Intent of the Manual

The intent of this is to provide a full set of distribution forms that can be used by companies in the
day-to-day administration of their ESOPs.

In our thirty years of administering over 2,000 ESOPs, we have found that the most difficult task for
the internal personnel who are responsible for the day-to-day administration of ESOPs is the task of
making distributions in accordance with the original intent of the plan, and in accordance with the
express terms of the plan document.

The use of proper distribution forms is essential for two reasons. First, use of the proper forms will
eliminate many of the errors that will otherwise occur if the forms are not standardized and used
consistently from year to year. Second, use of the proper forms will leave a complete paper trail in
the event that distribution procedures are subsequently challenged by the IRS, the DOL or
plan participants.

In profit sharing plans and in 401(k) plans, distributions are typically made in cash, in a lump sum
amount. Accordingly, distribution procedures and forms used for these types of plans are relatively
simple. In ESOPs, on the other hand, distribution options include lump sum cash distributions,
lump sum stock distributions, installment distributions of cash and installment distributions of
stock. In addition, if the distributions are made in stock, the company typically has the option of
having these shares repurchased, either by the plan or by the company, with the further option
of having these repurchases made either in a lump sum or in installments. Most of these options
are also available in the case of diversification distributions that are required under Section
401(a)(28) of the Code.

Readers will notice that many of the Sample Forms Packages relate to the distribution of plan
benefits in the form of shares of company stock rather than in the form of cash. Many readers will
wonder why companies would elect to make distributions in shares of company stock rather than
in cash. 

The reasons for making distributions in the form of shares of company stock rather than in cash
are twofold.

First, many companies reach the point in the lifecycle of their plans where they wish to shrink
their ESOPs. There are only two ways to shrink an ESOP. The first way is to simply have
the company repurchase some of the shares directly from the ESOP. This approach, however,
is dangerous, both from a fiduciary standpoint and from an operational standpoint.
From a fiduciary standpoint, any repurchase of company stock by a company from its
ESOP obviously involves a fiduciary decision for which the fiduciaries can be held liable if
it is later determined that the repurchase of the shares was for the benefit of the company and/or
the outside shareholders rather than for the primary benefit of the ESOP.

Any repurchase of company stock by a company from its ESOP also involves
possible transactional liability. That is, if company stock is repurchased from the
plan, this repurchase is a “transaction” with a “related party.” Accordingly, the fiduciaries
must comply with all of the same transactional requirements that apply when an ESOP
purchases company stock from an outside shareholder. For example, the transaction should
be documented with a stock purchase agreement. Also, if the trustees are also officers
and directors of the company, there is an inherent conflict of interest involved, possibly
necessitating the need for an independent fiduciary. Further, IRS rules and regulations require
that in the case of a sale of company stock by an ESOP, just as in the case of a purchase
of company stock by an ESOP, the stock that is involved in the transaction must be appraised by
an independent appraiser, and the appraisal opinion must be rendered as of the exact date of
the transaction.

Obviously, all of these problems and issues can be avoided if the company shrinks the ESOP on a
gradual basis by making the distributions in the form of company stock and by having these shares
repurchased by the company. In this case, the ESOP has not engaged in any “transaction.” Thus,
fiduciary issues do not come into play. Also, IRS rules and regulations provide that in the case of
a distribution of shares of company stock, the participant is permitted to “put” the shares to the
company (or to the trust) at the appraised fair market value determined as of the anniversary date
coinciding with or immediately preceding the date such shares are put. Thus, the regular year-end
appraisal will suffice for purposes of the “put” option. It is not necessary to have a separate
appraisal of the exact date of the shares are put to the company.

The second reason why ESOPs often elect to make distributions in shares of company stock rather
than in cash is to enable participants to take advantage of the favorable tax advantages that are
available when distributions are made in the form of shares of company stock.

§401(e)(4)(A) of the Internal Revenue Code provides that where employer securities are distributed
in a lump sum, the net unrealized appreciation will not be taxed until the securities are sold or
otherwise disposed of in a taxable transaction. The net result is that the cumulative cost basis will
be taxed at ordinary income tax rates, and the unrealized appreciation will be taxed at long term
capital gains tax rates when the participant puts the stock back to the trust or to the company. 

Since the long-term capital gains tax rate is currently 15%, if a participant’s account balance is
large and if there is substantial appreciation in the value of the stock, it makes sense to make
distributions in the form of shares of employer stock rather than in cash, which will be taxed
entirely at ordinary income tax rates.  By the same token, in such cases, it usually makes sense
for the participant to pay the ordinary income tax on the cost basis and capital gains tax on the
appreciation currently rather than roll over the distribution to an IRA where the distribution can be
deferred, but will be taxed entirely at ordinary income tax rates upon eventual distribution.

Please bear in mind, however, that the capital gains tax on net unrealized appreciation only applies
to lump sum distributions, i.e. a distribution of the entire balance of a participant’s account. It does
not apply to in-service distributions, diversification distributions or required minimum distributions.
Please also bear in mind that if the distribution occurs before the participant attains age 59 1/2,
the 10% excise tax on premature distributions will also be assessed on the cumulative cost basis
if the participant elects to receive the distribution and not roll it over to an IRA.

In order to cover all of the options and alternatives that are available under an ESOP, we have
provided 48 different distribution forms packages.  These forms are in Word format, as well as pdf
format, so that they can be downloaded and used in the day-to-day administration of an ESOP
without having to cut and paste from various different forms.  Complete instructions are provided
with each of the sample forms packages so that the reader will be able to follow the proper
sequence in preparing these forms.

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