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ESOP Operational Issues

ESOP Diversification (Part Four)

Nancy Dittmer

April 2, 2012

(Nancy Dittmer)One of the questions that I indicated I would address in my first column on the ESOP diversification rules is whether former ESOP participants are eligible to diversify their ESOP balances. For example, if you have a former ESOP participant who still has a balance in shares in the ESOP and satisfies the age 55 and 10-years-of-participation requirements, should that person be eligible to diversify?

This question stems from the use of the word "employee" in the Internal Revenue Code's definition of a qualified participant for purposes of these diversification rules. Does the use of the term "employee" as opposed to "participant" imply that only active employees are eligible to diversify?

As I mentioned in a prior column, the determination letter group within the IRS submitted several requests for technical assistance to the national office of the IRS during 2010. On this issue, the guidance issued by the national office to the determination letter group indicated that a plan document may use the terms "participant" and "former participant" rather than "employee" in its diversification provisions. If those terms are used, then former participants who meet the requirements would be eligible to diversify. So the answer to whether former participants are eligible to diversify depends upon the terms of your plan document.

If your plan document does provide that former participants are eligible to make a diversification election, then there are a couple of issues relating to the coordination of diversification payments with distributions that need to be considered.

First, what if a former participant is both eligible to diversify and is receiving installment distributions? Assume the former participant is to receive an installment distribution of the value of 50 shares of stock. He or she is also eligible to diversify 25 shares of stock. So does this person get paid the value of 50 shares or 75 shares?

Next, the computations for years 2 to 6 can get even more complicated. It would appear that you add back the shares previously distributed via the installment distribution as you do shares previously diversified (see the example in ESOP Diversification (Part One).) The rationale for this is that according to the IRS guidance issued back in 1988, the starting point in the calculation is the number of shares that have ever been allocated to the participant's account. But it is not clear that you can subtract the shares previously distributed via the installment distributions. The language of the relevant IRS notice provides only that shares distributed pursuant to a prior diversification election should be subtracted.

As an aside, the "ever allocated" language can also be problematic if your plan allows for extra diversification or if the plan is rebalanced.

So if the "ever allocated language" is to strictly interpreted, the calculations would be as follows:

On these points, many believe that the solution is to draft your plan document to provide the answers to these questions that you desire and feel are a reasonable interpretation of the requirements. This may mean that the your plan document will be drafted to coordinate the installment and diversification payments so that the participant in the example above will only receive the value of 50 shares and would also specify that the installment distributions are both added back and subtracted in the diversification calculation.

In other words, as I have said here frequently, consult with your own ESOP advisor regarding your specific situation.

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