Repurchase Liability

What is Repurchase Liability?

The repurchase liability represents the legal obligation of a privately held company sponsoring an employee stock ownership plan (an “ESOP”) to buy back its shares of company stock from participants when they become eligible to receive distributions from the ESOP.

Why Repurchase Liability?
Since an ESOP is a qualified retirement plan under ERISA, one of its main purposes is to provide benefits to plan participants. An ESOP holds assets that consist primarily of the sponsoring company’s stock, and thus there must be a means for participants to realize the value of the stock that has been allocated to their stock accounts. In the case of a privately held company sponsoring an ESOP, there is no public market for the stock; therefore, the Internal Revenue Code (the “Code”) requires that the sponsoring company buy back the stock from participants who are entitled to receive distributions from the plan.

When Does a Company Face Repurchase Liability?
Repurchase liability is an ongoing, real cash expense for every privately held company sponsoring an ESOP. When participants terminate due to death, disability, retirement, or other termination reasons, they are entitled, via a “put” option, to require the company to buy back the participant’s stock at fair market value.

An additional cash requirement for ESOP companies is associated with allowing participants the right to diversify out of a percentage of the company stock allocated to their accounts after they have met the statutory requirements, which begin when a participant has attained age 55 and ten years of participation in the ESOP. This right is designed to protect participants from the investment risks of having a lack of diversification in their retirement accounts.

The sponsoring company’s obligation to honor the “put” option, and to provide cash to the ESOP when participants exercise diversification rights, together comprise a company’s repurchase liability or “repurchase obligation.”

What Drives the Repurchase Liability?
The timing and amount of the liability is dependent on a number of factors, including the provisions of the ESOP plan document, the demographics of the sponsoring company’s participant population, and the value of the company’s stock.

The plan provision that has the most impact on the timing and amount of the cash requirements associated with the repurchase liability is the distribution policy, which dictates the timing, method, and form in which distributions are paid. The Code requires that distributions for death, disability, and retirement commence no later than the end of the plan year following the plan year in which the terminating event occurs. Distributions for other terminations can be delayed for an additional five years or, in some cases, can be delayed until an internal “ESOP loan” used to acquire the stock is repaid. Distributions can be paid in a single lump sum, or in installments that are paid typically over a period not exceeding five years, with an exception for especially large account balances.

There are pros and cons of adopting different distribution policies. For instance, paying immediate lump sum distributions will allow the company to fund each year’s entire repurchase liability and terminated participants will no longer be invested in company stock thereby benefiting from potential future increases in the company’s stock value. However, paying immediate lump sum distributions provides less of a planning horizon for the company, and also accelerates the repurchase liability, as typically the shares are reallocated to the remaining eligible participants right away; these shares ultimately end up being repurchased over and over again at an accelerated pace. Paying distributions in installments provides the company more of a planning horizon to fund the distributions, and has a smoothing effect on the reallocation of shares to the remaining eligible participants. However, an installment policy typically allows terminated participants to remain invested in company stock, which results in terminated participants continuing to benefit from potential increases in the company’s stock value, and when used with delays, can result in a large number of shares in the ESOP being held by terminated participants.

Demographically speaking, the primary characteristics of the participant population that drive the timing of cash requirements related to repurchase liability are the age distribution of the population and turnover rates. The age distribution of the population determines when participants will be eligible to elect diversification rights and receive retirement distributions. If many participants are close in age that may be eligible to elect diversification rights and retire in the same year or group of years, this can result in certain years of especially high cash requirements, which the company should anticipate and prepare for. High rates of turnover can often accelerate the repurchase liability, that is, if the turnover occurs among groups of the participant population who have accumulated vested balances in the plan.

Planning for the Repurchase Liability
While not required by law, a prudent thing to do and what should be a company’s first step in planning for funding its future repurchase liability is the preparation of formal repurchase liability study. A study will project the timing and amount of the cash requirements associated with the company’s future liability based on its existing demographics, plan provisions, and the company’s expectations about future growth rates. A study is usually best prepared by a consulting firm with expertise specifically related to ESOP repurchase liability, to assist the company in developing reasonable assumptions, and guide the company on alternative strategies it may want to explore for managing and funding the liability.

How is the Repurchase Liability Funded?
There are a variety of different strategies available to ESOP companies to fund the repurchase liability. Many companies tend to fund the ESOP on a “pay-as-you-go” basis, contributing only the cash amount needed each year to fund that year’s cash requirements. However, the cash requirements can vary significantly from year to year; therefore, in order to allow for more of a planning horizon, some companies set funds aside, either in the company or in the ESOP trust, which are intended to fund future cash requirements related to the repurchase liability. Corporate owned life insurance (“COLI”) is also used, in addition to providing funding in the event of a participant’s death, to accumulate funds for repurchase liability. There are other techniques available to fund the repurchase liability, which may include external and/or internal debt and a “releveraging” of the ESOP, which would get shares back into a suspense account that could be allocated over an extended period of time as the internal loan is amortized.

Why is Planning for the Repurchase Liability so Important?
In cases where an ESOP owns a large majority or 100% of the sponsoring company’s stock, and/or the value of the company’s stock is appreciating rapidly, the cash requirements associated with repurchase liability can be substantial. Companies would typically have a plan in place for other large cash requirements it will or may face; funding the repurchase liability, which is a real cash requirement for the company, should be no different. Planning in advance of recognizing the liability is important so that the company can understand the long-term implications of certain plan provisions and its demographics, and quantify its potential cash requirements, so that it can prepare appropriately. Preparation to manage and fund the future liability may involve making changes to the plan, or perhaps just putting a funding strategy in place that will help the company fund its future repurchase liability. This is critical, for companies whose goal is to sustain its ESOP as a retirement benefit for its participants far into the future.