Does your company need a written distribution policy? The purpose of this article is to provide a high level overview of the importance of a written distribution policy and topics to consider.
Your Plan Document will discuss the requirements for paying out distributions to plan participants once a distributable event occurs - death, disability, retirement, termination, QDROs or diversification. Some plans also allow for in-service distributions, dividend pass-through, and hardship withdrawals, which you may want to include in your policy. The provisions listed in the document generally fall along the statutory guidelines, which are the maximum payout terms allowed by the Internal Revenue Code (IRC). Your written distribution policy should address form, method and timing of distributions payouts.
A distribution policy may be part of the plan document, yet most times it is a separate document. A separate document allows for easy modification when the need arises. Qualified plans are subject to IRC Section 411(d)(6) regarding distribution requirement modifications, however ESOPs are an exception to this rule as long as they are updated in a “non-discriminatory” manner. Along with the plan document, the IRS may request to review the policy as part of their determination review process.
The plan document typically will include the form, method and timing options the plan will allow - cash vs. stock, lump sum vs. installments. A distribution policy will specify how distributions will be paid. For example, a distribution policy may read: Upon death, disability, or retirement, distributions will be paid out lump sum in cash and commence no later than one year following the event.
There are many things to consider when drafting a distribution policy - repurchase liability, cash flow projections, future transactions, corporation status, benefit levels and compliance testing issues. All of these will impact how you structure your policy to meet your company’s objectives. Here are some items to include when creating your distribution policy: cash vs. stock, lump sum vs. installments, small amount force-outs, leveraged stock delays, QDROs, and diversification.
Below are some topics to think about and address in a distribution policy:
Cash vs. Stock
Cash distributions are commonly known as recycling in the ESOP industry. Recycling occurs when the company deposits cash into the ESOP Trust and the shares are purchased within the ESOP; i.e. the number of shares in the ESOP remains the same. Stock distributions are commonly known as redemptions. When redeeming stock, the shares will be distributed out of the ESOP and the company will purchase the shares from participants in lieu of cash thus, reducing the number of shares in the ESOP.
Should you pay out distributions in cash versus stock? It is difficult to control the benefit level your participants are receiving each year if you pay out distributions in cash, as the benefit is driven partly based on your repurchase obligation for the year. Paying distribution in stock helps control the benefit level your participants receive. After distributions are processed, you (often the Board) can decide how much stock you would like to contribute back to the ESOP as a benefit to the participants. If this is something you would like to consider, keep in mind that if the shares decrease in the ESOP, this may drive up the stock price and in essence increase participants’ balances. You also want to look at your company’s bylaws and corporation status to determine if the participants are allowed to hold onto their stock.
Lump sum vs. Installments
You can decide to pay out distributions in lump sum or installments. You can also set a certain threshold which determines how you will pay out the distribution. For example: balances under $10,000 will be paid out in lump sum, balances over $10,000 will be paid out over 5 annual installments. You can also apply a minimum installment amount. For example, you will receive 5 annual installments, but the minimum installment you will receive will be $10,000 or the remainder of your balance. Paying out in installments helps to level out the repurchase liability over several years; flatter vs a roller coaster.
IRC Section 409(o)(1)(A) instructs the payout of distributions commence no later than 1 year after the close of the plan year following:
- The end of the Plan year in which a participant terminates due to death, disability or retirement
- The fifth plan year in which a participant terminates employment due to reason other than death, disability or normal retirement.
You may accelerate distributions from these statutory requirements. For example, for vested balances under $10,000, terminated participants will commence distributions no later than 1 year after the close of the plan year following termination. Vested balances over $10,000 will commence no later than 2 years after the close of the plan year following termination.
Small amount force-outs
You may consider having a provision in your distribution policy to force out those participants with small account balances. If the plan document allows, participant balances under $1,000 can be paid directly to the participant as a taxable distribution without their consent. For balances between $1,000 and $5,000, you can process their distribution as a rollover to an IRA set up in the participant’s name. Participants with account balances over $5,000 will require consent to receive a distribution. Forcing out small balances may have an impact when considering audit requirements. If you were previously a large plan filer - subject to audit, and your participant count drops below 80, you are no longer required to have an audit completed. You also may run into issues with missing participants.
Leveraged stock delay
If the plan document allows, another option you can apply is a leveraged stock delay. If your plan has a leveraged transaction, you can delay participants to receive any of the stock tied to the loan until the loan is paid in full. The IRC, as currently written, allows C corporations to apply this delay to distribution payouts. Some believe S corporations can also apply this idea, but this is something you will want to discuss with your ESOP attorney.
Upon receiving a qualified domestic relations order, you can document how to handle the distribution to the alternate payee. Your policy should state whether the alternate payee may receive the distribution as soon as administratively possible, or if there is a delay until the participant is eligible for a distribution.
List the definition of a qualified participant and qualified election period. Will you follow only the statutory requirements (Age 55 and 10 years of service), or provide for non-statutory requirements? For example, you provide an accelerated option for those who are age 60 with 20 years of service. The policy should also discuss how the diversification will be processed. Will the payment be processed as a cash distribution, stock distribution, transferred to another qualified plan maintained by the employer, or will the eligible amount be transferred into investment options within the ESOP?
Over the life of the ESOP, it may be necessary to change the provisions in your distribution policy. For example, you may pay out lump sum distributions at the beginning of your ESOP while participants’ balances are relatively small, but as the ESOP matures, you may move to paying out distributions over installments to help with cash flow.
It is recommended to do a repurchase liability study every 3 years in order to project future cash flow obligations and to determine if there is a need to adjust your distribution policy to meet certain needs. Some valuation companies will request a copy of a distribution policy as part of their valuation process. Along with repurchase studies, you will want to consider cash flow projections, ESOP sustainability studies and compliance testing - 409(p) for S corporations and non discrimination testing, to ensure the changes to your distribution policy are going to accomplish what you intend and follow the necessary regulations.
If you would like assistance in drafting a written distribution policy, please contact your ERISA attorney or your Blue Ridge Plan Administrator.