Terminating an employee stock ownership plan takes most companies 12 to 24 months from the board’s vote to the final distribution check, and every step is governed by IRS and Department of Labor rules that, if missed, can disqualify the plan and create tax bills for everyone involved. An ESOP termination has three moving parts that have to line up: the corporate and plan paperwork, the valuation and distribution of participant accounts, and the company’s cash obligation to repurchase private stock. Get the sequence right and the plan closes cleanly. Get it wrong and the IRS can strip the plan’s qualified status retroactively, which pulls participants and the sponsor into the fallout.
Board Resolution and Plan Amendment
The termination starts with a formal board vote. The resolution has to state two things: the intent to end the plan and the specific effective date. That date locks participant account balances and starts the clock on distribution deadlines, so it isn’t a placeholder.
The plan document then has to be amended to reflect the termination, stop future employer contributions, and freeze benefit accruals as of the termination date. Legal counsel should read the existing plan document before drafting the amendment, because every operational step during the wind-down must match the plan’s own terms. A mismatch between what the document says and what the company actually does is one of the fastest ways to create a qualification problem.
Once the amendment is executed, the plan administrator notifies participants that the plan is ending and no further contributions will be made.
One distinction catches employers off guard. The decision to terminate is a business decision (what ERISA calls a “settlor” function), but every step taken to carry it out is subject to full fiduciary standards.1U.S. Department of Labor. Field Assistance Bulletin No. 2014-01 Valuing stock, selecting distribution methods, locating missing participants, and choosing service providers all have to be done prudently and solely in the interest of participants, and every decision should be documented.
Full Vesting and the Final Stock Valuation
The moment the plan terminates, every affected participant becomes 100% vested in their accrued benefits, regardless of the plan’s normal vesting schedule.2Office of the Law Revision Counsel. 26 USC 411 – Minimum Vesting Standards A participant who was 40% vested under a six-year graded schedule is suddenly fully vested on the termination date.3Internal Revenue Service. Retirement Plans FAQs Regarding Plan Terminations There is no exception.
Next comes a final independent appraisal of the employer stock. A qualified, independent appraiser determines fair market value as of the termination date or most recent valuation date. For privately held companies, this number drives every dollar amount that follows.
Unallocated Shares and the ESOP Loan
Many ESOPs still carry a loan used to acquire employer stock. Shares purchased with that loan sit in a suspense account and release to participant accounts as the loan is repaid. On termination, any shares still in the suspense account must be allocated to participant accounts under the plan’s allocation formula, and those newly allocated shares become fully vested along with everything else.
The loan itself has to be dealt with. If the stock is being converted to cash for distribution, the loan payoff often comes from those proceeds, and the company and lender need to coordinate the payoff alongside the distributions. The company needs enough liquidity to retire the loan, fund distributions, and cover the repurchase obligation described below.
Filing Form 5310 for IRS Approval
Filing Form 5310 to request a favorable determination letter is technically optional. Skipping it is risky. The form asks the IRS to confirm that the plan’s termination procedures comply with the Code and that the plan remains qualified.4Internal Revenue Service. About Form 5310, Application for Determination for Terminating Plan Without the letter, the company distributes assets with no assurance that the IRS won’t later decide the plan lost its qualified status, which would create tax problems for the company and every participant who received a distribution.
The IRS user fee for Form 5310 is $4,500 as of 2026. The submission includes the complete plan document, all amendments, and detailed participant data, and IRS review typically takes several months.
Filing also buys time. Under Revenue Ruling 89-87, distributions are presumed late if not completed within one year of the termination date. Filing Form 5310 extends that one-year period while the IRS reviews the application.5Internal Revenue Service. Plan Termination – Failure to Timely Distribute Assets Most plan administrators wait for the favorable letter before distributing anything. Filing Form 5310 also requires giving a Notice to Interested Parties to affected employees so they can submit comments to the IRS or DOL.6Internal Revenue Service. Instructions for Form 5310
Distributing Benefits to Participants
Once the determination letter arrives (or the administrator decides to proceed without one), distributions have to happen promptly. The IRS standard is “as soon as administratively feasible,” and distributions not completed within one year of the termination date are presumed late unless Form 5310 has extended the window.5Internal Revenue Service. Plan Termination – Failure to Timely Distribute Assets
Participants must be offered a choice of how to receive their benefits:
- A direct rollover to an IRA or another qualified employer plan, which avoids immediate taxation and the 20% withholding described below.
- A lump-sum cash payment, in which private company shares are converted to cash at the final appraised value.
- In some plans, an in-kind distribution of actual employer stock, which opens the door to net unrealized appreciation treatment.
The plan administrator provides each participant with rollover election forms and a 402(f) tax notice explaining the consequences of each option. After distributions are complete, each one is reported to the IRS and the participant on Form 1099-R.7Internal Revenue Service. About Form 1099-R
Tax Consequences for Participants
What a participant owes depends on what they do with the money.
Mandatory 20% Withholding
Any eligible rollover distribution paid directly to a participant, rather than rolled over, is subject to mandatory 20% federal income tax withholding.8Internal Revenue Service. Topic No. 413, Rollovers From Retirement Plans The plan administrator withholds the money and sends it to the IRS. Overwithholding can be recovered on the annual return, but in the meantime the participant sees only 80% of the check. A direct rollover avoids the withholding entirely.
10% Early Withdrawal Penalty
Participants under 59½ who take cash and don’t roll it over owe an additional 10% tax on the taxable portion.9Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions Several exceptions apply, including separation from service at age 55 or older, death, and total and permanent disability.10Internal Revenue Service. Topic No. 558 – Additional Tax on Early Distributions From Retirement Plans Other Than IRAs The plan administrator documents the reason for each distribution so the correct code appears on Form 1099-R.
Net Unrealized Appreciation on Employer Stock
A participant who receives employer stock in kind as part of a lump-sum distribution may qualify for net unrealized appreciation treatment under IRC Section 402(e)(4). Only the original cost basis of the stock is taxed as ordinary income at distribution. The appreciation that built up inside the plan isn’t taxed until the shares are sold, and at that point it’s taxed at long-term capital gains rates.
To qualify, the distribution has to be a lump-sum distribution (the entire account balance in a single tax year) triggered by separation from service, reaching 59½, or death, and the stock has to leave the plan as shares, not cash. For a private company ESOP, NUA only works if the plan permits in-kind stock distributions. The ordinary income tax on the cost basis is due immediately even if the shares aren’t liquid, so anyone weighing this route should talk to a tax advisor first.
The Repurchase Obligation and Put Option
For ESOPs holding stock that isn’t publicly traded, the company must give participants who receive stock distributions the right to sell the shares back to the company at fair market value. This put option is the single largest financial exposure in most ESOP terminations.11Office of the Law Revision Counsel. 26 USC 409 – Qualifications for Tax Credit Employee Stock Ownership Plans
The put option must stay available for at least 60 days after distribution. If the participant doesn’t exercise it during that first window, a second 60-day period opens during the following plan year.12Internal Revenue Service. ESOP Legal Reference Manual Terminating the plan does not eliminate this obligation for shares distributed in kind.
When a participant exercises the put on a total stock distribution, the company can pay the full repurchase price in a single sum or in substantially equal annual installments over up to five years, with installments beginning no later than 30 days after the option is exercised.11Office of the Law Revision Counsel. 26 USC 409 – Qualifications for Tax Credit Employee Stock Ownership Plans Installment payments require adequate security and reasonable interest on the unpaid balance.
Because a termination concentrates distributions into a short window, the repurchase demand can hit the company all at once rather than trickling out over years of normal retirements. Companies need to plan for that liquidity well in advance, through cash reserves, a line of credit, or a sinking fund set up before the termination date. Failing to honor a put option is a fiduciary breach with real consequences.
Locating Missing Participants
The plan cannot fully close while participant accounts still hold assets, and some participants will always be unreachable. The DOL requires fiduciaries to make reasonable efforts to find them, and ignoring low-cost search methods violates the duty of prudence regardless of the account size.1U.S. Department of Labor. Field Assistance Bulletin No. 2014-01
At a minimum, the administrator should send certified mail to the last known address and use free electronic tools (search engines, social media) to look for updated contact information. The old IRS and Social Security Administration letter-forwarding services are no longer supported.1U.S. Department of Labor. Field Assistance Bulletin No. 2014-01 Reasonable search costs can be charged to the missing participant’s account.
When a participant truly can’t be found, the PBGC’s Missing Participants Program accepts transfers from terminating defined contribution plans and holds the funds (earning interest at the federal mid-term rate) until the person surfaces. PBGC charges a one-time fee of $35 for transferred accounts over $250, with no ongoing fees.13Pension Benefit Guaranty Corporation. Missing Participants Program for Defined Contribution Plans The plan requests a PBGC case number by email before submitting Form MP-200.
Final Form 5500 and Record Retention
The plan administrator files a final Form 5500 for the plan year in which all assets are distributed, marked as the “Final Return/Report.”14U.S. Department of Labor. Form 5500 Series That filing tells the DOL and IRS the plan is closed. Without it, the agencies treat the plan as still active, and the DOL can assess penalties of up to $2,739 per day for a late or missing Form 5500, with no cap.
After the final Form 5500 is filed, ERISA Section 107 requires the plan sponsor to keep all plan records for at least six years from the filing date.15Department of Labor. Recordkeeping in the Electronic Age That should include the plan document and all amendments, participant election forms, the final stock valuation, distribution records, missing participant correspondence, the IRS determination letter, and every Form 5500. These are the evidence that the termination was handled properly if a claim or audit surfaces years later.
ESOPs are defined contribution plans and are generally exempt from PBGC insurance coverage, so in the typical case no PBGC premium payments or termination notices are required beyond the Missing Participants Program filing described above.