ESOP Deemed Distributions
My previous blog post on forfeiting ESOP account balances discussed a forfeiture event can occur when an ESOP participant takes a complete distribution of their vested account balance.
What happens if the participant is zero percent vested? Must a plan wait until five breaks in service to forfeit the non-vested balance?
ESOP documents can be drafted to have “deemed distribution” language. The deemed distribution provision states a participant that is zero percent vested shall be deemed to have received a distribution of the entire vested account balance. Having this clause in an ESOP document will trigger a forfeiture event under the cash-out distribution rule. While the IRS has not formally recognized the deemed distribution concept, they do approve plan document language with this wording on a routine basis.
If the deemed distribution language is in the plan document, the IRS will require the forfeited amounts are restored to the participant’s account in the event they return to employment within 5 consecutive breaks in service.
Timing of the Deemed Distribution
Plan documents should also specify when the deemed distribution occurs in order to determine when the forfeiture event is triggered. Two common approaches are having the deemed distribution at date of termination or the first day of the subsequent plan year following termination of employment. The second option would be better used in the case of a plan that provides allocations to terminated participants in their year of termination. Otherwise a participant would forfeit their non-vested account balance and share in the current year allocations, giving them another non-vested balance. Plan documents can also be drafted to have the deemed distribution date based on whether or not the participant will get an allocation in the year of termination.