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ESOP Operational Issues

ESOP Diversification (Part Two)

Nancy Dittmer

January 12, 2011

(Nancy Dittmer)As I mentioned in my prior column, a participant in an ESOP sponsored by a privately held company is eligible to diversify a portion of his or her account balance out of company stock when such participant has both attained age 55 and completed 10 years of participation in the ESOP.

So what is a "year of participation" for this purpose?

Let us compare these alternatives by assuming that a participant's date of hire is 7/03/2000. He does complete 1,000 hours of service in 2000, but his date of entry into the plan is 1/1/2002 since the plan requires the completion of one year of service with plan entry on the next January 1 or July 1. He receives allocations of the contributions made for all plan years from 2002 to 2008. He terminates employment on August 1, 2009. He did complete 1,000 hours of service in 2009 but is not eligible for an allocation of the 2009 contribution because he is not employed on 12/31/2009.

Until 2010 there was very little guidance from the IRS to help us define the term "year of participation." During 2010, the determination letter group within the IRS submitted several requests for technical assistance to the national office of the IRS. One of these requests related to the diversification provisions. The guidance provided by the national office of the IRS to its determination letter group provides valuable insight as to how the IRS views the diversification requirements.

With respect to the definition of the term "year of participation," the IRS indicated that any of the three alternatives mentioned above would be permissible if currently used in the operation of the ESOP. (Note: requiring more than 1,000 hours of service in a plan year in any of the above alternatives would not be allowable.) And if an ESOP was currently using a more restrictive definition such as the last alternative above, the plan could be amended to use a more liberal definition such as the first alternative. However, an ESOP cannot be amended to make the definition more restrictive. In other words, an ESOP that is currently using the first option above could not be amended to change to the third method.

Of course it is important that the terms of the plan document are consistent with the actual diversification calculations.

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