Coronavirus concerns for ESOPs and ESOP auditors

By Scott Miller, CPA/ABV

The coronavirus pandemic has presented new challenges to virtually every company and individual in every discipline in the current economy.

Employee stock ownership plans (ESOPs) and their plan sponsors — as well as auditors of the plans — certainly will have new issues to consider as a result of the pandemic.

Today most ESOP companies are S corporations largely driven by unique tax attributes in high-percentage stock ownership applications. Most of those firms have a calendar year end for financial and tax reporting.

From a GAAP reporting standpoint, the COVID-19 pandemic represents a “non-recognized subsequent event” for entities with Dec. 31, 2019, calendar year ends as the pandemic is widely viewed as occurring after the date of the financial statements. Although recognition in the financial statements is not required, subsequent event disclosures may be required.

Entities with year ends after December 2019 will have pandemic-related events that may require an adjustment to the financial statement or additional disclosures. Due to subsequent reactions by many states with stay-at-home orders among several other restrictions, the economic impact on many industries and companies is substantial and often negative.

Craig Olinger, managing partner in the valuation firm ESI Equity, observes that in the early months of 2020, COVID-19 issues in ESOPs have ranged from minor material effects in many circumstances to less onerous challenges. He noted the reason for this is that many ESOP companies are business-to-business entities and have been open during COVID-19. Unfortunately, as the year progresses, there will be additional ESOP companies in more stressed circumstances such as those in the hospitality industry or narrowly focused nondiversified contractors with suspended projects.

ESOP companies are required by regulation to value their stock at least once a year. Some plan documents permit interim valuations if circumstances warrant. Since COVID-19 was largely unforeseen for calendar-year-end companies, the audited financial statements, including a consideration of the value of the company stock, should not consider the effect of the pandemic.

The entity may disclose the subsequent event in the footnotes, and in more severe circumstances the auditor may include an “emphasis of matter” paragraph in the audit opinion report. An emphasis-of-matter disclosure does not change the financial statements, but it will highlight to the user that the subsequent event should be taken into account.

Brian Ippensen, CPA, president of TI-Trust, which serves as a trustee for many ESOPs, notes that as a user he wants to see an indication that the entity and auditor are aware of the subsequent event. If the COVID-19 impact is material to the financial statements, he expects the disclosure to be emphasized. He also understands that at the audit date the impact of COVID-19 may not be known but disclosed.

Compliance risks

The significance of COVID-19 is illustrated in compliance with federal regulations. One marquee example is the test in Internal Revenue Code Sec. 409(p). The intent of this Code section is to ensure that the benefits of stock ownership in S corporation ESOPs remain broad-based and not concentrated in the accounts of only a few participants.

Most ESOP compliance testing is done annually. The Sec. 409(p) analysis must be made throughout the year. There are complex requirements to identify “disqualified persons,” who are individuals with deemed ownership including synthetic equity in excess of 10% of the total.

If the total percentage equity in the accounts of the disqualified persons exceeds 50%, there will be a “nonallocation year.” If such an event occurs, the company will be exposed to substantial excise taxes on the prohibited allocations (Sec. 4979A).

Aaron Juckett, CPA, president of ESOP Partners, a benefits administration firm, notes that the potential Sec. 409(p) penalties are so severe that it is likely a company will not survive if exposed to them. Even if the errors are inadvertent, the penalties could apply with damaging results. An auditor needs to be aware of this testing because of the risk to the company, as discussed below.

Negative cascade effects

Juckett notes that there may be a negative cascade effect in benefit plan administration if the COVID-19 effect is materially severe following the release of the initial calendar-year-end financial statements. The greatest area of concern is the company stock’s value following a consideration of the effect of COVID-19.

The stock’s value is typically linked to matters such as required cash distributions and plan diversification requirements. If the financial consequences are dire, the company may not have the liquidity to meet its distribution requirements later in the year. If the company is subsequently forced to have substantial layoffs, it may be confronted with a partial plan termination if more than 20% of the employees are laid off (Rev. Rul. 2007-43).

If a partial plan termination occurs, the affected participants will automatically become 100% vested, which could result in an even larger repurchase obligation.

The cascade effect may lead to other areas of concern such as the violation of loan covenants. This is a significant risk in newly established ESOP companies that are heavily leveraged. There may even be a going concern issue if, in management’s opinion, there is substantial doubt about the company’s ability to remain viable in the upcoming year.

Due to these connected issues with GAAP reporting and regulatory compliance, ESOP companies may consider performing an interim valuation and possibly preparing interim financial statements. This likely would require performing a new valuation, redoing ESOP plan administration, and updating financial statements. In addition, the decision to use an interim date must be communicated with the plan participants, and it must be applied fairly to all plan participants. For instance, small balances cannot be paid out as of Dec. 31, 2019, while making participants with larger balances wait until the interim valuation date.

The cost/benefit analysis will be undertaken to determine if interim results need to be considered as opposed to just staying with calendar-year-end results. Users of financial statements have expressed concern about doing interim work when the financial news is material and negative and then not doing similar work if the financial news is disproportionately positive.

A one-way bias toward negative news is concerning to trustees, as noted by Kyle Spader, CPA, independent trustee and president of Acumen Advisory Services LLC. It is appropriate to have a balanced approach to both material negative and positive developments, according to Spader.

Employee benefit plan audits

In ESOP companies, as with other ERISA-qualified plans, the actual benefit plan may require an audit if there are more than 100 participants.

Many of the issues related to the nonrecognized subsequent event for GAAP purposes will also apply to the ESOP. Such items include analysis of required distributions, the value of the stock, Sec. 409(p) testing, diversification issues, partial plan termination, the filing of IRS Form 5500, Annual Return/Report of Employee Benefit Plan, and account rebalancing, among others.

If there are errors in any of these requirements, the cost of restated reports is substantial and time-consuming. The calendar-year-end balances may be so materially misleading that companies may decide that fairness and prudence demand an interim assessment.

Assuming that an interim analysis is justified, the auditor will still have to determine an effective date for the analysis. In the unanticipated world of COVID-19, the uncertainties are unknown. It may be prudent to delay the work as long as practicable to attempt to obtain the most representative numbers.

Juckett noted that if the calendar-year-end numbers are not indicative of ongoing results, waiting as long as practicable within the regulations and using a single set of results for all reporting are essential to avoid confusion.

Going concern issues

As a result of the COVID-19 pandemic, there will be a number of ESOP companies severely impacted to the point there may be a going concern issue. The going concern opinion applies when substantial doubt in aggregate exists regarding the company’s ability to meet its obligations within one year of the date of the financial statements or within one year after the date the financial statements are available to be issued when applicable.

The company and its management are responsible for the determination of a going concern, according to FASB ASC Subtopic 205-40. Brian Sweeney, CPA, audit partner and ESOP Practice Leader at Redpath & Company in St. Paul, Minn., notes that management understands its responsibilities but will often seek assistance in how to disclose the information in the footnotes. The CPA may include the going concern opinion after consulting with management. Great care is taken before a going concern opinion is issued in an ESOP company.

One unique aspect of the ESOP company in such trying circumstances is its capital structure with the trust as a shareholder. In the most extreme cases, there are instances when an ESOP company may experience a “run on the bank.” Once the financial difficulty of the company is known, ESOP participants may immediately resign or retire, demanding ESOP payouts from the company before the stock is worthless. This magnifies the cascade effect and only worsens the financial matters, perhaps to the point of insolvency.

If management thinks the company is a candidate for a going concern opinion, Sweeney will work with them to determine if the opinion and disclosure needs to be modified. Currently, the COVID-19 pandemic has created substantial short-term uncertainty for some companies. Management may not be sure what the future holds or how quickly the company will rebound once the crisis has subsided. With the current COVID-19 environment, circumstances may materially change from day to day, and more time may help resolve troubling issues. Management may elect to delay issuing the financial statements as long as practicable while trying to resolve difficult uncertainties such as injecting more capital, working with suppliers and customers, or liquidating nonoperating assets.

In addition to the company, there may also be concern with the solvency of the employee benefit plan, the ESOP. The ESOP is intended to be primarily invested in the securities of the company, generally understood to have more than 50% of its assets in company stock. In many instances of recently installed ESOPs that are leveraged, the plan has little cash liquidity, but there is a substantial percentage of illiquid company stock. If the financial viability of the company is in doubt, it is also likely that the plan will not be able to honor the repurchase obligation.          

Eventually the financial statements for the company and the ESOP will likely be issued. The complexity of the reporting issues indicates that footnote disclosure may be substantial depending on the circumstances. Even if the auditor decides upon an analysis of the total circumstance that a going concern opinion does not have to be issued, there may still be significant disclosure in the footnotes. During this trying process, the auditor will work closely with management to resolve any reporting issues.

Specialized expertise is essential

ESOP auditing is a specialty discipline with a discrete set of report users and complex interconnected issues involving GAAP compliance and federal regulations. The COVID-19 pandemic highlights the need for specialized expertise in this area. Because of the interconnected regulations and GAAP requirements, ESOP reporting contains a number of areas of potential auditor risk if there is a failure to understand these relationships.

When there is a financial unraveling of the ESOP company, there is often a cascade effect of bad outcomes. Those considerations range from disclosure requirements, possible going concern issues, Sec. 409(p) defaults with material and devastating penalties, misstatement of distributions and diversifications, and loan covenant defaults, among others.

Auditors will likely be even more dependent on the reports of specialists. Auditors are encouraged to consider gaining technical ESOP reporting insights by accessing the relevant resources of the National Center for Employee Ownership and The ESOP Association in addition to the AICPA. The penalties for getting ESOP reporting incorrect are substantial in this highly visible arena.

Resources related to COVID-19 for CPAs are available at

For more news and reporting on the coronavirus and how CPAs can handle challenges related to the pandemic, visit the JofA’s coronavirus resources page.

Scott Miller, CPA/ABV, is the retired founder of ESI Equity, a consulting firm that specializes in employee and management equity participation, and president of the consulting firm Enterprise Opportunities LLC. To comment on this article or to suggest an idea for another article, contact Ken Tysiac (, the JofA’s editorial director.

Additional resources

  • AICPA: Accredited in Business Valuation credential.
  • National Center for Employee Ownership (NCEO): Not-for-profit organization offers free and fee-only information regarding ESOPs, employee ownership community, and COVID-19 at Information includes COVID-19 resources for businesses, a coronavirus Q&A blog, and COVID-19 webinars.
  • The ESOP Association (TEA): Not-for-profit organization’s site at offers limited free resources (such as a blog) and also lists helpful resources oriented to the pandemic. These services and resources are focused on members and fee-based.

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