Blue Ridge ESOP Associates Industry News

What is diversification in an ESOP and what are your responsibilities as a Plan Sponsor?

Posted by Jessica Sinnen

Dec 22, 2021 10:02:13 AM

financial_accountingInternal Revenue Code Section 401(a)(28) allows employees to diversify a portion of their stock once they meet certain eligibility requirements. There are specific age and service requirements outlined by the IRS to determine who is a Qualified Participant, however your plan may allow for rules that are less restrictive.

Statutory Requirements:

    • A Qualified Participant is a participant who is age 55 or older and has participated in the ESOP for 10 years
    • Once you become a Qualified Participant – there is a six-year Qualified Election Period in which you are eligible to diversify a portion of the stock you have acquired. If the ESOP had shares acquired before 1987 and has separately accounted for those shares, the ESOP document may limit the diversification opportunity to shares acquired after 1986.
    • The first five years of your Qualified Election Period, you may diversify 25% of your eligible shares. During the sixth year, you may diversify an additional 25% of your eligible shares.

Diversification Example

To determine the number of shares to diversify is not as simple as taking 25% (or 50% in the sixth year) of the shares in your account. The diversification calculation is cumulative, meaning shares you diversify each year are incorporated in the calculation to determine the number of shares you are eligible to diversify in the future. During the six-year qualified election period the maximum you are eligible to diversify is 50% of the eligible shares ever owned. Here is an example:

1st Year Eligible  
Number of shares owned: 1,000.0000
Shares previously distributed or diversified: 0.0000
Subtotal: 1,000.0000
Since 1st Election period multiply by: 25%
Subtotal: 250.0000
Less shares previously diversified: -0.0000
Total shares eligible to diversify: 250.0000

 

6th Year Eligible  
Number of shares owned: 1,500.0000
Shares previously distributed or diversified: 250.0000
Subtotal: 1,750.0000
Since 6th Election period multiply by: 50%
Subtotal: 875.0000
Less shares previously diversified: -250.0000
Total shares eligible to diversify: 625.0000

Responsibilities as a Plan Sponsor

While drafting your plan document there are two items to discuss that must be defined in your plan document:

    1. What is a Qualified Participant? Will you follow the parameters set by the IRS requiring age 55 and 10 years of participation in the ESOP or will you provide for less restrictive terms such as age 50 and 5 years of participation in the ESOP.

    2. What is a year of participation for diversification purposes? Will a year of participation be defined as years of participation until termination, years of participation with eligibility of a contribution or years of participation until distribution?

Your next step will be to determine how you will offer diversification. The IRS allows a few different methods to satisfy diversification:

    1. Cash or Stock distribution to Participant. Keep in mind the distribution is a taxable event unless participant elects a direct rollover the distribution to an IRA or other plan. If the participant elects to  have the distribution paid to them but have not attained age 59 ½, the distribution is subject to an early withdrawal penalty.

    2. Diversify funds to another qualified plan with three investment options. A company 401(k) plan is often used as a participant may already have investments set up that will satisfy the investment option requirement.

    3. Your ESOP may offer at least three investment funds in which the participant may choose to invest in. Very few plans use this option as it is more difficult administratively with additional costs and disclosures associated with this process.

Finally, there is the responsibility of notifying your participants of their eligibility to diversify. The IRS requires qualified participants to make a diversification election within 90 days after the close of the plan year and distribute those funds within the following 90 days. For many ESOPs the number of shares and value of those shares are not known within 90 days of the plan year end. In the past, plan sponsors have satisfied the deadline outlined by the IRS by providing a preliminary notice within 90 days of the plan year end and then processing the diversification election within 90 days of the initial notice. In 2015, the IRS issued new guidance which allows plan sponsors to provide notice to diversify within 90 days of receiving the valuation. This new guidance eliminates the need for preliminary notices and provides relief for those plan sponsors who do not receive their valuation in time to process diversifications within 180 days of the plan year end. This language must be included in your plan document.

Exception to the Rule

There is a de minimus rule for diversification where an ESOP is not required to offer diversification if the value of stock in the participant’s account is $500 or less. This exception can be followed but must be written in your plan document.

Considerations

Other items to consider including in your plan document or distribution policy:

1.  How will you handle employees who are eligible for both diversification and distribution?

          1. Allow eligible participants to take both a diversification and distribution keeping in mind they will only receive payment up to the vested balance in the participant’s account.

          2. Calculate the amounts would be eligible for a distribution and a diversification in a given plan year and offer the larger of the two.

          3. Process the participant’s diversification election. After processing, calculate the amount the participant’s eligible distribution amount.

      1. 2. Will you allow terminated employees to diversify or is diversification only available to active participants?

          1. Some plans only allow active participants to diversify

          2. If terminated employees can diversify, do you offer different options for active versus terminated participants? For example:

            1. Transfer to your company’s 401(k) for active participants

            2. Distribution of stock or cash to terminated participants

Conclusion

Whether you are in the process of drafting your plan document, your ESOP is reaching the ten-year mark or the age of your workforce is increasing; it is important to understand your plan requirements and your role as a plan sponsor regarding diversification. It may be a good idea to have a Repurchase Study done to see how diversification will affect your future cash flow. If you have any questions regarding diversification don’t hesitate to reach out to your Blue Ridge ESOP Associates Administrator.

Topics: Diversification, Plan Document