ESOP Account Segregation, Rebalancing Update

Some months ago, there was optimism that the IRS would issue some kind of pronouncement on what approach it would take toward ESOP account segregation or rebalancing. Account segregation is where an ESOP company buys the shares of former employees and reinvests that money in other investments until distribution occurs some years later. Segregation is used to prevent former employees from benefiting from increases in share prices and to protect them from losses, arguably a very prudent retirement policy. Segregation can also help free shares for new employees and may be useful in managing repurchase obligation for some companies. Rebalancing occurs while participants are still employees. Each plan year, cash in the ESOP is used to buy shares in the ESOP in such a way that everyone ends up with the same proportion of cash and stock. Rebalancing is appealing to many mature ESOPs as a way to get shares to new employees.

The IRS had not been issuing letters of determination for plans with segregation provisions, although there was no official policy to this effect. But in the last several weeks, there have been reports that its concerns have been mollified. One concern was that employees would be impaired in their ability to demand a distribution in the form of company stock. While they could make that demand, if the plan used the cash to buy shares from the company, the basis for those shares could be much higher than it would have been if the account had stayed in company stock. Companies can solve this problem by reacquiring shares from accounts in the plan that have a basis as close as possible to the participant's basis at the time of segregation.

The IRS approach on rebalancing is also ambiguous. Rebalancing is not allowed to solve anti-abuse problems in S ESOPs, but many companies do have this feature in their plans for other purposes. Some IRS officials have informally said they may want to evaluate if rebalancing is consistent with ERISA, but there have been no indications that plans with these provisions have faced any specific problems.