ESOP Operational Issues
ESOP Diversification (Part Three)
December 9, 2011As a new calendar year approaches, it seems fitting to review the rules governing the timing of notifying the employees of their right to diversify and implementing any such diversification elections made by participants. (See parts one and two in this series.) This is yet another subject where there exist some uncertainties in the practical application of the rules. Please consult with your ESOP advisor on these issues.
Notice and Election TimingThe applicable provision in the Internal Revenue Code indicates that the participant should make his or her diversification election within 90 days after the close of the plan year in which he or she satisfies both the age and service requirements. So if your ESOP has a calendar plan year, then your participants eligible to diversify should make their elections by each March 31.
There is no specific guidance indicating that a formal diversification notice or election form should be provided to the eligible participants. Still, most practitioners would advise that each eligible participant receive a notice/election form as a best practice. The information typically included on such notice would be the number of shares that the participant is eligible to diversify, the value of the shares and how the diversification will be implemented (e.g., cash distribution, transfer to the 401(k) plan, etc.).
What if you do not receive your stock valuation until after March 31? Do you wait and provide the notice when the updated information on share balances and stock value is available? Or do you give the employees notice by March 31 based on data from the prior year?
The conservative approach would be to give the employees some type of notice and election form before March 31 using the best information available so that employees can indeed make their elections within the 90-day period. Then a second notice/election form can be sent when the new share balances and stock value are known. Reasonable operating procedures to guide the use of the two notices/elections can be implemented. For example, you could provide that the first election will be revoked by the receipt of the second election but will remain in effect if the participant does not submit a second election.
Implementation TimingOnce the participants have made their elections, when must their elections be satisfied? I.e., when must the cash distribution, transfer, or investment election be made? The requirement here is that the ESOP trustee has 90 days from the end of the 90-day election period to satisfy the participant's election. So for a calendar year plan, the distribution, transfer or investment must be made by June 30.
Again, there are situations where the updated share balances and stock values are not known within that 180-day time period. So should the diversification elections be implemented using prior year data? What if that would result in an overpayment to such participant? Or should the implementation of the election be delayed until the updated shares balances and stock value are known?
From my experience, very few companies would make a partial implementation of a diversification election based on prior year data. As noted above, this option would either result in an overpayment or the need for a second true-up payment.
It is more typical to for a company to make arrangements with the valuation firm and the third-party administrator to ensure that the new share balances can be determined and diversification elections can be implemented within 180 days. If that is simply not possible, then the satisfaction of the elections is delayed but completed as soon as administratively feasible after the new share balances are known. To deal with diversification elections that are satisfied after the 180-day period has expired, some ESOPs are drafted to provide the affected participants with an earnings adjustment.