunity to participants for all shareholder votes. At the minimum, participants are allowed to direct the trustee on major corporate events such as a merger or other major financial restructuring. Employment Termination If your employment is terminated while you are a participant in an ESOP, you may face specific choices regarding your plan assets. Many of these choices depend on the wording of the plan document. Please consult your Summary Plan Description (SPD). Vesting The vesting in your account immediately freezes upon employment termination. You should consult the SPD for the date when vesting becomes effective. It is often the last day of the plan year. If this is the case and your employment is terminated at any time prior to this date, your vesting stays at the prior year s level. Distribution restrictions If your company s ESOP is leveraged, there are often provisions in the plan document that prohibit or restrict distributions until the loans are paid off. You may be required to leave your vested shares with the company until these restrictions are removed. This can often be for five years or more after the initial loan. Sometimes, employers will want to convert your shares to a note but still not distribute money to you until the loan restrictions are removed. In this case, they must have adequate collateral for that note. 2

3 Distribution options Once any restrictions have been removed and you wish to take a distribution, you have the following options: Sell the shares to the company and roll the money over into a qualified plan of your next employer, if the new plan accepts rollovers. Roll the shares or money over directly into an individual retirement account (IRA). Sell the shares to the company and request a check written directly to you. In this case, the amount distributed is fully taxable. The administrator will withhold 20% of the amount distributed. In addition, you will owe a 10% penalty on the amount when you file your tax return if you are under age 59½. Request that the shares of company stock in your account be re-registered in your name and given to you. While nothing will be withheld, you will still owe taxes on the cost value of those shares and there will be a 10% penalty on that amount when you file your tax return if you are under age 59½. Many closely-held companies will not allow a terminated participant to hold shares and will require you to sell them to the company at the price established at the last valuation. Plan Termination The decision to terminate an ESOP is the right of the plan sponsor. There are several reasons to terminate an ESOP, such as: The sale or merger of the sponsoring company The liquidation of all ESOP debt The bankruptcy of the sponsoring company When a plan is terminated, the employer/plan sponsor will normally file a form 5310 with the IRS. This gives notice to the IRS and allows them to examine the provisions of the termination. When a plan is terminated, all participants immediately become fully vested in all balances that have been allocated to their accounts. If the ESOP is being terminated as the result of a sale or merger of the sponsoring company, then the ESOP trustee still has an obligation to follow the provisions of the plan document and assure that the trust is receiving adequate consideration in return for the shares it holds. Termination of a plan is a distributable event under the 1974 Employee Retirement Income Security Act (ERISA), and participants may elect to receive cash directly or to roll their accounts over into an IRA or a successor 401(k) plan. Removing Assets Due to potential tax consequences, you should carefully weigh the alternatives before removing assets from an ESOP. Consult your tax advisor for guidance on the approach that s appropriate for you. The rules for removing assets from an ESOP vary, depending on whether the assets consist of company stock or other investments. Here are some of the major factors to consider for each type of asset: For ESOP assets in company stock Company stock receives special tax treatment for individuals. For example, when you remove shares of company stock from your plan, they are taxed at ordinary income tax rates only to the extent of the original cost of the shares. The full amount of the gain in excess of original cost will be taxed at capital gains rates when you actually sell the shares. Two strategies you may want to consider when removing company stock are: IRA strategy: Rolling shares of company stock over into an IRA can have adverse tax 3

4 consequences, because it negates the special tax treatment available to company stock. You may find it a better tax strategy to take the distribution in shares, pay taxes immediately on the cost of the company stock, and then hold the shares outside of your IRA, 401(k) or other qualified plan. This strategy may enable you to pay taxes on any gains at the lower capital gain rates instead of the normally higher ordinary income tax rates. Estate strategy: Generally, shares of company stock enter one s estate at the stepped-up basis, which would potentially result in significant tax savings. For ESOP assets other than company stock The regular deferrals you make into an ESOP or 401(k) Plan are tax-deferred, as are employer contributions and any earnings on your investments. When you start to take distributions from your plan, these cash distributions are all taxed at ordinary income tax rates. Two strategies you may want to consider when removing non-company stock assets are: IRA strategy: Rolling distributions over from investments other than company stock into an IRA can be a valuable strategy. It may help you avoid mandatory withholding while allowing your assets to grow on a taxdeferred basis until withdrawals are made after retirement. Estate strategy: All assets of an IRA or other qualified retirement plan go to the designated beneficiary/ies. The estate steps up the tax basis of the assets to the market value at the date of transfer to the beneficiary/ies. What is Leverage? Leverage refers to borrowing. A leveraged ESOP is one where the trust has borrowed money in order to acquire shares of the employer s stock to hold for the benefit of participants in the retirement plan and the loan(s) are still outstanding. Once the loan(s) are paid off, the ESOP is no longer leveraged. What is a Leveraged ESOP? Many ESOPs are leveraged, meaning that the trust has borrowed money to purchase the shares of company stock that are now held in the trust. Many special rules apply to leveraged ESOPs. For example, the sponsoring company is required to make regular payments (contributions) to the trust in order for the trust to make its required payments of principal and interest on the loan. Because the ESOP is a qualified retirement program, the payments made by the employer into the trust are fully tax deductible. What Happens to Shares in a Leveraged ESOP? Usually when an ESOP is leveraged, some of the shares of company stock held in the trust are collateral for the ESOP loan. As loan amortization payments are made, shares must be released from collateral. When they are released, they can then be allocated to individual participants in the plan. Usually the shares of company stock are allocated to participant's accounts at the end of each plan year. If loan payments are made more frequently during the year, then some shares are held in reserve. This means that some shares of company stock are no longer available as collateral against the loan but have not yet been allocated to individual participant accounts. How are Shares in an ESOP Valued? If the sponsoring company is publicly held, the value of the shares is established every day by the stock market. If the company is private, the shares of stock held in the trust must be valued at least once per year. An independent appraiser is hired by and reports to the trustee for this purpose. 4

5 What Keeps an S Corp from Converting to a C Corp to Take Full Advantage of the ESOP Roll Over Feature? This response is not intended to be comprehensive, nor does GreatBanc Trust Company or our affiliates offer tax advice. The ESOP rollover feature referred to in the question is the ability of shareholders of a C corporation who sell stock to an ESOP to defer gain on the sale under Section 1042 of the Internal Revenue Code if certain requirements are satisfied. This option is not currently available to shareholders of an S corporation. A number of other factors need to be considered before a conversion from S corporation to C corporation status. These factors include the following: 1. Terminating an S election requires consent of shareholders owning more than one-half of the corporation's stock. 2. Conversion to a C corporation may require changes to accrual accounting for tax purposes. 3. There can be restrictions on converting back to S corporation status for 5 taxable years. 4. If an S corporation converts to C status and then back to S status, the 10 year waiting period to avoid built-in gain on the sale of assets and businesses starts over from the date of the reconversion to S status. Under the facts described in item 4 above, the corporation also could acquire liability for tax on LIFO reserves. These are just the primary factors that need to be considered before making a decision to convert a corporation from S to C status in order to take advantage of the 1042 deferral for selling shareholders. As always, you should consult your tax advisor before taking any action. Why Can't I Get My Money or Shares out of My ESOP any Time I Want? Because it is a type of retirement plan, an ESOP s operations are governed by the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. As a result, distributions from an ESOP are only permitted when one of several narrowly defined events occurs. These events may include termination of employment, retirement, death or disability. The rules for distributions from leveraged ESOPs may be more restrictive than these general rules. See your Summary Plan Description for specific information about the distribution rules for your plan. What is Vesting? Vesting refers to the percentage of the money or shares in your account that you are entitled to keep when you terminate employment. Money that you contribute or defer into your account, along with any earnings on it, is always 100% vested. Money that the employer contributes, such as a contributions to an ESOP, often has a vesting schedule attached to it. Under a vesting schedule your vested percentage will generally increase with each additional year of full-time employment, until you become 100% vested. You can find the vesting schedule for your plan in your Summary Plan Description (SPD). You may need to be employed by the Company for a certain number of years before you become 100% vested in the money contributed by the employer and the earnings thereon. What are the Vesting Rules for ESOPs? Vesting rules are established by each employer. Sometimes employment is counted from the first day of employment with a company, while other times it is counted from the first day of participation in the ESOP. This information is disclosed in your Summary Plan Description (SPD). 5

6 When am I Vested in the Portion that I Contribute? Participants are always immediately vested in the money they contribute to a plan. Most ESOPs do not allow employee contributions (deferrals). When am I Vested in the Employer Contributions? The vesting rules for each plan are different. These are shown in the Summary Plan Description (SPD) available to you from your company. What Does it Mean When Shares are Allocated? When the ESOP is leveraged, shares of employer stock held in the trust are often collateral for the loans used to buy those shares. As the loans are paid down, these shares are released from collateral and become available for allocation to the ESOP accounts of individual participants. Some plans have an allocation date (often the plan year end) on which these shares are actually allocated to individual participant accounts. After shares are allocated, they will appear on the next statement the participant receives. Your statement will show the total number of shares allocated to your account, regardless of your vesting percentage. If you terminate employment, your vesting percentage is multiplied by the total shares allocated to your account in order to determine the amount of your distribution. The allocation of shares to a participant s account is unrelated to the participant s vesting percentage. What Exactly am I Entitled to When I Terminate Employment? What Happens to My ESOP Shares if I'm Not Vested? Termination of employment is a distributable event under the Employee Retirement Income Security Act (ERISA). When you terminate employment, your vesting percentage stops increasing and the non-vested percentage of your account will be handled according to the rules established in the plan document for forfeitures. In many plans the non-vested shares are allocated to the remaining participants and used to increase their holdings. If entitled to a distribution, you may have to wait until the ESOP stock acquisition loan is paid off in order to receive it. How Often Will a Performance Summary Be Given Out? Performance summary availability will depend on each company. An ESOP maintained by a publicly traded company may provide quarterly participant statements, whereas an ESOP of a privately held company may only provide annual statements, since private company shares must be valued by an independent appraiser and usually only once per year. When Do the Shares Go into My Account? For any ESOP, shares go into your account when they are allocated. The timing for allocation to participant accounts depends upon the type of ESOP and the specific provisions of the plan document. Please see your Summary Plan Description (SPD). In a leveraged ESOP, when shares are released from collateral, they go into a suspense account, until they are to be allocated in accordance with the plan provisions. In a non-leveraged ESOP, shares are allocated to participants according to the plan document. Can I Roll My Money Over from a Previous Company? Normally, you cannot roll money over from a previous employer's plan into an ESOP. However, if the ESOP is combined with a 401(k) plan, then the plan document might allow for rollovers. 6

7 Check your Summary Plan Description (SPD) to find the rules for your plan. What is Pass-through Voting? Shares of company stock held in an ESOP are actually registered to and owned by the ESOP trust. The trustee votes all of the shares held in the trust. In some circumstances, however, participants are afforded the opportunity to direct the trustee as to how to vote the shares allocated to their individual accounts. That is, the vote is passed through to participants and they are able to direct the trustee on how to vote the shares allocated to them individually. What is Mirror Voting? When the voting of shares is passed-through to participants, each of them has the opportunity to direct the trustee on how to vote the shares allocated to that participant s account. In a leveraged ESOP where some shares are not allocated to participants, the trustee normally decides how to vote the unallocated shares. Mirror voting directs the trustee to vote the unallocated shares in the same way that the participants directed the voting of the allocated shares. When can I Diversify out of Company Stock? When participants reach age 55 and have been participants in the ESOP for more than 10 years, they are entitled to diversify some of their account balance out of company stock and into other investments. There is a very restrictive period when participants who want to diversify may give notice to their employer. The qualified election period is a 6 year period that begins when the participant becomes qualified by reaching the age and service requirements. The period runs for 90 days following the end of each plan year in which the election is available. There are three ways to satisfy the diversification rules: 1. Diversity into cash within 90 days after the elections period; 2. Diversify holdings if the ESOP plan offers three alternative investment options. The election must be implemented within 90 days after the last day of the period during which the election can be made; 3. Transfer the assets to another plan that offers the three alternative investment options. The transfer must be made within 90 days after the last day of the period during which the election can be made. In the first five years of the diversification period, the participant may diversify up to 25% of the employer stock that has been allocated on or before the most recent allocation date. The 25% is applied to the balance reduced by the prior number of shares distributed, transferred, or diversified with previous elections. At the end of the 5 year period, no more than 25% of the shares allocated to a qualified individual may be diversified. In the final (sixth) year of election, the participant may diversify up to 50% of her or his account balance. Will I Receive Statements of my ESOP Account? Yes. You will receive an individualized statement showing the number of shares held in the trust for your benefit, along with the most recent value of the company shares. It is through these quarterly or annual individual statements that you can track the value of your ESOP account. What Happens if My Employment is Terminated? If your employment is terminated while you are a participant in an ESOP, you may face specific choices regarding your plan assets. Many of these choices depend on the wording of the plan 7

8 document. Please consult your Summary Plan Description (SPD). Vesting The vesting in your account immediately freezes upon employment termination. You should consult the SPD for the date when vesting becomes effective. It is often the last day of the plan year. If this is the case and your employment is terminated at any time prior to this date, your vesting stays at the prior year s level. Distribution restrictions If your company s ESOP is leveraged, there are often provisions in the plan document that prohibit or restrict distributions until the loans are paid off. You may be required to leave your vested shares with the company until these restrictions are removed. This can often be for five years or more after the initial loan. Sometimes, employers will want to convert your shares to a note but still not distribute money to you until the loan restrictions are removed. In this case, they must have adequate collateral for that note. Distribution options Once any restrictions have been removed and you wish to take a distribution, you have the following options: Sell the shares to the company and roll the money over into a qualified plan of your next employer, if the new plan accepts rollovers. Roll the shares or money over directly into an individual retirement account (IRA). Sell the shares to the company and request a check written directly to you. In this case, the amount distributed is fully taxable. The administrator will withhold 20% of the amount distributed. In addition, you will owe a 10% penalty on the amount when you file your tax return if you are under age 59½. Request that the shares of company stock in your account be re-registered in your name and given to you. While nothing will be withheld, you will still owe taxes on the cost value of those shares and there will be a 10% penalty on that amount when you file your tax return if you are under age 59½. Many closely-held companies will not allow a terminated participant to hold shares and will require you to sell them to the company at the price established at the last valuation. How are ESOP Shares Distributed? The general rules for ESOPs of C Corp companies allow participants to take any distributions from their account as shares of company stock. Some privately-held companies, however, restrict ownership to employees only. In these cases, participants are required to take their distributions in cash. When possible, because of potential tax benefits, participants might consider taking distributions in the form of stock. What Happens to Distributions under a Leveraged ESOP? Depending upon provisions in the plan document, distributions of either cash or shares for reasons other than death, disability or retirement may be delayed until the acquisition loan is paid off. This can often take five years or more. Can I ever Own Other Investments through my Company s ESOP? At age 55, if you have been a participant for more than 10 years, you may be entitled to diversify some of your ESOP account out of company stock and into other investments. 8

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