ESOP Operational Issues
ESOP Diversification (Part One)
September 20, 2010The diversification rules that apply to closely held companies with ESOPs tend to generate many questions from ESOP sponsors. One reason for the questions is that there is some degree of uncertainty in how the rules are to be applied. The official guidance that we have from the IRS is a notice from 1988 (Notice 88-56), and this guidance does not address many of the uncertain issues. There has been much discussion of the diversification rules in the ESOP community recently, so it seems appropriate to review those rules here.
The theory behind the diversification requirement is simple. An ESOP is a retirement savings vehicle that is designed to be invested in company stock as opposed to a diversified portfolio of investments. As an employee nears retirement, these rules allow him or her to diversify at least a portion of his or her account out of the company stock and into such diversified investments.
In very general terms, the Internal Revenue Code provides that an ESOP participant who has 10 years of participation in the ESOP and who has attained age 55 must be able to elect to diversify 25% of the balance in his or her company stock account. This election must be provided annually for 5 years after the participant meets both the service and age requirements. So if a participant is age 55 but has not completed 10 years of participation until he or she attains age 57, then the 5-year period for this person will be from ages 57-61. Then in the 6th year, the participant can elect to diversify 50% of his or her company stock balance. Then, unless the ESOP document includes more liberal diversification provisions, the diversification election period ends.
The diversification calculations are cumulative, so prior-year elections are factored into the current-year calculation. Again, in very general terms, the cumulative nature of the calculations is illustrated by the following example:
- The first diversification year was 2008.
- The participant's balance eligible for diversification was 200 shares.
- The participant diversified the full 25% for 2008 (200 shares x 25% = 50 shares).
- At the end of 2009 (after the allocations for 2009,) the participant has 170 shares.
- The calculation of the shares eligible for diversification for 2009 would be as follows:
|Shares as of 12/31/2009||170|
|Shares previously diversified||50|
|Less shares previously diversified||(50)|
|Shares eligible to be diversified for 2009||5|
- The ESOP can offer a menu of investment choices within the ESOP. At least three investment alternatives must be available.
- The ESOP could make a distribution to the participant. The participant can then re-invest the distributed amount on his or her own. If the funds are rolled over to an individual retirement account (IRA), the participant would not be subject to income tax on the amount distributed or any early withdrawal penalties.
- The diversified amounts could be transferred to another qualified retirement plan maintained by the employer that offers investment choices (e.g., a 401(k) plan.)
- What is a year of participation?
- What are the notice, election and implementation timing requirements?
- Do former participants have the right to diversify?
- If former participants have the right to diversify, how are the diversification calculations coordinated with other distributions that they may be receiving from the ESOP.