Re-evaluating your ESOP

By Joseph Marx, VP-Consulting, Principal Financial Group®

Is it time to re-evaluate your organization’s ESOP? When a mature ESOP begins to pose potential challenges, there are several alternatives for bringing the ESOP back in sync with company/participant goals and objectives, and ensuring it is still delivering the right value.

Key indicators for modification include:

  • Benefit levels that are too high, too low, or inconsistent
  • Inability to attract or retain key people
  • Current ESOP structure is not right for the company
  • Overwhelming repurchase liability forecasts
  • Lack of understanding/appreciation of benefits
  • ADP/ACP plan compliance nondiscrimination testing failures

For the purpose of this article, we will focus on what can be done to help manage benefit levels, address retention and recruiting concerns, and institute an appropriate ESOP structure.

Benefit levels

ESOP benefit levels can have a profound impact on a company. If levels are too low, the company may have trouble motivating employees or creating an “Employee Owned” culture. If levels are too high, repurchase liability, cash flow concerns, and plan compliance testing issues may arise. If inconsistent, a have/have not environment may develop among employees, as well as providing a benefit that is not aligned with the actual results of the company.

The company has the ability to manage benefit levels and align the allocation of benefits with the company objectives by modifying the share repurchase strategy through recycling, redeeming, re-leveraging or any combination thereof.


The ESOP repurchases shares from departing participants and the shares are reallocated to other ESOP participants. In this scenario, the ESOP ownership percentage remains unchanged, the company’s equity value may decline as a result of the cash requirement and per share value may be diluted. Recycling all of the shares typically results in inconsistent benefit levels from year to year, depending upon the number of shares needing to be repurchased and allocated. To whom the shares are reallocated will depend upon whether repurchases are funded by cash contributions (allocated based on compensation), dividends/S distributions (based on account balance), or existing plan assets (depends on source of cash).


The shares are redeemed by the company and leave the ESOP trust. ESOP ownership percentage decreases (if less than 100% ESOP-owned). Similar to recycling, the company’s equity value may decline due to the outflow of cash for repurchases, but no dilution results to the per share value.  Future growth is allocated among fewer outstanding shares. No shares are reallocated unless the company decides to re-contribute shares to accomplish a desired level of benefit.


The shares are redeemed by the company. The company then sells newly issued shares to the ESOP in return for a new ESOP loan. ESOP shares are released and allocated as the loan is repaid. ESOP ownership percentage remains the same, the company’s equity value may decline due to the cash outflows, and per share value may be diluted. This strategy allows the company to structure the new loans in a way that provides a more consistent and desired level of benefit over the term of the loan.

Re-leveraging can be done one time or routinely, and is a great option for smoothing out the annual hills and valleys of repurchase liabilities, as it spreads reallocation of shares over multiple years and avoids the anti-dilutive effect of redemptions.

When the company is experiencing an unsustainable or unreasonably high benefit level resulting from the value of shares released in combination with the repurchase liability, or the required contributions are consistently exceeding IRS limits, a company might also consider renegotiating or stretching the ESOP loan. This option requires negotiation with the trustee, potentially necessitates a fairness opinion, and must consider the best interests of the participants. The company should also be prepared to provide additional benefits or enhancements to plan participants in order to offset the slower release of shares.

Retention/attraction of key people

Another concern of ESOP companies lies in the attraction and retention of key people or “rainmakers.” These individuals are typically highly regarded within the organization and are key to the success of the organization. If the current ESOP is not delivering the appropriate value to keep these individuals interested, the company may consider strategies to get mores shares to them and all current employees, including rebalancing or reshuffling (segregation).


Plan accounts are rebalanced annually so each participant has the same percentage of his or her account invested in employer stock and other investments.

Rebalancing is a viable option for solving a have/have not situation, improving repurchase liability planning and avoiding 409(p) compliance issues. On the other hand, issues may arise related to diversification calculation, or if longer term employees hold significant cash in proportion to newer employees.


The mandatory transfer of employer securities into or out of participant accounts, not designed to result in equal proportion of employer securities in each account. For example, segregating the accounts of former participants out of company stock and into more diversified investments.

Reshuffling provides a way to avoid former employees sharing in the risk and reward of the investment in company stock, allows more control over repurchase liability funding, and helps the company avoid becoming former employee-owned. This option, however, must satisfy plan compliance nondiscrimination requirements, be outlined in the plan document, and should not cause significant detriment to those who opted not to take a distribution from the plan.

ESOP structure is not right for the company

If the current ESOP structure is not right for the company, it could be due to challenges associated with minority ESOP ownership or a change in business that caused an originally successful ESOP to decrease in significance or value. To address this issue, the company primarily has two options: move to majority or 100% ESOP-owned, or terminate the ESOP.

Minority ESOP ownership can pose significant challenges to a business. In such cases, allocation of S distributions are exacerbating have/have not issues, cash building up in the trust is unavailable to the company, and regular contributions may have ceased or been significantly reduced. Making the switch to become majority or 100% ESOP-owned can place meaningful stock in employee accounts and balance concerns of new participants against those of long standing participants.

Whether by choice or necessity, choosing to terminate an ESOP includes determining if the ESOP meets a few key requirements, not the least of which is the requirement to liquidate all of the shares in the trust, which can be a significant cash constraint. The ESOP must consider the “permanency” (IRS facts and circumstances) test and whether the plan holds 1042 shares beyond the holding period. The company must also consider fiduciary issues related to termination such as the trustee’s ability to challenge the decision and remaining compliant with the ESOP loan primary benefit rule.

As an ESOP matures, the need to make adjustments is a natural part in the life of an ESOP and an expected process. Understanding and recognizing key indicators, and evaluating alternatives and strategies and their impact on the ESOP, the company and your participants, is key to the sustainability, long-term success and value of the ESOP and the company.

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

Insurance products and plan administrative services provided through Principal Life Insurance Co., a member of the Principal Financial Group®, Des Moines, IA 50392.