Are you new to ESOPs or new to repurchase obligation?
By: Michael Lesinski, Sr. Client Service Associate–Principal®
Language can sometimes be confusing…particularly when it is a defined, technical term. From a high level, this article looks at the differences between “recycling” and “redeeming” and provide an understanding of some fundamental mechanics to ESOP repurchase obligation. Let’s take a closer look.
What exactly is "recycling" and “redeeming”?
With every ESOP comes repurchase obligation—paying participants the fair market value of the company stock in their ESOP accounts when they are eligible to receive a distribution. How distributions from an ESOP are funded is important, not only to ESOP participants, but to the company sponsoring the ESOP, since the amounts and timing of the distributions and the amount of cash needed to fund the distributions can impact the financial health of the company. Understanding the difference between “recycling” and “redeeming” can help you make the right decision for your organization.
Recycling refers to a method of funding distributions from the ESOP by converting stock in a participant’s account into cash. When a company chooses to recycle shares, the shares remain in the ESOP and are later redistributed among remaining participants. For example, a company may use cash already in the ESOP or ongoing cash contributions to the ESOP to buy back shares of former employees. As a result, shares stay in the ESOP and are reallocated each year to participants, instead of coming out of the ESOP and being retired.
Other key impacts:
- Recycling retains and provides shares to be allocated to participants.
- Recycling treats payments to participants for all reporting and withholding purposes as cash distributions.
- Recycling can be funded with tax-deductible employer contributions to the ESOP.
- The ESOP ownership percentage of the company stays at a constant level.
Redeeming shares refers to a method of funding distributions from the ESOP by distributing the participant’s stock—it comes out of the ESOP—and then the company buys it back. This purchase of shares by the company (redemption) results in the shares being “retired” (not counted as active shares), and reduces the overall number of shares in the ESOP and the overall number of outstanding shares. Shares that are retired may be contributed back to the ESOP as a tax-deductible employer contribution (subject to plan limits). Also, unlike recycling shares, the ESOP ownership percentage of the company will decline as shares are redeemed unless the ESOP is a 100% shareholder plan.
Other key impacts:
- When the company redeems shares the cash payments for stock are not tax-deductible
- The ESOP can distribute stock (redeem) unless the corporate bylaws or the plan documents restricts it.
- Redeeming shares could have an impact on the per share value since a fewer number of shares are outstanding.
Why is this important?
To help prevent repurchase liability from negatively impacting a company’s future growth, management should plan, and understand the fundamental differences between “recycling” and “redeeming.” This is one of the challenges for sustaining an ESOP and one of the reasons why company management should regularly plan for, review and assess projected repurchase obligation, carefully considering the implications of recycling and redeeming and other funding alternatives to address the ongoing repurchase liability as it becomes due. Overall, the decision to recycle or redeem shares should align with the company’s strategic plan. It’s also important to complete a repurchase liability study regularly. Remember, for the company it’s not just a funding obligation, it’s a fiduciary obligation.
Here are some suggested ways repurchase liability can be handled:
- Internal Spreadsheet
- My PERLS® Study
- Formal Repurchase Liability Study
If you want more information on repurchase liability studies and options, give us a call. We’re here to help.
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.
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