Complying with ESOP Diversification Rules

September 3, 2014 ( – The rule for who is eligible to diversify company stock holdings in a retirement plan is simple, but examining the criteria for eligibility can be complicated, says a white paper from the Principal Financial Group.

Every year, an employee stock ownership plan (ESOP) must offer eligible participants a chance to diversify, or sell off some of the stock. A qualified participant is an employee age 55 who has completed at least 10 years of participation in the ESOP, or who has met other requirements.

Overall, plans with an ESOP are in the minority (4%), but that percentage grows with the size of plan assets. According to PLANSPONSOR’s 2014 Plan Benchmarking Report, about 13% of plans with more than $1 billion in assets offer an ESOP.

“ESOP Diversification Requirements,” a white paper from the Principal Financial Group, gives an overview of eligibility and what is required of plan sponsors.

Eligible participants have the right to elect to diversify up to 25% of the company stock in their accounts for five years after meeting the eligibility requirements, says John Prodoehl, vice president of consulting at Principal Financial Group in Kaukauna, Wisconsin, and one of the paper’s authors. “In the final election, the sixth year, they may elect to diversify up to 50% of their company stock,” he tells PLANSPONSOR.

A key issue is how to measure years of participation, Prodoehl says. Do years of plan participation include all plan years in which a participant had an account balance, or does it only refer to plan years in which a participant is eligible for contributions and forfeitures? What if an employee was terminated and has deferred, vested benefits under the ESOP?

The Tax Reform Act of 1986 instituted the requirement for diversification. In a 2009 memorandum from the internal Revenue Service (IRS), the definition for a year of participation has a few options. It can mean a year in which a participant has an account balance in the ESOP. It does not mean the participant must be employed, or complete a stated number of hours of service, or be eligible for a contribution to be credited with that year of participation.

Some plans can have more restrictive language that defines participation for the purpose of ESOP diversification, and the plan sponsor may also choose to amend the language to be less restrictive. However, the opposite is not true. A less-restrictive plan cannot put in language to make the definition more restrictive.

Instead of years of participation, a plan can measure eligibility by years of service: but not more than 1,000 hours, according to the IRS guidance. A participant who leaves employment after 10 years of participation but before age 55, will be eligible for diversification upon reaching age 55.

One way to measure years of participation for the purpose of ESOP diversification is to mirror the plan’s definition of vesting years of service, Prodoehl says. When the documents are drafted, he recommends, attorneys should specify exactly what is meant by “year of participation” so the plan can be precise about how participation years are being tracked. “It helps the plan sponsor to avoid missing someone who should have been eligible [to diversify company stock], and not operating the plan according to its terms,” he explains.

Another key point is how plan sponsors can satisfy the requirements for diversification without incurring a lot of additional costs, Prodoehl says. A common best practice is using the company’s 401(k) plan to accept the funds that are elected to be diversified. “The plan sponsor can use the 401(k) chassis to offer up the various investment options,” he explains, “versus having to establish that investment lineup and recordkeeping platform within the ESOP which is not a participant-directed plan.”

In other words, the plan sponsor that chooses to build this part into the ESOP would find it cumbersome and costly, he says. “Why not use the 401(k)?” Prodoehl says. “It’s legal." According to Prodoehl, the law also states that the plan sponsor can distribute the money directly to participants, who can pay taxes. Or, he says, participants can roll the distribution into their own individual retirement account (IRA).

But, the plan can also outline a process to establish these investments as an automated plan-to-plan transfer. “It depends on the plan sponsor’s attitude toward retirement planning,” Prodoehl says, “If they want to protect that money as much as possible they will transfer to 401(k) plan.” This option would spare the participant having to pay taxes.

“Typically, the plan sponsor will notify the eligible participants by mailing a notice to them explaining their right to diversify and explaining the rules, the timing and how to make their elections,” Prodoehl says. “They must be offered at least three different investment alternatives with three different levels of risk. If they’re transferring into a 401(k) plan, odds are most plans have that criteria already satisfied.

Another advantage to using the 401(k): those participants who want to diversify but do not pick new investments can be placed in the plan’s qualified default investment alternative (QDIA), Prodoehl adds. “The 401(k) plan’s QDIA will come into play just as it would for any other monies in the 401(k) plan where the participant fails to direct the investment,” he explains.

Imposing an early withdrawal penalty on participants that take a distribution seems odd to Prodoehl. “The IRS requires the plan sponsor to offer this to participants at age 55, but if it is processed as a distribution and the person doesn’t roll it over, they’re going to have pay a penalty,” he says. “There is no exclusion for [ESOP] diversification from [the early withdrawal penalty] rule.” The only way around it is to roll the distribution into a 401(k) or IRA until the participant is 59-1/2. “It could catch people. They think it’s a right they have, and they shouldn’t be penalized for early withdrawal—but they could be.”

No matter which option the plan sponsor chooses, the company is going to have to come up with the cash to liquidate those shares, Prodoehl points out. The best plan is for the company to look forward a couple of years to determine their list of eligible employees, and what its maximum exposure would be from a cash standpoint. “This way, it’s not a surprise when they have to offer it, and it’s a big number and they haven’t planned for it,” he says. “You don’t know what people are going to elect to do, but you know when it will happen and what the maximum amount could be, so you can prepare for it.”

More information, such as diversification examples and different compliance time frames, are detailed in “ESOP Diversification Requirements,” which can be downloaded from The Principal’s site.