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ESOP repurchase obligations―Planning for future pay ups

11.19.20

Read this if you are a financial manager of an ESOP.

Employee Stock Ownership Plans (ESOPs) must generally buy back, or repurchase, participants’ shares when they leave the plan or want to diversify holdings. If the ESOP does not purchase the stock the company is required to purchase the shares from the participant under the “put option” described in Internal Revenue Code (IRS) Section 409(h).These rules require the company to either provide enough cash to the ESOP to fund stock repurchases, if adequate other assets are not available within the ESOP, or to fund the repurchase of shares outside of the ESOP. Anticipating the amount and timing of these repurchases requires a lot of number crunching and assumptions to arrive at an estimated “Repurchase Obligation” at a point in time. In most cases, ESOPs enlist the help of valuation specialists, actuaries, or outsider vendors to prepare a study.

All this is done as a component of ESOP cash flow planning but also begs the question, what do you need to record or disclose in your company’s financial statements related to this obligation?

The Financial Accounting Standards Board’s guidance on the subject is contained in Accounting Standards Codification (ASC) Topic 718, Compensation - Stock Compensation. More specifically, ASC Section 718-40-50 clearly outlines the terms, allocated share and fair value information, compensation and other related disclosure requirements for ESOPs in paragraphs 1a through g. One of these requirements—paragraph f—requires disclosure of “the existence and nature of any repurchase obligation...” While the existence of a potential repurchase obligation is undeniable due to the requirements of IRC Section 409(h), disclosure of the nature of the obligation may require judgement and a careful reread of the plan documents.

Existence of the obligation

What private companies record for redemptions is straightforward. They are required to accrue obligations related to redemption events initiated on or before the balance sheet date and disclose share and obligation balance information related to those transactions of material.

Disclosures must include the number of allocated shares and the fair value of those shares as of the balance sheet date. This sounds like a general disclosure of terms, but the intention is to communicate maximum repurchase obligation exposure. If redemptions subsequent to the balance sheet date require material and imminent use of cash, the company should consider whether it is required to disclose them as a subsequent event (including amounts) under ASC Topic 855, Subsequent Events.

Nature of the obligation

So, what do you need to disclose specific to the nature of your company’s ESOP shares repurchase obligation?

Put options against the ESOP trust (i.e., rights afforded under the ESOP requiring the trust to purchase outstanding stock at given prices within specific time horizons). Plan terms allowing redemption payments in excess of a certain threshold to be made over a defined period of time (e.g., retiring employees with vested balances greater than $5,000 may receive their payments in equal installments over a five-year period, while those with lower balances may receive their benefit in a lump sum).

If your company’s ownership has an ESOP component or you are considering an ESOP as part of your exit strategy, please reach out to Linda Roberts and Estera Ciparyte-McDonald. They can help you better understand the myriad considerations to be taken into account, and the required and potential financial statement impact and disclosures.

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BerryDunn experts and consultants

Read this if you are an employee benefit plan fiduciary.

Fiduciary risk management

This is the final article in a series to help employee benefit plan fiduciaries better understand their responsibilities and manage the risks of non-compliance with ERISA requirements. You can find the full series here.

If, as part of your involvement with an employee benefit plan, you have decision-making ability; you advise those with decision-making ability; or someone tasks you with decision-making related to the plan, you are more likely than not, a fiduciary. As discussed in the first article of the series, this status comes with responsibilities and, therefore, risks and consequences.

The general approach to handling risk is a cycle of identifying, assessing, controlling, and reviewing controls over risks. Based on the assessment of a given risk, there are four ways to manage it: you can avoid, reduce, transfer, or accept the risk. 

Identifying and assessing fiduciary risk1 

The risks facing a plan fiduciary include, but are not limited to, the following:

Removal of fiduciary

In appropriate cases, a fiduciary may be removed and permanently prohibited from acting as a fiduciary or from providing services to ERISA plans.

Civil penalties

Among other penalties, the DOL may assess a civil penalty equal to 20% of the amounts recovered for the plan through litigation or settlement.

Criminal prosecution

Upon a conviction for a willful violation of ERISA’s reporting and disclosure requirements, a fiduciary may be subject to fines and/or imprisonment for not more than ten years. There is also a provision in ERISA that applies to any person, not just ERISA fiduciaries, that makes coercive interference with ERISA rights a criminal offense punishable by fines and/or imprisonment for up to ten years. In addition, outside of ERISA, there are a number of criminal statutes that apply to any person, not just ERISA fiduciaries, including criminal statutes for embezzling from an ERISA plan, making false statements in ERISA documents, and taking illegal kickbacks in connection with an ERISA plan.

Participant lawsuits

Additionally, plan participants may file a lawsuit against the fiduciary for breach of their fiduciary duty. Over the past few years, this has become more common and has generally been related to the fiduciary’s failure to adequately negotiate and monitor plan fees. 

Co-fiduciary liability

ERISA's unique co-fiduciary liability provisions make each fiduciary responsible for the actions of the other plan fiduciaries but only under certain circumstances. As a general rule, fiduciaries aren’t responsible for the breach of another fiduciary unless:

  • They participate knowingly in, or knowingly undertake to conceal, an act or omission of such other fiduciary, knowing such act or omission is a breach;
  • Their failure to be prudent in the administration of their own fiduciary responsibilities enables the other fiduciary to commit a breach; or
  • They have knowledge of a breach by such other fiduciary and don’t make reasonable efforts under the circumstances to remedy the breach.

Controlling fiduciary risk

There are several ways to effectively manage fiduciary risk. When used together, they give you solid controls to greatly reduce your level of risk.

Plan documentation

A fiduciary and/or plan sponsor should reduce their exposure to the risks identified above and their first line of defense is through plan documentation (discussed in depth here). Broadly speaking, the organizers and fiduciaries of the plan should ensure that policies and procedures are laid out to ensure proper oversight and internal controls are in place to prevent any voluntary or involuntary noncompliance with ERISA and the DOL.

Oversight

Fiduciaries should meet formally on a regular basis to review the plan’s offerings, service providers, fees, and other issues that may affect the plan. A single individual who is the sole fiduciary for a plan may not have the knowledge or bandwidth to appropriately fulfill the responsibilities of the plan. Additionally, having an auditor come in and audit the plan can help identify some of the risks identified above, although an audit of the plan does not reduce your responsibility to monitor and review the plan’s activity on an ongoing basis.

Third Party Administrators (TPA) & recordkeepers

Fiduciaries may also be able to mitigate some of the risks identified above through use of a TPA and/or recordkeeper. While TPAs and recordkeepers are not generally considered fiduciaries or co-fiduciaries, TPAs have varying service offerings, including recordkeeping, that are powerful tools to plan administrators to review and operate the plan. For example, depending on the plan sponsor’s existing payroll and HR structure, inclusive of TPAs and recordkeepers, fiduciaries may be able to automate the transfer of contributions to ensure timeliness of deposits. The plan may also be able to add another layer of internal controls by incorporating the TPA’s or recordkeeper’s internal controls into the plan’s control environment assuming the fiduciary has gained an understanding and comfort around the controls present at the TPA and/or recordkeeper.

Professional investment advisors and co-fiduciaries

Employee benefit plans must meet certain requirements with regard to their investment offerings. For instance, the plan must allow participants to invest in a diversified portfolio. The plan may try to transfer some of these risks and employ the help of a professional investment advisor to help ensure the plan’s investment offerings meet such criteria. This could involve hiring either an ERISA 3(21) fiduciary or an ERISA 3(38) fiduciary. The former serves as an advisor and a co-fiduciary, but does not have any authority by themselves, while the latter is an investment manager and therefore authorized to select investments for the plan. Doing so may help demonstrate to regulators that a fiduciary has fulfilled their duty in this regard. Alternatively, a plan may hire a 3(16) Fiduciary. 3(16) Fiduciaries are individuals or organizations that are charged with running plans as the plan administrator. A company may be able to shift most of their fiduciary risk to such a fiduciary. 

In any case, the plan fiduciary must continue to monitor a 3(16), 3(21) or 3(38) advisor to make sure it is still prudent to use that advisor.

Bonding and fiduciary liability insurance

Bonding is required for most EB plans and does not protect the fiduciary from any risk. It does however protect the plan from fraud or dishonesty. On the other hand, fiduciary liability insurance can protect the fiduciary in the case of breach of fiduciary duty. This type of insurance is not required but is another option to transfer fiduciary risk.

As mentioned in our second article, much like owning a car, regular preventative maintenance can help you avoid the need for costly repairs. Plan fiduciaries should periodically refresh their understanding of ERISA requirements and re-evaluate their current and future business activities on an ongoing basis. Doing so will help mitigate any risks associated with non-compliance with the DOL and IRS and keep the plan running smoothly. 

Need help navigating the fiduciary road? Reach out to the BerryDunn employee benefit consulting team today.

1From Fidelity’s Plan Sponsor Webstation: Consequences of breach of fiduciary duties 

Article
Fiduciary risk: Five ways to control and reduce it

What are the top three areas of improvement right now for your business? In this third article of our series, we will focus on how to increase business value by aligning values, decreasing risk, and improving what we call the “four C’s”: human capital, structural capital, social capital, and consumer capital.

To back up for a minute, value acceleration is the process of helping clients increase the value of their business and build liquidity into their lives. Previously, we looked at the Discover stage, in which business owners take inventory of their personal, financial, and business goals and assemble information into a prioritized action plan. Here, we are going to focus on the Prepare stage of the value acceleration process.

Aligning values may sound like an abstract concept, but it has a real world impact on business performance and profitability. For example, if a business has multiple owners with different future plans, the company can be pulled in two competing directions. Another example of poor alignment would be if a shareholder’s business plans (such as expanding the asset base to drive revenue) compete with personal plans (such as pulling money out of the business to fund retirement). Friction creates problems. The first step in the Prepare stage is therefore to reduce friction by aligning values.

Reducing risk

Personal risk creates business risk, and business risk creates personal risk. For example, if a business owner suddenly needs cash to fund unexpected medical bills, planned business expansion may be delayed to provide liquidity to the owner. If a key employee unexpectedly quits, the business owner may have to carve time away from their personal life to juggle new responsibilities. 

Business owners should therefore seek to reduce risk in their personal lives, (e.g., life insurance, use of wills, time management planning) and in their business, (e.g., employee contracts, customer contracts, supplier and customer diversification).

Intangible value and the four C's

Now more than ever, the value of a business is driven by intangible value rather than tangible asset value. One study found that intangible asset value made up 87% of S&P 500 market value in 2015 (up from 17% in 1975). Therefore, we look at how to increase business value by increasing intangible asset value and, specifically, the four C’s of intangible asset value: human capital, structural capital, social capital, and consumer capital. 

Here are two ways you can increase intangible asset value. First of all, do a cost-benefit analysis before implementing any strategies to boost intangible asset value. Second, to avoid employee burnout, break planned improvements into 90-day increments with specific targets.

At BerryDunn, we often diagram company performance on the underlying drivers of the 4 C’s (below). We use this tool to identify and assess the areas for greatest potential improvements:

By aligning values, decreasing risk, and improving the four C’s, business owners can achieve a spike in cash flow and business value, and obtain liquidity to fund their plans outside of their business.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Article
The four C's: Value acceleration series part three (of five)

Read this if your company is a benefit plan sponsor.

While plan sponsors have been able to amend their 401(k) plans to include a post-tax deferral contribution called Roth for more than a decade, only 86% of plan sponsors have made it available to participants, according to the Plan Sponsor Council of America. Meanwhile, despite the potential benefits of such plans, just a quarter of participants who have access to the Roth 401(k) option use it. Plan sponsors may want to consider adding a Roth 401(k) option to their lineup because of the potential tax benefits and other advantages for plan participants.

A well-designed Roth 401(k) may be an attractive option for many plan participants, and it is important for plan sponsors considering such a feature to design the plan with the needs of their workforce in mind. It is also critical to clearly communicate the differences from the pre-tax option, specific timing rules required, and the tax-free growth it offers. Additionally, plan sponsors should be mindful of potential administrative costs and other compliance requirements in connection with allowing the Roth option.

Roth 401(k)s: The basics

A Roth is a separate contribution source within a 401(k) or 403(b) plan that differs from traditional retirement accounts because it allows participants to contribute post-tax dollars. Since participants pay taxes on these contributions before they are invested in the account, plan participants may make qualified withdrawals of Roth monies on a tax-free basis, and their accounts grow tax-free as well.

Participants of any income level may participate in a Roth 401(k) and may contribute a maximum of $20,500 in 2022—the same limit as a pre-tax 401(k). Contributions and earnings in a Roth 401(k) may be withdrawn without paying taxes and penalties if participants are at least 59½ and it’s been at least five years since the first Roth contribution was made to the plan. Participants may make catch-up contributions after age 50, and they may split their contributions between Roth and pre-tax. Similar to pre-tax 401(k) accounts, Roth 401(k) assets are considered when determining minimum distributions required at age 72, or 70 ½ if they reached that age by Jan. 1, 2020.

Only employee elective deferrals may be contributed post-tax into Roth 401(k) accounts. Employer contributions made by the plan sponsor, such as matching and profit sharing, are always pre-tax contributions. If the plan allows, participants may convert pre-tax 401(k) assets into a Roth account, but it is critical to remember that doing so triggers taxable income and participants must be prepared to pay any required tax. In addition, plan sponsors must be careful to offer Roth 401(k)s equally to all participants rather than just a select group of employees.

Qualified distributions from a designated Roth account are excluded from gross income. A qualified distribution is one that occurs at least five years after the year of the employee’s first designated Roth contribution (counting the first year as part of the five) and is made on or after age 59½, on account of the employee’s disability, or on or after the employee’s death. Non-qualified distributions will be subject to tax on the earnings portion only, and the 10% penalty on early withdrawals may apply to the part of the distribution that is included in gross income. Participants may take out loans if permitted in the plan document. 

First steps for plan sponsors

A common misconception among plan sponsors is that a Roth offering requires a completely different investment vehicle. The feature is simply an added contribution option; therefore, no separate product is needed.

When considering the addition of a Roth 401(k) option, it is important for plan sponsors to check with service providers to determine whether payroll may be set up properly to add a separate deduction for the participant. Plan sponsors may also need to consider guidelines for conversions, withdrawals, loans, and other features associated with the Roth contribution source to ensure the plan document is prepared and followed accurately.

Education is an important component of any new plan feature or offering. Plan sponsors should check with service providers to see how they may help to explain the feature and optimize its rollout for the plan. One-on-one meetings with participants may be very helpful in educating them about a Roth account.

A word about conversions

If permitted by the plan document, participants may convert pre-tax 401(k) plan assets (deferrals and employer contributions) to the Roth source within their plan account. The plan document may allow for entire account conversions or just a stated portion. When assets are converted, participants must pay income taxes on the converted amount, and the additional 10% early withdrawal tax won’t apply to the rollover. Plan sponsors should educate participants on the benefits of converting to the Roth inside the company 401(k).

Collaborate with the right service providers to educate your participants

The right service providers may review your current plan design, set up accounts properly, actively engage and educate your participants, and offer financial planning based on individual circumstances to show how design features like a Roth account may benefit their situation. If you would like to start the conversation about adding a Roth option or enhancing your participant education program, contact our employee benefits team. We are here to help. 

Article
Plan sponsor alert: Roth 401(k) remains underutilized despite potential benefits

Read this if you are a Maine business or pay taxes in Maine.

Maine Revenue Services has created the new Maine Tax Portal, which makes paying, filing, and managing your state taxes faster, more efficient, convenient, and accessible. The portal replaces a number of outdated services and can be used for a number of tax filings, including:

  • Corporate income tax
  • Estate tax
  • Healthcare provider tax
  • Insurance premium tax
  • Withholding
  • Sales and use tax
  • Service provider tax
  • Pass-through entity withholding
  • BETR

The Maine Tax Portal is being rolled out in four phases, with two of the four phases already completed. Most tax filings for both businesses and individuals are now available. A complete listing can be found on maine.gov. Instructional videos and FAQs can also be found on this site.

In an effort to educate businesses and individuals on the use of the new portal, Maine Revenue Services has been hosting various training sessions. The upcoming schedule can be found on maine.gov

Article
New Maine Tax Portal: What you need to know

Read this if you are a financial institution with income tax credit investments.

Financial institutions and other businesses that participate in tax credit investments designed to incentivize projects that produce social, economic, or environmental benefits could benefit from proposed rules that simplify the accounting treatment of such investments and result in a clearer picture of how these investments impact their bottom lines.

FASB proposal

On August 22, 2022, the Financial Accounting Standards Board (FASB), issued a proposal that would broaden the application of the accounting method currently available to account for investments in low-income housing tax credit (LIHTC) programs to other equity investments used to generate income tax credits. The proposal, titled “Investments – Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method”, would expand the eligibility of the proportional amortization method of accounting beyond LIHTC programs to other tax credit structures that meet certain eligibility criteria.  

FASB introduced the option to apply the proportional amortization method to account for investments made primarily for the purpose of receiving income tax credits and other income tax benefits in ASU 2014-01. However, the guidance limited the proportional amortization method to investments in LIHTC structures.

The proportional amortization method is a simplified approach for accounting for LIHTC investments in which the initial cost of the investment is amortized in proportion to the income tax credits and other benefits received (allocable share of depreciation deductions). The cost basis amortization and income tax credits received are presented net on the investor’s income statement as a component of income tax expense (benefit). Under existing guidance, investments in non-LIHTC projects are accounted for using either the equity method or cost method, depending on certain factors. 

The proposal aims to address the concerns that the equity and cost methods do not offer a fair representation of the economic characteristics for investments for which returns are primarily related to federal income tax credits. Supporters of the proposal argue that the accounting method applied should not be determined by the legislative program under which the tax credits are authorized, but instead by the economic intent under which the investment was made. The hope is the FASB proposal will create a heightened sense of uniformity in accounting for investments in income tax credit structures. 

Additional provisions

Other provisions within the proposal would require a reporting entity to “make an accounting policy election to apply the proportional amortization method on a tax-credit-program-by-tax-credit-program basis” and disclose the nature of its tax equity investments and the impact on its financial position and results of operations. 

The significance of this proposal is amplified by the uptick in tax credit programs in recent years, including the New Markets Tax Credit (NMTC), Historic Rehabilitation Tax Credit (HTC), and Renewable Energy Tax Credit (RETC). While the FASB has yet to declare an effective date for the implementation of the proposal, comment letters from stakeholders were due October 6, 2022. 

For more information

To discuss the impact this new accounting pronouncement may have on your financial institution, please contact the BerryDunn Financial Services team. We’re here to help.

Article
FASB proposes changes to accounting for income tax credits

This is our second of five articles addressing the many aspects of business valuation. In the first article, we presented an overview of the three stages of the value acceleration process (Discover, Prepare, and Decide). In this article we are going to look more closely at the Discover stage of the process.

In the Discover stage, business owners take inventory of their personal, financial, and business goals, noting ways to increase alignment and reduce risk. The objective of the Discover stage is to gather data and assemble information into a prioritized action plan, using the following general framework.

Every client we have talked to so far has plans and priorities outside of their business. Accordingly, the first topic in the Discover stage is to explore your personal plans and how they may affect business goals and operations. What do you want to do next in your personal life? How will you get it done?

Another area to explore is your personal financial plan, and how this interacts with your personal goals and business plans. What do you currently have? How much do you need to fund your other goals?

The third leg of the value acceleration “three-legged stool” is business goals. How much can the business contribute to your other goals? How much do you need from your business? What are the strengths and weaknesses of your business? How do these compare to other businesses? How can business value be enhanced? A business valuation can help you to answer these questions.

A business valuation can clarify the standing of your business regarding the qualities buyers find attractive. Relevant business attractiveness factors include the following:

  • Market factors, such as barriers to entry, competitive advantages, market leadership, economic prosperity, and market growth
  • Forecast factors, such as potential profit and revenue growth, revenue stream predictability, and whether or not revenue comes from recurring sources
  • Business factors, such as years of operation, management strength, customer loyalty, branding, customer database, intellectual property/technology, staff contracts, location, business owner reliance, marketing systems, and business systems

Your company’s performance in these areas may lead to a gap between what your business is worth and what it could be worth. Armed with the information from this assessment, you can prepare a plan to address this “value gap” and look toward your plans for the future.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Next up in our value acceleration series is all about what we call the four C's of the value acceleration process. 

Article
The discover stage: Value acceleration series part two (of five)