Tom Ochs, CFO, Ohio Valley Supply

Coming up with cash to pay out ESOP participants is a major worry for most ESOPs and both short-term and long-term repurchase planning may become more complicated for ESOP firms that have converted to Sub-S corporations. At the Network's ESOP Administration Forum last July two Ohio ESOP firms, both recent converts to Sub-S status, discussed their issues and solutions.

Managing a Short-Term ESOP Repurchase Shortfall
Prior to 1999, Ohio Valley Supply Company's ESOP Trust balance and the yearly tax-deductible cash contributions were always sufficient to meet our repurchase obligation. However, in 1999 it appeared that the repurchase obligation for that year would be greater than the estimated available funds. US tax law changes, a restructuring of our business, and the design of our ESOP plan all played a role in creating the problem.

When the former president of OVS, a Cincinnati-based distributor of DuPont Corian, and other building materials, retired in 1985, he expressed the wish that the company be owned by the employees. His wish became reality when we purchased his shares with funds from a profit sharing plan and an ESOP loan. From the beginning, we were concerned with repurchase obligation, because our plan requires lump sum payouts, and each year contributions nearing 25% of eligible payroll were made to the ESOP.

In 1996 our company was restructured and profits increased, so in 1998 we changed to an S corporation. In 1999 we faced the payout of several terminated employees with substantial ESOP account balances. As a C Corp, we contributed a higher percentage to the ESOP than allowed as an S Corp. This, along with the recent growth in profitability, means repurchase problems. How do we finance this potential shortfall?

I prepared a list of available options along with some advantages and disadvantages and circulated this list to our ESOP attorney and third party administrator for input. Then I presented the list to our Board of Directors.

I found seven ways to finance the shortfall:

Option 1: Available funds in ESOP trust. Use the balance of an account that will not be paid out until the year 2000.

Option 2: Make a non-deductible contribution to the ESOP. One disadvantage is paying the 10% excise tax; but you also offset the non-deductible part of the contribution against your next year's ESOP contribution.

Option 3: Make an AAA distribution to the plan (An S corporation's equivalent of a C corporation's non-deductible dividend). The advantage is the distribution does not count against the ESOP contribution. The disadvantages are: 1) the distribution is based on number of shares, rewarding older employees more than our newer employees, 2) it drives up the values of participants' accounts and reduces the value of the company; and 3) if the distribution is used to pay down the loan it decreases the next year's tax-deductible net cash contribution.

Option 4: Make a deductible loan from OVS to the ESOP. The advantages are the loan does not add to ESOP account balances and loan principal and interest could be spread over more than one year. The disadvantages include initial cost and sufficiency of ESOP contributions in future years to cover repurchase obligations and the loan.

Option 5: Increase eligible payroll through bonus payouts to employees. This method went against the company policy of paying bonuses based on our financial performance.

Option 6: Have the company redeem shares and place them in a treasury. One advantage is that ESOP participants can rollover their payout to an IRA. Disadvantages are that the company uses after tax dollars to purchase shares and that newer employees miss out on a chance to get additional shares until the shares are recontributed to the plan at some future date.

Option 7: Amend the plan for multiple year payouts. Though the most obvious solution, all past terminees were paid out in the year they were due and this set a precedent. This option was not well-received by the board. The reasoning was, and still is, that because terminees have no control over the company's future they should also have no personal finance exposure.

Deciding on the best option
Normally, our current tax year's contribution is made the following year, but to meet our 1999 payouts and generate interest income, the 1998 and 1999 ESOP contributions were made in the respective year. If the increase in stock value resulted in having the payout greater than the funds available, then the board approved an AAA distribution. The good news was our stock increased only slightly, so the AAA distribution was not required.

As time passes, laws change and businesses restructure. Just about every ESOP will experience a time when payouts will be greater than the plan can support. Be prepared for this and write your plan to allow for multi-year payouts.

Looking at the Long-term
Setting aside current Sub-S profits for future ESOP repurchase needs?

The Mosser Group, a Fremont-based firm that offers general contractor, design/build, masonry, and highway/bridge services, operates within the highly cyclical construction industry. The firm, which has a long-standing tradition of sharing profits, saw a boost in profits resulting from their recent conversion to a Sub-S ESOP. This has caused them to look for ways to contribute cash or stock above the 15% limit and earmark the profits from tax savings in upcycle years toward meeting repurchase obligations during downcycle periods.

Skip Carter, president of Mosser Construction, explained that the firm worked with ESOP attorney Carl Grassi of McDonald, Hopkins, Burke & Haber Co., L.P.A. to address these issues. They decided to redesign Mosser's existing KSOP to incorporate an entirely new plan structure. First, the 401(k) portion of the old KSOP was split out into its own separate plan. Second, the ESOP portion of the old KSOP was restructured into two components — a stock-bonus-ESOP and a money-purchase plan-ESOP.

The 401(k) plan and the stock-bonus-ESOP permit the company to make discretionary contributions. These two plans share a 15% of compensation deduction limit. The money-purchase plan-ESOP requires a non-discretionary company contribution. The level of contribution is fixed as a percentage of compensation. Because of the overall 25% limit, the money-purchase plan-ESOP contribution could be fixed anywhere from 1% to 10% of compensation.

In Mosser's situation, the 401(k) plan receives employee contributions. The company also makes a 2% matching contribution in stock which is contributed into the stock bonus ESOP. The stock-bonus-ESOP also holds employer stock rollovers from the profit sharing contributions made by the company. The money-purchase-ESOP plan receives a set annual percentage of compensation as an employer contribution in cash or stock.

Through the use of these three interrelated plan vehicles, the company has found a way to share additional profits with employees, in the form of cash or stock, beyond the limits normally imposed on Sub-S ESOP plans.

Tom Ochs is Chief Exectutive Officer of Ohio Valley Supply, a 100% employee-owned company in Cincinnati.