ESOPs are not required to invest exclusively in company stock. Kevin Long explains.
It’s a fundamental requirement for ESOPs that they be primarily invested in employer securities, and typically, that’s the common stock of the corporation sponsoring the plan. ESOPs may also hold preferred shares as long as they meet certain requirements regarding being convertible into common stock, but this is no longer prevalent with the advent of S corporation ESOPs.
Despite the requirement to be primarily invested in company stock, S corporation ESOPs accumulate significant amounts of non-stock assets, i.e. cash and other investments, due to distributions from the S corporation. The ESOP is a shareholder and must receive its pro rata of share of any distribution the S corporation makes to any of its shareholders to allow them to pay income taxes with their Form 1040 on S corporation income passed through to shareholders and reported to them on a form K-1. Where an ESOP owns less than 100% of the company’s stock, the ESOP will typically receive cash distributions annually. Such distributions are not necessary where the ESOP owns 100% of the employer’s stock. In that case the company need not make distributions since the ESOP incurs no taxes on its income.
As a result, an ESOP may hold cash that exceeds the amount necessary to fund participant benefit distributions in the near term or forecasted time frame, depending upon the fair market value of the stock and how it might fluctuate, and the pattern and amount of share distributions that are being made from the plan.
How an ESOP Can Invest Its Non-Stock Assets
So how can and should the S corporation ESOP invest its non-stock assets? First and foremost, an ESOP is a qualified retirement plan under IRC sections 401(a) and 501(a). Even though it might be exempt from the diversification of investment provisions of ERISA, the non-stock assets must be prudently invested. Regardless of how large the non-stock investment account is, both in terms of its absolute balance and its proportion to the value of stock held by the plan, the ESOP should have an investment policy statement governing how the non-stock assets will be invested. The investment policy statement will of course specify that the plan is to be primarily invested employer securities, but the principles for investing the non-stock assets should be included in the investment policy, similar to what you would see for a profit sharing plan.
An ESOP should prudently have cash available to pay distributions. The investment policy statement may include provisions for retaining some balance in cash to cover foreseeable distribution amounts. How that is forecasted or determined is an open issue that each ESOP plan sponsor and its fiduciaries wrestle with, but remainder of the non-stock assets should be prudently invested on a longer term asset allocation basis.
As a practical matter, how might one approach this? It might be straightforward for the trustees or the administrators of the plan to invest those assets in the same manner as the client’s profit sharing plan, if they have one, if the profit sharing plan is a pooled trust investment fund. If the profit sharing plan is a 401(k) plan, which has a menu of available options for the participants, it might be prudent for the ESOP to invest in the same asset classes, or funds, in the 401(k) plan’s Qualified Default Investment Alternative (QDIA). 401(k) plan assets that are not directed by participants are invested in this option, which is typically a balanced portfolio with a long-term investment horizon; but 401(k) plan investments will vary.
Some ESOP trustees are not interested in undertaking fiduciary investment duties for the non-stock assets in the ESOP. Some have even required non stock assets be transferred out of the ESOP to avoid having the responsibility for an investment policy. In any case, it would be prudent for the corporation to appoint an independent fiduciary who is a registered investment advisor (RIA) under ERISA section 3(38), who can direct the ESOP trustee how to invest those assets. A 3(38) investment manager generally has the authority to select, monitor, and replace the plan’s investments without input from the plan sponsor. This is a best practice for other ERISA qualified retirement plans. If the company’s other retirement plans are not currently utilizing such an independent fiduciary for investments, the ESOP issue might prompt them to do so, to invest the assets of all of the employer’s plans.
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Transcript
The statute only requires that an ESOP be primarily invested in employer securities and presumably, that means over the life of an ESOP.
The trustee is required by law to also prudently invest all of the assets of the ESOP. Very often an ESOP will carry a significant amount of cash in its trust which it might be, for example, investing for the purposes of future repurchase liability needs or for the purposes of the future transaction. And when an ESOP is holding nonstock assets, they must be prudently invested according to what the investment policy for the plan says and what’s appropriate to meet the ESOP’s objectives.
