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The ESOP Administrator's Notebook

ESOP Design Strategies, Part 1

Anthony Mathews

December 1997

(Anthony Mathews)In establishing an ESOP, the first step to take is to investigate whether an ESOP is financially and culturally feasible for your company. After all that is done, if the answer is that an ESOP will meet your needs and you want one, your design work isn't over. Once you've decided to adopt an ESOP, and figured out how it fits into your company's structure, planning and culture, the real work of plan design begins. The following are the areas in which plan design decisions are made together with some discussion of alternatives and outcomes.

Eligibility and Participation Criteria

What's Typical

Under current law, eligibility service may be as little as one hour of service or as much as two years. In all cases, service before age 21 can be ignored. If eligibility service is longer than 1 year, vesting must be full and immediate upon entry. 1 year of service for eligibility is fairly typical with entry occurring either retroactively for an entire plan year or prospectively from the date the criteria are met. Once in the plan, it is typical to require minimum annual hours of service (usually 1000) and plan year end employment for continued participation.

Some Thoughts on the Matter

Where the transaction will allow it, ESOP sponsors might well consider longer eligibility periods (up to two years under current law) even with the requirement for full and immediate vesting. If the resulting payroll is sufficient to allow the transaction to occur and the effect on repurchase liability is not prohibitive, the administration will be much simpler.

Also, final regulations governing plan coverage, discrimination, and other benefit related requirements which were released in 1991 have caused some practitioners to rethink conventional wisdom in these areas. Because of the way those requirements interact with the turnover patterns in certain businesses, eligibility and participation criteria that would not have been a problem under law before the regulations may very well result in plan disqualification today. It is very likely, for example, that a plan that requires plan year end employment and 1000 hours of employment to qualify for annual allocations could fail the discrimination tests in the regulations if the company experienced even moderate turnover in a given year.

Also, there is no requirement that the eligibility criteria in you plan be linear. For example, there is nothing to automatically prevent an ESOP from having very liberal eligibility criteria in the first years of the plan (e.g. one hour of service in the year in order to get access to the largest possible payroll) and then to have the plan revert to a more strict eligibility (e.g. one year of service with prospective entry dates) after the early high funding need is over.

The point is there is nothing automatic about what criteria you use within the legal limitations, and you should consider your options fully and test carefully any choices you make. Also, you should always test every decision in the light of the likelihood that the plan will be around into the future where the company may have very different needs.

Contribution Allocation Basis

What's Typical

Allocation of contributions based on relative compensation is almost always treated as a given in ESOP design although what's included as compensation by definition varies widely. There's a very good reason for the use of compensation for this purpose since compensation is the only statutorily approved basis on which qualified plan benefits may discriminate. In fact, the "safe harbors" for discrimination testing are not available to ESOPs that include a factor in allocations for some other criterion (e.g. length of service). Given all of that, though, plan sponsors should be aware that other methods are possible (e.g. points systems, per capita, etc.), and one of them might fit better in your circumstances.

Some Thoughts on the Matter

No matter how you design your ESOP to handle allocations, the most significant allocation issues for ESOPs (and therefore the most important design considerations) will relate somehow to compensation.

The problem here comes from the fact that, for different purposes, the word compensation can have very different meanings. Frequently, for example, ESOP sponsors will limit or exclude extraordinary compensation (like bonuses or commissions) from compensation for allocation purposes. Or, even more frequently, sponsors will include non-W-2 compensation (like 401(k) deferrals) in the allocation base.

There's nothing legally wrong with either of these design features, but in testing for the legal limitations on deductions and individual allocations, you have to be aware that compensation includes the former, and must exclude the latter. If your plan is running near the limitations, this can be a problem.

Author biography and other columns in this series

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