Clear and comprehensive plans for the timing of ESOP distributions are essential to effective ESOP management. A written distribution policy complements the ESOP plan documents, and helps ensure that all participants understand your plan’s current distribution process.
While there are clear ESOP distribution rules that govern the timing of distributions for terminated employees with vested ESOP account balances, there are also exceptions, which allow some flexibility. At the same time, these exceptions could cause confusion if distribution plans are updated without clearly communicating changes to participants.
Many ESOP employers have questions about requirements for the timing of distributions, especially for vested employees who are not retiring, disabled, or deceased. Here’s what you need to know about the requirements for ESOP distribution timing, and how to ensure your plan for distributions is not only in compliance with IRC regulations, but is also clear and easy to understand for plan participants.
ESOP Distribution and Payment Requirements
ESOPs have their own special set of rules regarding the timing of distributions to terminated participants with vested account balances. According to IRC Section 409(o)(1)(A), “the distribution of the participant’s account balance in the plan will commence not later than 1 year after the close of the plan year—
(i) in which the participant separates from service by reason of the attainment of normal retirement age under the plan, disability, or death, or
(ii) which is the 5th plan year following the plan year in which the participant otherwise separates from service, except that this clause shall not apply if the participant is reemployed by the employer before distribution is required to begin under this clause.”
In plain language, distribution of a participant’s balance must begin not less than one year after the close of the plan year during which the participant retired, became disabled or died; or within the year after the fifth plan year following the year in which the participant terminated (or was terminated from) employment.
Confusing? Here’s an example: John Doe terminates employment on November 15, 2020 for a reason other than normal retirement, disability, or death. If the ESOP’s plan year runs on a calendar year, John needs to begin receiving a distribution of his vested account balance no later than December 31, 2026.
To meet this requirement, the ESOP plan administrator should allow John to receive a distribution after the December 31, 2025 recordkeeping is completed in 2026, so the distribution can be processed by December 31, 2026.
Exceptions for ESOP Loans
Now it sounds simple, right? Well for better or worse, there are a number of exceptions to the timing rules above that an ESOP administrator needs to understand and monitor.
ALSO READ: How Can an Admin Handle Alternate Payees? ESOP QDRO Distribution Options
Financed Securities Exception
IRC Section 409(o)(1)(B) allows an ESOP to implement a special delay of distributions related to the stock balances in a terminated participant’s account that were purchased with an exempt loan. A distribution of those shares does not need to occur until the close of the plan year in which such loan is repaid in full.
ALSO READ: How Are ESOP Distribution Rules Affected by the Exempt ESOP Loan Exception?
While this clause can be applied to all terminated participants, plan documents normally limit it to terminated participants other than retired, deceased and disabled participants. Most plan sponsors do not want to apply the extra delay for retired, deceased, and disabled participants. The ESOP plan document must clearly and specifically indicate which terminated employees this provision applies to in order for the financed securities exception to be applicable in the administration of the plan.
Required Minimum Distributions (RMDs)
ESOPs must comply with the Required Minimum Distribution rules of IRC Section 401(a)(9). These rules set the final deadline by which ESOP distributions must begin, and generally, these rules are to ensure that participants actually use ESOP benefits for retirement.
General Qualified Plan Distribution Requirements
ESOPs must comply with the distribution commencement rules of IRC Section 401(a)(14). These rules apply to the commencement of benefits of all qualified retirement plans and cover conditions including:
- Participant age and plan retirement age
- Participant years of plan participation
- Termination of service with the employer
- And other important details
Death Benefits 5-Year Rule
As stated in IRC Section 401(a)(9)(B)(ii), in some cases the entire interest of the deceased participant must be distributed to the beneficiary within 5 years after the death of the participant. This requirement supersedes the Financed Securities Exception, which is another reason to not use the loan delay option for distributions to deceased participants.
ALSO READ: What Happens to ESOP Benefits When a Company Closes or is Sold? and How Does an ESOP Distribution Work After the Death of a Participant?
A Complete Written Plan is an ESOP Best Practice
Flexibility can be built into the timing of ESOP distributions. Creating a written distribution policy to complement the plan document and further define the timing of distributions to plan participants is a best practice and a good way to communicate the current distribution process to the ESOP participants. Promoting awareness in this way is consistent with ESOP cultural values of employee ownership.
Whether or not you already have an ESOP distribution policy in place, it’s important to carefully document the timing, form, and method to demonstrate that you operate your ESOP in a nondiscriminatory way. Our eBook, ESOP Distribution Policy: Timing, Form, and Method, can help you get started following this important best practice. Just click the link below to get started.
