How an ESOP Termination Process Works

An Employee Stock Ownership Plan (ESOP) termination is the formal process of discontinuing the plan and distributing all its assets to employee participants. This process is governed by strict legal and fiduciary standards to ensure all participants receive their entitled benefits and that the company adheres to federal regulations.

Initiating an ESOP Termination

A company may decide to terminate its ESOP for several reasons, such as a sale or merger. Other catalysts include a strategic decision to move away from employee ownership, the liquidation of the business, or concerns over the financial burden of plan administration. If the company must buy back shares from many departing employees, the resulting cash drain can become unsustainable, prompting termination.

The process of ending an ESOP begins with a resolution from the company’s board of directors. Following the board’s resolution, the company must legally amend its ESOP plan document to establish the official date of termination.

This termination date is significant because it freezes the plan. From this date forward, no new participants can join, and company contributions cease. Most importantly, the termination date triggers a requirement under federal law: all plan participants become 100% vested. This means every employee with a balance in the ESOP gains a non-forfeitable right to all the shares allocated to their account, regardless of their length of service.

Winding Down the ESOP Trust

A primary task during the wind-down phase is addressing any outstanding debt the ESOP trust used to acquire company stock, known as an ESOP loan. If the termination is due to a company sale, proceeds from selling the ESOP’s shares to the acquirer are used to satisfy this loan.

After the ESOP loan is fully paid, any shares held in a suspense account as collateral must be allocated to the accounts of active participants. The allocation is based on a pre-existing formula in the plan document, proportional to each participant’s compensation. This final allocation ensures that all remaining stock in the trust is credited to individual employee accounts before distribution.

An independent appraiser must perform a final valuation to determine the stock’s fair market value as of the final transaction date. This is especially important for a private company where no public market exists for the shares. This value is used to calculate each participant’s account for the upcoming distribution.

Distributing Plan Assets to Participants

After the trust’s affairs are in order, the process of distributing assets to participants begins, with the plan document dictating the available forms of distribution. The most common form is a cash payment, especially if the company was sold and its stock converted to cash.

Alternatively, the plan may permit a distribution of actual shares of company stock. This option is more likely if the company continues to operate as a private entity after the ESOP termination. The plan document will specify the rights of these new shareholders, including a “put option” that allows them to sell their shares back to the company at a future date for fair market value.

Distributions may not be immediate, as the administrator needs time to liquidate assets and finalize accounts. Distributions must be made as soon as administratively feasible, often within one year of the plan’s termination date. Participants must be notified about the timing and the options available to them.

Participants have a right to defer income taxes on their distribution by executing a direct rollover. This allows them to move their entire account balance into another qualified retirement plan, such as a 401(k) or a personal Individual Retirement Account (IRA). By choosing a rollover, the funds remain in a tax-deferred state, continuing to grow until they are withdrawn during retirement.

Tax and Regulatory Finalization

If a participant takes a cash distribution without rolling it over, the entire amount is considered ordinary income for that tax year. This income is subject to federal and state taxes, and if the participant is under age 59½, a 10% early withdrawal penalty may also apply. The plan administrator is required to withhold 20% of the distribution for federal income taxes.

A different set of tax rules applies if a participant receives company stock and does not roll it over, bringing the concept of Net Unrealized Appreciation (NUA) into play. The participant pays ordinary income tax only on the cost basis of the stock—what the ESOP originally paid for it. The NUA, which is the increase in the stock’s value, is not taxed until the participant sells the shares, at which point it is taxed at more favorable long-term capital gains rates.

While not mandatory, companies often file IRS Form 5310, Application for Determination for Terminating Plan. This asks the IRS for a “determination letter,” which provides assurance that the termination complies with tax laws and protects fiduciaries against future disqualification of the plan.

Regardless of whether a determination letter is sought, the company must file a final Form 5500, Annual Return/Report of Employee Benefit Plan. This form is required for every year the plan was in existence, including its final, partial year of operation. The final Form 5500, marked as such, informs the IRS and the Department of Labor that the plan has been terminated and all assets have been distributed.