This article describes the use of reverse allocations in Employee Stock Ownership Plan (ESOP) companies to provide a meaningful number of shares for newer and younger employees and to help ensure the ESOP’s sustainability.
ESOPs reward longevity and provide a meaningful stake in a company’s success. For ESOP companies that started with large initial sales of shares to the plan, shares can over-accumulate to those with tenure. This could happen to the dismay of newer employees who may not have the opportunity to accumulate a meaningful number of shares in their ESOP accounts.
Companies that face the challenge of making equity sharing and participation in their ESOP plan more meaningful to newer and younger employees may consider the option of a reverse allocation. This approach alters the ESOP ownership structure to provide a greater opportunity to newer employees.
Employee Stock Ownership Plans (ESOPs) reward longevity and provide a meaningful stake in a company’s success. For ESOP companies that started with large initial sales of shares to the plan, shares can over-accumulate to those with tenure to the dismay of newer employees who may not have the opportunity to accumulate a meaningful number of shares in their ESOP accounts.
These ESOP companies face the challenge of how to make equity sharing and participation in the plan more meaningful to newer and younger employees. Companies may consider using “reverse allocations” in their ESOPs to alter the ESOP ownership structure and to provide a greater ESOP opportunity to newer employees.
The Challenges of Success
In one case, a client underwent a leveraged ESOP transaction to purchase 51% of a company from its owner. Due to rapid growth, the company paid off the deal much faster than planned. Suddenly, 51% of ownership was in employee accounts. Although the company knew it needed to provide retirement benefits to new employees, they appeared to be unable to participate in the already allocated 51% of ownership. That fact particularly mattered at a point when the company was expanding and needed to hire new employees.
Reverse allocations require a broader view of the ESOP’s objectives – shared ownership, but with an understanding of the “total benefit experience” the plan offers every employee. A reverse allocation permits the ESOP to allocate shares to allow more stock participation for newer employees than tenured employees – either with shares that are purchased or distributed from over-accumulated accounts, or with new cash or stock contributions.
These creative ESOP plan designs evaluate the total workforce benefit levels and target share allocations within the IRS rules that require nondiscrimination in benefits.
ESOP reverse allocations present many design challenges. Guidance from an experienced ESOP team providing both the legal advice and consulting experience is key.
Creative Solutions
To solve the issue, an experienced employee benefits law firm that’s highly proficient in ESOPs brought a fresh perspective. They rethought the presumption that the ESOP had to function the same way the second time around.
Starting with a blank slate, the firm began by asking questions and questioning assumptions. The client wanted to offer all employees a meaningful share in the ESOP’s ownership of the company.
The original plan had started in 2006 and was designed to allocate a lot of stock – using standard allocation methods – driven by the size of the transaction. The chips fell where they landed. Under the new 2015 plan design, the firm focused on whom they needed to benefit and worked backward from there to design the formulas to allocate shares and define funding levels and sources.
Newer employees were grouped by their own tenure and compensation levels, and then targeted stock and nonstock benefit levels. Each of the relevant design criteria was tested to ensure the design met IRS nondiscrimination requirements. The design was customized to meet the objective.
As a result, the plan welcomed the newest employees who had the least shares, effectively creating a new ESOP going forward. The firm accomplished this fairly by analyzing the overall benefit levels within the plan, determining meaning within it and applying the tests required to ensure it was compliant and effective.
Finding Fairness
Attracting and retaining new employees will support ESOP sustainability, which is where an ESOP reverse allocation comes in. Ideally, reverse allocations provide shares favoring newer employees to help them “catch up” to longer-tenured employees. However, the design must also provide and maintain benefit levels for all employees when measured, including stock, cash, dividend levels and other earnings in the plan. This expanded view of an ESOP addresses employee ownership and the true effectiveness of an ESOP as a retirement plan.
Other alternatives, of course, could be used to benefit new employees with stock-based incentives, such as restricted stock and stock appreciation rights, but these are not immediately tax-deductible by the company and don’t address divisions in the work force – they can worsen the problem.
ESOP Reverse Allocation: The Greater Benefit
The client was delighted with the solution, which met the corporation’s primary objective of avoiding over-concentration of stock accounts and sharing the 51% ownership of the company with all employees. Beyond that, it gave senior employee owners and managers a powerful tool for managing and incentivizing their workforce, no matter how fast it expanded.
Because of its essential fairness and transparency, the plan allowed middle management to promote cohesion and a positive workforce culture. Everyone had a chance to grab a brass ring, which helped greatly in hiring and retention. The senior managers were no longer the “haves” managing junior employees who were relegated to being “have-nots.”
Such plans could be applied during new acquisitions, expansions, mergers or in any number of other scenarios.
Count on Experts
ESOPs are created by lawyers and are layered in complexity. ESOP documents require expertise that even deeply experienced retirement plan administrators won’t have. An experienced employee benefits law firm with experienced embedded consulting talent knows the rules and regulations well enough to offer clever ways around roadblocks while staying fully compliant with rules in complex issues such as ESOP reverse allocations.
Finding the Right Partner
Find an ESOP attorney and an employee benefits law firm that listens to your objectives and has the talent and depth of experience to know how to guide you to them. Here are some questions to ask yourself prior to choosing an ESOP attorney and team:
- Can they see the big picture? Do they view an ESOP as a single project, or holistically as a part of an entire benefits package?
- Do they have both the legal and certified pension consulting resources in-house to evaluate issues and overcome any challenges you may face with an ESOP?
- How much ESOP experience do they have and what is their track record?
- Can they help communicate the plan to your workforce? A good firm will help your in-house people execute any ESOP and assist with every aspect of a benefits package.
- Are they creative thinkers? Do they look for innovative options in plan design and consulting? Do they have the new ideas to help ensure key people and new employees get the benefits the company wants them to get – now and in the future?
