IRS Holding Approval of Plan Provisions Providing for Account Segregation

The January 5, 2009 Employee Ownership Update is online and discusses the following:

• Repricing Wave?
• IRS Puts Hold on Approving Plan Provisions Segregating Accounts in ESOPs
• Germany Enhances Employee Ownership Opportunities
• Employee Ownership at Change.Org
• How Are You Dealing with the Downturn?

In ESOP Planning 2008: Distributions (2 of 4) we discussed the strategy of using ESOP cash (in the accounts of active participants or to be allocated to active participants) to purchase the shares from the accounts of terminated participants at termination. The segregation strategy is used to prevent terminated participants from sharing in the ups and downs in value of the company stock when they are no longer working for the company, limiting the risk and reward potential of holding company stock by former employees. It can also used as a method to provide shares to active employees and for repurchase obligation planning purposes. One downside is that the ability to delay funding distributions is lost with segregation.

Why would a plan that wants to limit the exposure of former employees to company stock not just use the cash to pay distributions? The main reason is to avoid creating an incentive for participants to leave the company to get access to their account balance. This could create retention and hiring issues, and could even contribute to a "run on the bank", or more accurately, a "run on the ESOP".

The Update discusses how the IRS has put a hold on approving segregation plan provisions until they develop a position on the issue:

Representatives from the IRS have informally told ESOP advisors that they were putting on hold approving plan provisions that segregate ESOP accounts at termination until the agency comes up with a position on this issue. Segregation is a common ESOP practice in which employee accounts are converted into invested cash when an employee terminates, then held there until the account is distributed. Companies do this for a number of reasons, including freeing up shares for other employees, limiting the risk (and potential gain) of holding employer stock by former employees, and locking in a repurchase price at current value.

The issue is whether segregation violates ESOP rules by preventing employees from having the benefit of ownership, and does so in a discriminatory fashion. An argument can be made that it is far more prudent for former employees not to be concentrated in employer stock, but, opponents of segregation have asked if this is only offered to former employees, shouldn't it be offered to everyone?

At this point, there is no regulation or technical advice on this matter. Companies that currently have segregation features do not necessarily have to change them, but when they refile for a new letter in their five-year filing cycle, it is unclear yet whether the IRS will approve. Similarly, new plans can add incorporate this provision, but will probably also have to wait until the IRS decides how to deal with the issue. Because of the uncertainty on this issue, good legal advice is needed.

Companies can attempt to accomplish some of the same goals by offering employees the choice of moving out of some or all of their stock holdings at termination. If that is not sufficient, the company could extend the offer to employees meeting non-discriminatory requirements, such as minimum age/participation rules more liberal than the current diversification requirements. That could result in the same number of shares being released for recirculation and the same amount of control over the repurchase price, but it might not fully address the issue of former participants still holding company stock.

Of course, if the company has the cash for segregation, it could just pay people out sooner, perhaps in installments. The fear is that that provision might lead some people to leave to get access to their accounts, although just how much of an issue this is hard to assess.

The Update also discusses how companies are looking at repricing their underwater stock options and shares a link to Companies breathe life into options.