An ESOP is invested primarily in the stock of the sponsoring company. It can also hold cash (including the current year contribution and dividends) and other investments which can be used to fund distributions when someone triggers a benefit event. By paying with cash instead of stock, the recycled shares remain in the ESOP and are then allocated to the remaining participants. 

Recycling can be particularly beneficial to a mature ESOP because shares are available for future allocations. The ownership percentage of the ESOP is not diluted when recycling is used. 

If the company pays a cash contribution to the ESOP to recycle shares, the contribution is generally tax deductible. This deductibility reduces the net cost to the company. 

Redemption

When share redemption is used, the company buys back the shares from the ESOP (or the participant) and then retires them or places them in treasury stock. These shares are no longer currently available for allocation and the percentage of ownership by the ESOP will decrease over time unless the company contributes additional shares to the plan. Redemption may be part of a longer-term strategy to minimize or eliminate the ESOP. 

The cash used to redeem the shares is not a tax deductible expense to the company.

The decision to recycle or redeem (or a combination of both) involves many factors. Since the decision is discretionary, it can change from year to year. The choice impacts the ownership percentage of the employee stock ownership plan and the tax consequences to the company. Companies evaluating their choices should consult with a qualified ESOP consultant to understand the benefits and costs of each approach. 

Recycling and redemption can bring rewards

Regardless of whether a company recycles or redeems, it creates opportunities for financial advisors. The ESOP participant typically receives a lump sum that can be rolled over into another qualified retirement plan, including an Individual Retirement Account (IRA). The amounts can be significant and often represent a sizable portion of the individual's retirement savings. 

However, just under a third of employees use a financial professional who provides them with financial advice, guidance, or products, according to a Principal Financial Well Being Index taken Q1 2013. If you are advising the employer, it is a good opportunity to prospect those participants receiving a distribution.

Recycling and redeeming are not just about litter control, they can also be about growing your business.

See also:

• Beginning at the end: Designing benefits that work
• The three Rs of ESOPs
• Creating some certainty in an uncertain world

No investment strategy, such as asset allocation or diversification, can guarantee a profit or protect against loss in periods of declining values. Company stock is not a pooled investment. Stock may experience greater volatility and should not be directly compared to investment options that have a more diversified investment mix. It is not intended to serve as a complete investment program by itself.

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company a member of the Principal Financial Group (The Principal), Des Moines, IA 50392.