An unprecedented crisis. A black swan event. No matter the description, the meaning is clear: COVID-19 is having a global impact on business.
Company leaders, trustees, administrators and fiduciaries have spent months assessing the impact of the pandemic and reassessing their company’s value in regards to their Employee Stock Ownership Plans (ESOP). The two big questions are: How can you tell if the pandemic affected your ESOP? And, if it has, what can you do to mitigate the impact and create a positive result for you and your employees?
COVID-19 and company valuations
ESOP is a benefit plan that provides employees ownership in a company. They are considered qualified plans because they give the company and stock owners tax benefits. Companies use ESOPs to create alignment among both employees and shareholders.
Part of creating an ESOP is the company valuation, which is required at inception and annually each subsequent year. Appraisers use the IRS’s definition of fair market value, which is defined under Revenue Ruling 59-60 as:
“The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
With COVID-19, a company’s value may have changed, especially if the valuation took place at the end of 2019 or before March 2020. That means companies could be using incorrect valuations when making stock distributions, budgeting for human capital or ensuring company obligations are met.
The impact of COVID-19 on a company’s ESOP value depends on factors such as the valuation date and the size of the stock distribution for the plan year. Here are ways to evaluate and reassess your plan:
Consider an interim valuation
Start by reviewing your ESOP’s administrative documents to see if interim valuations can be performed. Check your plan carefully because not all plans allow for this.
Whether an interim valuation is needed depends on the actual impact of the pandemic on your company’s value. Plan administrators, trustees and legal advisors should look at your current financial statements, updated forecasting that takes the pandemic into effect, current industry updates and research, and the state of your company. Using that information, they can determine whether your company can meet its ESOP obligations without compromising cash flow.
If your company can meet its payment obligations, then it may not be necessary to do an interim valuation. In fact, the valuation cost may outweigh the cost of stock distributions for the year.
Adjusting or delaying distribution schedules
If you have problems meeting your distribution schedule due to cash flow, you can change the amount you pay out in distributions to former employees. Generally, distributions can be paid out in a lump sum amount or in equal payments over a period not exceeding more than five years. Cash-strapped companies can amend their plans from lump-sum payments to installments, saving a significant amount of money over an extended period. Those savings can be used to mitigate cash flow issues and help weather this volatile economic period.
The IRS issued Notice 2020-23 in April, allowing for slight distribution delays. As that extension has passed, another alternative is to temporarily change the distribution schedule or switch distributions from cash to stock. Distributions are not a protected benefit so you can make the change from cash to stock.
Whatever you do, always work with your administrators, trustees, legal counsel and fiduciaries to find the best option for your company and employees. If any changes are made, make sure to communicate them clearly to your employees. Alignment benefits everyone – and is a key reason for using an ESOP.
How Wipfli can help
Our teams provide clarity and confidence when evaluating your ESOP. See our ESOP Services web page to learn more or read these additional ESOP articles:
5 reasons companies are choosing ESOP structure
How to avoid biggest mistakes in ESOP valuations
Developing owner-employees in your ESOP
ESOPs have an advantage during a recession
Is there a problem with your ESOP?