Annual ESOP Checklist for Compliance and Long-Term Success

Key Takeaway

Maintaining a successful ESOP requires an annual, repeatable checklist so that compliance, valuation, repurchase planning, and culture don’t drift. Your checklist should cover five areas each year:

• Financial review & planning (cash flow, debt, repurchase obligations)
• Annual valuation (timely process + trustee coordination)
• Compliance & administration (testing, filings, participant reporting)
• Plan document review (confirm design still fits your ESOP’s maturity)
• Employee education & engagement (sustain an ownership culture)

Each year end, company managers and executives will often be focused on reviewing annual company performance, closing the books and performing the tedious task of preparing the budget for the upcoming year. Companies may even have a checklist to make sure that all year-end filings and tasks are completed. If you do not already have one, your ESOP also deserves to have an annual checklist so that important ESOP considerations, tasks, and filings are not inadvertently overlooked. Maintaining a successful ESOP depends on doing the important “repeatable” things right every year—not just getting the transaction done.

Author Insight: Ken Sommers, Former CFO of an ESOP-Owned Company
"When our company transitioned to ESOP ownership in 2010, I quickly learned there is an "ESOP learning curve." I didn’t have a checklist in the early years (but I wish I had). I started with a small list and added to it each year."

This article will lay out some of the annual ESOP requirements that should be included on your checklist from the viewpoint of former ESOP administrator so you can start with a solid best-practice "blueprint" instead of building it the hard way.

While every ESOP is different, most annual checklists fall into five repeatable categories. Depending on the life cycle stage of your ESOP, the blueprint of your ESOP checklist can be broken down into categories such as:

1. Financial Review and Planning
2. Annual Valuation
3. Compliance and Administration
4. Plan Document Review, and
5. Employee Education/Engagement
   
   

This blueprint is not all-inclusive; your checklist should be a living document and be tailored to your specific ESOP.

It should be noted that the responsibilities included on an ESOP checklist do not all fall on one person to complete. There will be many hands in this pot, ranging from the company’s internal ESOP administrator and HR Department, the trustee, the valuation professional, the third-party administrator (TPA), the outside accountants/auditors, and possibly others (ESOP attorney, lender, etc.). Because responsibilities are shared, your checklist should make ownership and timing explicit. Here’s a blueprint to start with.

Financial Review and Planning

There are annual financial responsibilities that need to be addressed each year:

• Provide the necessary information to the trustee so that the ESOP financial statements can be drafted (including the number of shares released).
• If your ESOP has 100 or more participants, be sure to schedule an ESOP audit with a certified public accounting firm that has expertise in employee benefit plan audits.
• Most companies begin the budgeting process for the upcoming year in Q4 of the current year with the goal of finalizing the budget at (or around) current year end. When preparing the annual company budget, do your best to estimate what the share price will be next year (don’t worry…you will get better at this with practice and experience).
  • This will allow you to accrue ESOP compensation expense in the monthly financial statements as accurately as possible (and hopefully avoid a big year-end adjustment once the valuation is completed).

For more mature ESOPs, there are financial planning issues that should be evaluated annually. These evaluations can be part of year-end procedures or part of strategic planning sessions:

• Review the current debt structure. If enough of the initial bank debt to finance the ESOP transaction has been paid down, it may make sense to reload the bank debt and pay down a portion of the seller notes.
• Analyze cash flow. Are cash demands balanced to provide for working capital demands, company growth and the ESOPs pending repurchase obligations?
  • As the initial transaction debt is paid down and participant balances begin to become meaningful, consider performing periodic repurchase obligation studies with a qualified ESOP advisor.
• Is your ESOP sustainable? Corporate governance, management succession, the current financing structure, the ability to grow organically or through acquisitions and the ability to fund the repurchase obligations are only a few things that should be reviewed annually for sustainability.
  • As your ESOP matures, consider performing periodic sustainability studies with a qualified ESOP advisor.

   

Annual Valuation

Every ESOP-owned company must perform an annual valuation that determines the fair market value of the company’s shares. The trustee is responsible for hiring a qualified and independent appraiser to perform the annual valuation. Make sure to:

• • Work with the trustee to engage the valuation professional in a timely manner.
  • Coordinate schedules and timing with the outside auditors.
    • Most outside lenders require audited financial statements within 90-120 days of year end.
    • Timing and coordination are critical:
      • The valuation professional needs assurance from the auditors that the numbers in the draft financial statements (that they are relying on) will not move in order to determine a share value.
      • The auditors need a share value to complete the footnotes and finalize the audit opinion.

It is recommended to schedule a valuation meeting with company management, the trustee and the valuation professional after the books have been closed (perhaps in February). Discuss prior year performance, including successes and challenges, and discuss the future outlook of the company. In my previous role as the CFO of an ESOP company, this was an annual standard practice. I received continual feedback from both the trustee and the valuation professional of how valuable these in-person meetings were to the valuation process.

Once valuation and financial planning are underway, the next annual risk area is compliance and administration.

Compliance and Administration

This is the most common area where things have the potential to be forgotten if there is not an ESOP checklist in place. There are numerous compliance issues, filing requirements and administrative functions that are very important (and can expose the company to undue liability if missed):

Compliance

1. Work with the TPA to perform annual nondiscrimination and coverage testing to make sure the ESOP is compliant.
2. Ensure that the ESOP is in compliance with any new regulations for the upcoming year.
   
   

Filings

1. File IRS Form 5500 (due the last day of the seventh month after the plan year ends).
2. File the IRS Form 1099-R (and send to participants) for any distributions made during the plan year.
   
   

Administration

1. Wire the annual ESOP contribution to the ESOP and ensure the ESOP wires the corresponding funds back to the company prior to year end (and keep records of the wire transfers for the auditors).
2. Work with HR to ensure accurate participant records are up to date for eligibility, vesting and benefit calculations.
3. Provide information when available to the TPA so that they can properly allocate shares to participants and prepare participant statements:
   • Work with HR to provide a full and complete employee year-end census.
   • Work with the trustee to provide the ESOP financial statements (including number of shares to be released).
4. Work with HR, the TPA and/or ESOP attorney (as applicable) to distribute to ESOP participants:
   • The Summary Annual Report
     • Due 9 months after the plan year ends
   • The Summary Plan Description
     • Within 90 days of new participants entering the ESOP
     • Within 210 days after the end of the plan year if updates were made to the Plan Document
   • Annual Benefit Statements that include updated vested account balances
     • As soon as possible after the TPA has completed the statements and prior to the annual ESOP participant meeting
   • Preliminary diversification forms to eligible ESOP participants
     • Within 90 days of the end of the plan year in which they are eligible
5. Process distributions to former employees in accordance with the Plan Document’s distribution policy.
   
   

Plan Document Review

While the goal is not to continuously amend the ESOP Plan Document, as your ESOP matures it is prudent to review and make sure that the ESOP is working in the way it was initially intended. Some considerations to review:

• Are the distribution payout schedules (lump sum, annual installments) working as planned?
• As the ESOP has matured, is the ESOP still providing the intended benefit level to the participants?
• Are retired (or terminated) participants that are still in the ESOP benefiting from share appreciation?
  • Segregation (converting terminated participants out of stock and into cash) is an example of a possible amendment (if not part of the initial Plan Document).
    
    

Employee Education/Engagement

The continuous communication and education of the company’s employees is critical to the success of your ESOP – transform all employees to think like owners. The initial ESOP roll-out meeting is not enough. Consider continuous employee engagement by:

• Scheduling an annual employee meeting as soon as possible after the valuation has been completed and the TPA has completed the annual participant statements (for companies on calendar year end, this will likely be in the May-June timeframe).
  • Reveal the stock price related to the prior year-end valuation
    • Fun idea: Have all non-managerial employees submit a stock price guess prior to the valuation…closest guess wins a prize
  • Review how an ESOP works and reinforce the value of the ESOP benefit
  • Update the participants on any new ESOP related issues
  • Important: Allow participants to ask questions
• If you do not already have one, consider implementing an ESOP Communication Committee (that is comprised of non-executive employees).
• Consider planning a company-wide “play day” where all employees get together for a barbecue or some other fun activity. October is Employee Ownership Month and that can be a good time to get together and celebrate employee ownership.
  
  

PCE POV:
The healthiest ESOP companies treat the annual checklist as a business system—not a compliance chore—because repurchase obligations, valuation timing, and employee ownership culture are all value drivers.

Maintaining a Successful ESOP—In Practice

While there are certainly many year-end ESOP related requirements, there are also things to consider throughout the year in order to maintain a successful ESOP. Creating an Annual ESOP Checklist will help to prevent important tasks or deadlines from being overlooked…whether that be in Q1 or Q4. Revisit these five categories each year and your ESOP stays compliant, sustainable, and meaningful to employees. If you have comments or questions about this article or would like assistance in creating an Annual ESOP Checklist, please contact us.

FAQ: Maintaining a Successful ESOP

1. What are the most important annual requirements for maintaining a successful ESOP?

At minimum, you need accurate and up to date participant records, an annual valuation, required compliance testing and timely Form 5500 and related filings.

2. Who is responsible for the annual ESOP checklist items?

Responsibilities are shared among your internal ESOP administrator/HR, the trustee, valuation professional, TPA, auditors, and ESOP attorney. A checklist clarifies owners and deadlines.

3. How do ESOP repurchase obligations affect planning?

Repurchase obligations can become one of your largest recurring cash demands as the ESOP matures. Periodic repurchase obligation studies help you forecast the timing and size of payouts so you can plan for debt, working capital and growth spending accordingly.

4. When should we review or amend the ESOP plan document?

You don’t want constant amendments, but an annual review is prudent—especially as payout schedules, diversification rules, or terminated participant segregation may need adjustments as your ESOP ages.

5. What’s the role of employee communication in ESOP success?

Ongoing education helps employees think like owners and understand how their actions influence share value. Annual meetings and a communication committee support that ownership mindset.

Ken Sommers

Ken Sommers is a Managing Director at PCE and part of the firm’s ESOP Advisory Group. Based in Denver, he brings 27+ years of financial and operational experience, including first-hand leadership of an ESOP-owned company from installation through sale.

Read Ken's Full Bio