ESOP Vesting, Distribution, and Diversification Rules
This article was written to answer common questions from managers, rank-and-file ESOP participants in ESOP companies, and others about when and how ESOP participants are paid out. (The discussion assumes that the reader knows what an ESOP is, etc.; for basic background information, read our overview of employee ownership). Note that the rules below are the legal minimums required by law; your company's ESOP plan may be written to be more generous than the minimum required.
This discussion refers to "vested benefits," a concept that is unfamiliar to some ESOP participants. Vesting refers to the amount of time an employee must work before acquiring a nonforfeitable entitlement to his or her benefit. Employees who leave the company before being fully vested will forfeit their benefits to the extent they are not vested in them. An ESOP must comply with one of the following two minimum schedules for vesting (plans may provide different standards if they are more generous to participants):
- No vesting at all in the first years, followed by a sudden 100% vesting after not more than three years of service ("cliff" vesting); or
- Twenty percent vesting after the second year of service, with 20% more each year until 100% vesting occurs after the sixth year of service ("graded" vesting).
A "year of service" generally refers to a plan year in which a participant has 1,000 hours of service; it may include past service.
When departing employees leave before they are fully vested in their accounts, the amount that is not vested is forfeited; it is usually reallocated to remaining participants and may limit the amount of other contributions that can be allocated to such participants. Forfeitures may be used for administrative costs in rare situations.
Distributions from the ESOP After Employment Terminates
ESOP benefits are mainly paid to participants after their employment with the company terminates, whether because of retirement or other reasons. As far as how soon the ESOP benefits are paid, there is a crucial distinction between retiring (or death or disability) and simply leaving the company due to other reasons:
- When an ESOP participant retires, becomes disabled, or dies, the ESOP must begin to distribute vested benefits during the plan year following the event--unless one of the exceptions below applies.
- When an ESOP participant's employment terminates for reasons other than retirement, disability, or death, the distribution of his or her ESOP benefits can wait for awhile. The participant must be given the right to start distributions no later than the sixth plan year after the plan year in which termination occurred (unless the participant is reemployed by the same company before then). Where the balance exceeds the plan's cash-out provisions ($1,000 or $5,000), the participant may choose to defer distribution until normal retirement age or such other date provided in the plan.
- Here's another reason why ESOP distributions may be delayed: If the ESOP is leveraged (i.e., money was borrowed for the ESOP to buy company shares), distributions of ESOP-held shares acquired through the loan generally may be delayed until the plan year after the plan year in which the ESOP loan is fully repaid. This does not apply, however, to certain ESOP distributions following the retirement or death of the participant.
- Also see the remarks two paragraphs below about rules governing company stock the ESOP acquired before 1987; for example, such stock might not be distributed until the participant reaches retirement age.
ESOP distributions may be made in a lump sum or in substantially equal payments (not less frequently than annually) over a period no longer than five years (i.e., six payments over five years). However, this five-year period may be extended an additional year (up to a maximum of five additional years) for each $210,000 or fraction thereof by which a participant's benefit exceeds $1,050,000. Distributions are made in the form of cash or stock. These are the 2014 limits; they are adjusted annually.
The statements above summarize the special rules enacted for ESOPs in the Tax Reform Act of 1986. Employer stock the ESOP acquired before 1987 may be distributed according to the rules governing qualified benefit plans in general. Depending on circumstances, these rules often allow distributions to occur later than under the special ESOP rules; for example, a participant may leave now but wait many years until he or she reaches retirement age to receive the pre-1987 stock.
Distributions While ESOP Participants Are Still Employed
In certain circumstances, participants may receive benefits from the ESOP while they are still employed:
- As explained below, ESOP participants may "diversify" their accounts after a certain period and receive cash or stock directly.
- The employer may choose to pay dividends directly to ESOP participants on company stock allocated to their accounts.
- The plan must generally begin distributing benefits to an ESOP participant who is a 5%-or-more owner after the participant reaches age 70 1/2, even if the participant is still employed. (Before 1997, this rule applied to all participants who had attained age 70 1/2.)
- There are certain other circumstances in which the ESOP plan may provide for in-service distributions, such as after a fixed number of years, upon attainment of a specified age, or upon "hardship."
The "Put Option": How ESOP Participants Sell Their Stock If the Company Is Not Publicly Traded
Closely held companies that sponsor an ESOP must provide a "put option" on company stock distributed to participants by allowing them to sell the stock back to the company at its current fair market value. At a minimum, the put option must be available during two periods, one for at least 60 days immediately following distribution and one for at least 60 days during the following plan year.
Can a Company Prevent Employees from Selling Stock to Outsiders?
ESOP participants can generally sell company stock they receive from the ESOP to anyone, except that the plan may provide that the employer and the ESOP have rights of first refusal to match any offer received from a third party for such stock.
However, if the employer sponsoring the ESOP is a closely held company whose charter or bylaws restrict the ownership of substantially all (approximately 85%) of its stock to employees or a tax-qualified plan, the ESOP is not required to distribute stock; instead, it can distribute cash, or the employer can require the employee to sell distributed stock back to the employer.
Taxation of ESOP Distributions
Employees pay no tax on stock allocated to their ESOP accounts until they receive distributions, at which time they are taxed on the distributions. If they are younger than age 59½ (or age 55 if they have terminated employment), they, like employees in qualified plans generally, are subject not only to applicable taxes but also to an additional 10% excise tax unless they roll the money over (i.e., transfer it) into an IRA (Individual Retirement Arrangement) or a successor plan in another company (or unless the participant terminated employment due to death or disability).
If the money is rolled over into an IRA or successor plan, the employee pays no tax until the money is withdrawn, at which point it is taxed as ordinary income. Rollovers from ESOP distributions to IRAs are available for distributions of stock or cash over periods of less than 10 years.
As with other tax-qualified retirement plans, an ESOP distribution can be rolled over into a "traditional" (regular) IRA or a Roth IRA.
When dividends are directly paid to participants on the stock allocated to their ESOP accounts, such dividends are fully taxable, although they are exempt from income tax withholding and are not subject to the excise tax that applies to early distributions.
After ESOP participants reach age 55 and have participated in the plan for ten years, they have the right during the following five years to diversify up to a total of 25% of company stock that was acquired by the ESOP after December 31, 1986, and has been allocated to their accounts; during the sixth year, they may diversify up to a total of 50%, minus any previously diversified shares. To satisfy the diversification requirement, the ESOP must (1) offer at least three alternative investments under either the ESOP or another plan such as a 401(k) plan or (2) distribute cash or company stock to the participants.