What is an ESOP?
An Employee Stock Ownership Plan (ESOP) is a qualified employee benefit plan that focuses primarily on investing in company stock. It offers what would be an employee benefit if it weren’t structured specifically as a qualified retirement plan under subchapter K of the Internal Revenue Code. ESOPs are unique because they are often used as a tool for exit strategies by owners of closely-held, C-corporate companies that want to sell their business while offering their employees a solid benefit. Essentially, the ESOP provides a way for employee-owners to purchase their employer’s stock (whether directly from the employer or through a trust established by the employer) and reap the benefits as the employer continues to expand, thus enhancing the value of their shares.
Now let’s be clear: An ESOP isn’t a traditional retirement plan like a 401(k). That’s primarily because an ESOP enhances the employees’ experience in another way – it supplements their job duties with shareholder responsibilities . Unlike other employee benefits (or like a 401k), an employee’s job responsibilities are not only enhanced with the signing of the ESOP, but ESOP employees monitor the management of their company, thereby aligning individual and organizational interests toward the company’s mission. (This is interesting to larger employers, who don’t necessarily have closely-held ownership, or those with multiple locations dispersed across the U.S., where employees may feel that their day-to-day activity doesn’t impact the "bigger picture.")
The ESOP is intended to benefit all employees. Because the ESOP company stock is non-transferable during the employees’ employment, it vests based on years of service. Employees must await retirement or other termination of service (after 55 and ten years or 17 and six years for more than 5 percent owners) to receive their retirement benefit, which could be more substantial when the company’s value rises.
ESOPs and Diversification: What’s it All About?
Although early legislation pertaining to employee stock ownership plans ("ESOPs") did not include any diversification requirements, the Employee Retirement Income Security Act ("ERISA") of 1974 added diversification requirements for the benefit of participants in both employee stock ownership plans and individual account plans, such as 401(k) plans.
The diversification role was created to provide a means for employees in an ESOT to obtain the opportunity to diversify the investment of assets held under an ESOT, especially as employees approach retirement, when they may not want to take that risk. Such diversification can be accomplished by allowing participants to take distribution of their account balances and then reinvest those funds in other than company stock.
For a participant who has attained age 55 and completed at least 10 years of participation in the plan, the diversification rights of ERISA provide that the plan must be amended to permit the participant to elect to receive distribution of a portion up to 25% of the value of their account, or to direct its investment in other than employer securities, for each plan year during the period beginning with such date and ending on the close of the calendar month in which the 5th anniversary of the effective date occurs. However, there is no requirement that 25% of the account must be distributed or transferred (except that a de facto distribution, resulting in taxation to the participant in the year in which the distribution occurs, shall be treated as making a distribution, in accordance with IRS Notice 2001-64).
There are some special rules that apply to certain plans that have a single stock. For example, if the stock of an S corporation is held by an S corporation ESOP, the diversification rules allow an election to transfer or roll over amounts to an annuity contract or other investment media that are available under the plan. For a defined contribution plan, the term "diversification" means the maturing of any right of a participant under the plan to demand a distribution of the individual’s account.
Diversification simply provides the employee with the right (but not the obligation) to demand a distribution of a certain percentage of the benefit derived from employer stock after the "point-in-time" at which diversification rights initially occur, to be accepted by the employer "in-kind" (rather than in cash) or in cash, and to be immediately reinvested by the participant in another investment. This right is not forfeited or vesting in the same manner as a qualified retirement plan, but rather it is available as long as the Plan exists and the rights are timely exercised.
What are the Key Rules to Remember for ESOP Diversification?
In general, ESOP diversification rules require annual notice of diversification rights to participants and former participants who are 55 years of age or older and have completed 10 years of participation in the ESOP. Former participants with more than 10 years of participation who received an in-service distribution from their accounts due to diversification are entitled to a right to further diversification.
The diversification elections provided for under the diversification rules are limited to the following:
The diversification election is generally made as of the end of the plan year prior to the distribution year, although the diversification election may be made earlier if, prior to that date, the plan provides for such early election and the participant or former participant has reached age 55 and has 10 years of participation. If a second diversification election has previously been made, then subsequent elections are limited to the portion of the account that was previously not subject to an election (e.g., if a $100,000 election was made and a $40,000 in-service distribution was taken, there would be a $60,000 balance remaining under the election).
The diversification changes effective January 1, 2007 also require that participants or former participants be informed of the ability to defer beyond their election under the plan any amounts that would otherwise be distributed to them (as long as the election amount does not exceed one-fifth of the total vested accrued benefit). Those choosing to defer the distribution may do so by making an election under the plan within 180 days of their receipt of the notice.
Amount of Diversification In general, the amount of the required diversification is determined based on the portion of a participant’s ESOP account that is non-public company stock (i.e., other than S Corporation, professional service, or 404 (k) stock). If the diversification election amount exceeds the amount of shares held in the ESOP that cannot be diversified, unless the plan provides otherwise, the amount to be diversified will be from unfrozen stock, unvested benefits, or frozen stock as determined under the plan.
Distributions that may be Involuntarily Cashed Out Certain ESOPs provide that participants with low account balances or terminated participants may have their account involuntarily cashed out without an election (assuming they are not eligible for an in-service distribution). These accounts must be automatically cashed out upon termination of employment if the participating employee has an account balance under $5,000. If it is greater than $5,000 but under $10,000, the employer is permitted to cash out the amount without consent but must provide a direct rollover option. Otherwise, the cash out may be made only upon the affirmative consent of the participating employee (unless the amount is under $1,000).
Who is Eligible for ESOP Diversification?
Generally, an employee must have reached 55 years of age and 10 years of qualified participation to qualify for diversification opportunities. But this Age/Service Rule is not satisfied by just meeting the minimum age/service requirements necessary to be a beneficiary of the ESOP.
An employee will generally satisfy this rule only if he met the minimum age/service requirements at the same time that he became a holder of stock in the ESOP. In other words, an employee cannot satisfy the Age/Service Rule simply because he satisfies the minimum age/service requirement during the Plan Year, if at the time of meeting those requirements he is not a beneficiary of the ESOP. The A/S Rule is only satisfied if the employee was a beneficiary of the ESOP at both the time he met the 55/10 requirement and the time he had 10 years of ESOP participation.
ESOP Diversification Options for Employees
Under the rules, when an employee is age 55 or older and becomes a participant in an ESOP that has been in effect for at least 10 years, the employee may require the company to have the unvested account balance of the employee’s ESOP shares allocated to a separate "diversified" investment fund. The diversified fund is required to include publicly traded stock and interest-bearing obligations of the U.S. Government and likely mutual funds; however, these independent investments cannot be more than 55% bonds and the balance must be divided between stocks and cash.
In addition to having their accounts allocated to a diversified account, employees over age 55 may also choose how they want their allocated funds distributed. Employees may choose to participate in either (1) a lump sum cash distribution of the value of the assets in the diversified investment fund or (2) a distribution of the assets in the diversified investment fund in the form of a rollover into another employer-sponsored retirement plan, a traditional IRA or a Roth IRA .
If the employee elects to receive a distribution of the diversified investment fund in the form of a lump sum, the distribution will generally be taxable in the year it occurs unless (1) the distribution consists entirely of employer securities, the taxpayer elects to defer taxation on the gain and (2) the tax is paid on the unrealized appreciation in such employer securities as of the date of distribution. Deferred gains on the employer securities are taxable as income only when the securities are later sold or otherwise disposed of. Conversely, if the employee elects to have the gain on the distributed employer securities be taxable, the entire amount of the gain will be taxed in the year of the distribution.
Although disallowed in most contexts, the diversification election does allow employees over age 55 to receive a lump sum distribution (subject to the limitations described above) from their ESOP accounts prior to age 59 ½ without incurring an early distribution penalty tax. Unfortunately, the ESOP diversification rules do not apply to ESOPs established in S Corporations. However, an S Corporation ESOP can be designed to include a special opt-out option for employees over age 59 ½ at the time of their using their first diversification opportunity.
Benefits and Risks of Diversifying ESOP Interests
The decision to diversify is especially important for an employee with a relatively small amount of assets within an ESOP. The diversification event allows the employee to change a percentage of their ESOP balance to other investments. For example, a $300,000 account with 100% in an ESOP could allow for $120,000 to be allocated to an alternative investment, based on the 10-year window of diversification options, or 25% of the account balance. For someone in the peak income years, it is critical not to pay more than the minimum tax amount on this gain by failing to time a distribution properly.
Diversification can afford employees a chance to take gains from within the account and allocate a portion of their ESOP assets to another investment of their choosing. Diversification gives the employee the opportunity to take part of their ESOP balance and invest outside of the plan for the first time, or to immediately reinvest within the plan. Diversification can "diversify" the asset allocation of the ESOP balance, but doesn’t guarantee that the employee is required to do so. The intent of the diversification privilege is to allow employees to allocate assets to a more efficient portfolio that is beneficial to them based on their own circumstances and risk tolerance.
It is important to note that the diversification privilege neither guarantees the safety of the principal, nor assures a positive return on investment (ROI), since the underlying investment may depreciate just like any other holding or investment. It is possible that the non-ESOP investment has a worse performance, or even becomes worthless over time.
Investments are available to employees that include mutual funds, money markets, and guaranteed investment contracts (GICs). Typically, GICs and interest on money markets are taxable as ordinary income. Appreciating investments within the 401(k) plan, such as stock, will be taxed as investment gains at the capital gains or dividend rates, which tend to be lower than marginal income tax rates. For example, if an individual were to allocate $120,000 to a non-ESOP investment and hold that investment for a period of time, the gain on the non-ESOP investment that accrued would be fully taxed as ordinary income, but the appreciation on the ESOP would be taxed at a lower rate.
Employees may decide to either place the funds within a non-ESOP investment account outside of the plan or place the funds within another investment option within the 401(k) platform. If they elect to move the funds outside of the plan, they should consider the tax consequences of being taxed on the full amount of the entire gain all at once, versus being taxed over a series of years at a much lower capital gains rate. If this route is chosen, the employee may need to invest outside of the plan for a significant period of time before their pre-tax gains can be fully equal to that remaining in the ESOP balance. Depending on tax rules at the time of the change in investment strategy, the employee may realize a greater return on the investment if it is held for multiple years inside of the plan, rather than outside of the plan.
Recent Developments in ESOP Diversification Rules
The Employee Retirement Income Security Act of 1974 (ERISA), the law that initially enacted ESOPs, also requires ESOP participants to be offered the right to diversification of their stock investments in the plan. Regardless of the type of plan, however, the employer can limit the employee’s ability to change their investment to what is desirable to the company’s goals. If the company is structured to keep employees on staff, then this rule keeps that in place so that the employee cannot easily leave their position to take advantage of better stock opportunities. But if the company is closed, for instance, then it is desirable to allow the participant the latitude to diversify the stock and sell it back to the plan.
In recent years, there have been changes in the law that impact the diversification requirements. In 2009, Congress created the Worker, Retiree, and Employer Recovery Act (WRERA) which temporarily added certain clarifications to the diversification rules under ERISA. However, WRERA was enacted in preparation for the 2012 fiscal year, and did not apply past that year as an ongoing change in the law. Under WRERA, however, and absent significant changes to the nature of a company’s stock itself, the law allowed a right of diversification once a company reached a certain level of a participant’s age and service with the company. This was as follows, however:
"For plan years beginning after December 31, 2006, a company stock held by any qualified employee stock ownership plan that is leveraged shall be eligible for diversification at the election of the plan participant after the end of the sixth plan year (using the rules of section 409(o)(3) of the Internal Revenue Code of 1986 with respect to such plan year) in which such qualified employee stock ownership plan was established or was amended to permit investments in the ESOP. A plan shall comply with such diversification requirements for a plan year only if the plan (or plans, in the case of a multi-employer plan) in which the qualified employee stock ownership plan is held has sufficient cash or other liquid assets to pay any benefit that is accrued under the plan which is payable in accordance with section 409(h)(1)."
However, in anticipation of WRERA, the new provisions were amended and extended through September 30, 2014 under the Bipartisan Budget Act of 2013, a law passed in December of that year, along with a right for participants to obtain vested stock in the plan at any time. The longevity of the diversion rules was made permanent at the end of 2014, and a change in the language further defined what was meant by stock distributions, and maintained the required sample language for plans. Further, Congress clarified in 2012 that nothing in WRERA altered the fiduciary standards of 29 U.S.C. 404(a), which also dictates that the ESOP managers must be eligible to exercise the full scope of the responsibilities of a trustee and fiduciary. In 2016, further changes were applied under the Bipartisan Conference Budget Act, extending the language and further allowing for provisions, and improving the language on the ability of participants to obtain and hold stock in the plan.
Because the ESOP diversification right is part of the ERISA statutory scheme, a separate publication is available to discuss further the professional interaction of the demands of the law and private company objectives so that they can work together to create a meaningful participation plan for employees.
Employers’ Tips for Managing ESOP Diversification
Employers should deliver timely and accurate information concerning diversification opportunities and ensure such information is presented to employees in language that is easily understood. Many employers find it helpful to supplement the document delivery requirements under ERISA with a personalized letter that provides additional explanation of a participant’s options under the diversification rules. Employers faced with deciding whether to permit participants’ elections to diversify should consider the following: Plan documents must also be reviewed to ensure they provide for any diversification options at the required age or, if the plan permits diversification at an alternate age, that the plan document expressly provide for such alternate age. Employers may want to include helpful information on the timing and material risks associated with any eligible investments, such as the fact that generally, short-term gains should not generally be anticipated as the stock of privately held companies historically is intended for long-term investment. It is especially important to highlight the relatively high investment risk associated with employer stock if allowing diversification into employer stock . Employers should also review the plan’s financing and/or investment policies to ensure they properly permit diversification to commonly known vehicles, such as mutual funds, and, if consistent with the plan’s investment objectives, to employer stock. Employers should exercise care to protect from liability by ensuring that all employees are provided a reasonable opportunity to elect among the diversification options and that investment information provided to employees is reasonably accurate and does not mislead participants. Providing individual meetings with employees can be helpful because it provides clarification and an opportunity for employees to ask questions. The investment policy should describe how different investments, including employer stock, are evaluated and what the plan’s objectives are for diversification. It is not uncommon for companies to set up an investment committee to oversee plan decisions. Such committees might wish to have the following functions: Employers are well-advised to consult with their legal advisors, who can provide recommended best practices and examples of what has been done by other employers. The use of compliance tools and best practices will help employers insulate themselves from claims that the plan failed to meet the requirements of the diversification rules.