RSM McGladrey ESOP Blog

More on ESOP diversification and former participants

Let’s assume that former participants are eligible to make a diversification election and ignore the strange IRS position that I mentioned in my prior post.  I have a couple of issues to raise relating to the coordination of diversification payments with installment distributions.

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 – 6 can get even more complicated. It would appear that you add back the shares previously distributed via the installment distribution like you do shares previously diversified. The rationale for this is that according to the IRS guidance, 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.

On both of 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 will only receive the value of 50 shares and would also specify that the installment distributions are both added back and subtracted in diversification calculation.

In other words (and I am sure you may be growing weary of hearing this), consult with your own ESOP advisor.

Just an fyi – I won’t be writing here for a couple of weeks or so as I will be out for a short medical leave. I hope to return in early to mid March.

Are former ESOP participants eligible to diversify their ESOP balances?

Let’s assume that you have a former ESOP participant who does still have a balance in shares in the ESOP and does satisfy the age 55 as well as the 10 years of participation requirements. Should that person be eligible to diversify?

I think most ESOP practitioners would agree that yes, the former participant should be allowed to diversify.

But we have had the IRS tell us that former participants should not be allowed to diversify. They made this statement while reviewing a request for a determination letter for a restated plan document. They insisted that the document’s language be modified to provide that only active employees are allowed to diversify.

Now that just does not make any sense to me. If you will recall a post I did from back in November, the IRS apparently has an issue when former participants are segregated out of company stock into other investments. If the reason for their concern with that segregation practice was that the former employees were being treated differently than the active employees, then this position on diversification is at odds with that position as it is mandating that former employees be treated differently.

I actually am not sure why the IRS would not want former employees to be able to elect to diversify. I am also not sure if this is an official IRS position or if it is an issue with just one reviewer as I have only had this issue raised this one time by the IRS.

So how do we calculate the number of shares eligible to be diversified from a participant’s ESOP account?

If your ESOP has been in existence since before 1987, your first step is to check your plan document to see if the diversification applies only to the post-1986 shares or if it applies to all shares.

Then, in the first year, the calculation is pretty easy – you take the applicable share balance and multiply it by 25%.

In the following years, the calculation is cumulative so that you add back and then subtract out the number of shares that had previously been diversified as follows:

Example:
• The first diversification year was 2007 and the participant diversified the full 25% (200 shares x 25% = 50 shares.)
• At the end of 2008, the participant has 175 shares.

Shares as 12/31/2008                        175
Plus shares previously diversified          50
Subtotal                                            225
                                                       x 25%
Subtotal                                              56.25
Less shares previously diversified         (50)
Shares eligible for diversification              6.25

O.k., now that we have handled some of the basics, let’s tackle some of the tougher issues.

Are former participants eligible to diversify?
If former participants are eligible to diversify, how do you coordinate installment distributions that they might be receiving with the diversification amounts?

More on those next week.

A sale by a Dittmer to an ESOP

Well, I just had to share this story – Cattle Feeding Profile: Cactus Feeders

Not only is it about the first ESOP in the cattle feeding industry but the ESOP apparently was created for a purchase of shares from Thomas Dittmer (no relation.) How cool is that?

"For Cactus' customers, employee ownership brings the security of knowing that their cattle are being cared for and fed by people who have a vested interest in the day-to-day well being of their animals."

When can a qualified participant elect to diversify his or her ESOP balance?

As I mentioned previously, there is a six year period beginning with 1st plan year in which the participant satisfies both the age and service 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 6 year period for this person will be from ages 57-63.

If this person satisfies the 10 year of participation requirement in 2008, then he or she would first be eligible to diversify in 2009 based on the 12/31/2008 share balance (assuming a calendar year.)

I know this all seems real easy but we will soon be getting to some complications including what I think is a ridiculous position taken by at least one IRS representative. I just don’t want to jump ahead to those complications for those less familiar with the basic rules.

More on who is eligible to diversify their ESOP accounts?

An ESOP participant is eligible once he or she attains age 55 and completes 10 years of participation.
So this part of the diversification rules that apply to ESOPs seems easy – right?

But what exactly is one year of participation? Is it the same as a year or service for vesting purposes which is a plan year in which the participant completes at least 1,000 hours of service? Is it more similar to the ERISA definition of participant so that any year in which the participant maintains an account balance in the plan is considered a year of participation regardless of hours worked?  Or is it a year in which the participant would be eligible for a contribution under the plan’s terms (e.g., completion of 1000 hours of service plus employment on the last day of the plan year)?

The bad news is that there is not a definitive definition. But the good news is also that there is not a definitive definition. So you can consult with your ESOP advisor and determine how you want to define a year of participation and then spell that out in your plan document.  When you submit the plan document to the IRS for a determination letter, they can then let you know if they have concerns with your definition. And then of course, follow the terms of your plan document.

How is your company faring during these difficult times?

Corey Rosen did an informal survey of several ESOP practitioners on how their clients are faring  - ESOP Companies Weathering Tough Times

We would love to hear directly from ESOP companies on how they are doing so please share your thoughts here.

When do I notify my ESOP participants that there are eligible to diversify?

It may seem odd to talk about the timing of the notification to the eligible ESOP participants before better explaining the eligibility requirements. But depending upon how you choose to resolve a conflict between the Code’s requirements and practicality, time may be of the essence and you may want to work with your ESOP advisors immediately on getting notice out to the eligible participants.

The applicable provision in the Internal Revenue Code indicates that the participant should make his or her election within 90 days after the close of the plan year in which he or she satisfies both the age and service requirements. Then such election should be implemented within the next 90 day period.

So if your ESOP has a 12/31 plan year end, then you need to provide information (e.g., # of shares eligible to diversify, current share price, etc.) to employees so they can make their elections by March 31st.  And then the actual diversification distributions or transfers should be made by June 30th.

What if you do not receive your stock valuation until May 1st? It would seem to me that if I were eligible for a diversification election, knowing the most recent stock value would be important to me as I consider my options.

Do you give the employees notice by March 31st based on data from the prior year? Or do you just wait so you can give them completely accurate information and ignore the 90 day requirement as it seems unreasonable for most privately held ESOP companies? And there are probably a couple of other alternatives between these two extremes.

You have read it here before - you need to check with your ESOP advisor.