Account Segregation and Vesting in ESOPs

Pete J. Shuler and Mark D. Swanson, J.D., CEBS

Employee stock ownership plans (ESOPs) may allow the stock portion of terminated participants’ accounts to be converted to cash and invested in nonstock assets prior to payout. This approach is commonly referred to as account segregation, account conversion, or reshuffling. Companies often employ this strategy to make sure only active employees (those who affect the stock’s value) hold the company stock in the ESOP, to prevent terminated participants from sharing in the risk and return associated with company stock after they no longer have an effect on value, to manage their repurchase obligation, or for a combination of any or all of these reasons. Companies must tread lightly, though, as account segregation could violate plan document provisions and Internal Revenue Code (IRC) regulations if not done properly.

Dealing With Nonvested Shares

Companies considering account segregation often face the same issue: how to treat nonvested shares. Specifically, companies must determine what portion of terminated participants’ accounts will be converted to nonstock assets – the entire stock account or just the vested stock?

Many companies prefer to convert only the vested stock account balance because doing so requires less cash from the company. For example, assume that a terminated participant has 1,000 shares in his or her account, that he or she is 60 percent vested, and that the shares are worth $10 each. From a financial perspective, it seems ideal for the company to convert the 600 vested shares for $6,000, invest those proceeds in nonstock assets, and ultimately pay them out to the participant. The participant would then forfeit the 400 remaining shares based on the forfeiture timing in the plan document. Converting all 1,000 shares would cost the company $10,000 instead of $6,000, and because the shares are nonvested, the company likely would rather not spend the extra $4,000

Hazards of Segregating Only Vested Shares

Companies wanting to segregate only a participant’s vested stock account and locking that in as their vested account could be violating the plan document and the anti-cutback provisions under IRC Section 411(d)(6). Most plans have provisions that stipulate participants will forfeit their nonvested balance at the earlier of the plan year-end in which they receive their distribution or when they incur five consecutive one-year breaks in service (a break in service occurs when a participant works fewer than 500 hours for a plan year). Converting a portion of a participant’s account and labeling the converted component the “vested portion” and the nonconverted component the “nonvested portion” can lead to a participant’s account being partially forfeited before the time provided under the terms of the plan and to the participant receiving a distribution that is less than the amount to which he or she is entitled.

Using the earlier example, assume that a participant waited five years before taking a distribution. During that time, the $6,000 invested in nonstock assets increased 3 percent annually each of those five years, and the company’s stock price increased 8 percent annually over the same period. The participant’s nonstock asset account is now worth just less than $6,956, and his or her stock account is worth just less than $5,877. Because the participant’s total account balance is $12,833 and he or she is 60 percent vested, his or her true vested account balance – the amount to which the participant is actually entitled – is $7,700, not the $6,956 tagged as the vested amount. A bit more than 50 shares would have to be sold from the participant’s account to fund the rest of the cash distribution. Converting only the vested account without adjusting for the correct vested benefit upon payment results in a forfeiture that doesn’t comply with the plan’s terms and a cutback in the participant’s accrued vested benefit.

Initially converting to cash only vested shares in a terminated participant’s account is permissible, as long as the participant ultimately is paid the correct vested balance. If the company stock value grows faster than the nonstock assets, the sale of additional shares from the participant’s account will be necessary at the time of distribution.

Some companies transfer the proceeds from the conversion of stock to their 401(k) plan (or to the 401(k) component of their KSOP) so that the terminated participant can choose his or her own investments. This still can be done, but, as illustrated earlier, an additional sale might be necessary at the time of distribution, with the additional payout being made either from the ESOP or from the 401(k) plan subsequent to an additional transfer. Coordination between the third-party administrators of both plans is vital during this process.

Properly Converting Shares in One Step

It is possible to avoid the necessity of a second “true-up” sale. Companies that initially convert all of a terminated participant’s stock account – vested and nonvested – lock in the price they will pay to fund the participant’s distribution with no additional funds required. As noted earlier, converting entire accounts initially costs a company more, but the nonvested portion of those converted accounts, if the proceeds from the conversion are kept in the ESOP, eventually will be forfeited, reallocated to active and eligible participants, and available for future account conversions. If the proceeds are transferred to the 401(k) plan (or 401(k) component of a KSOP), then the nonvested portion will be forfeited and used as stipulated in that plan.

Account conversion is a powerful strategy for many reasons. It puts a company’s stock in the hands of the actively employed participants who can still have an impact on the company’s performance. From an administrative perspective, it is also relatively easy to accomplish, but the conversion and payout provisions must be set up carefully and with the advice of competent counsel.