The concept of diversification in terms of retirement investments gets plenty of attention, especially in times of market volatility, inflation, and uncertainty. By spreading investments across industries and asset classes, volatility risks may be reduced.
Many financial advisors help their clients ensure a portfolio that’s relatively balanced, and they often revisit and readjust, moving toward lower-risk, lower-growth assets as retirement nears, with the intention of minimizing risk of loss.
Unlike many other qualified plans, an employee stock ownership plan (ESOP) is primarily invested in shares of the company that employs the plan participants. That is to say, it is not inherently diversified.
Since an ESOP is a qualified retirement plan, part of its purpose is to help provide a more financially secure retirement to plan participants. Diversification is often undertaken to help improve the likelihood of a more secure retirement — so it makes sense to offer ESOP participants the option to diversify as retirement approaches.
Here, we’ll take a brief look at diversification rules for ESOPs: what qualifies an ESOP participant for diversification, and how diversification works.
What Are the Rules Governing ESOP Diversification?
The Tax Reform Act of 1986 established the ESOP diversification rules under Internal Revenue Code (IRC) Section 401(a)(28). In short, the rules allow a qualified ESOP participant to diversify 25% of their post-1986 ESOP stock balance for the first five years, and 50% of their post-1986 balance during the sixth and final year of their qualified election period.
Pre-1986 shares predate these rules. If the ESOP acquired shares before 1987 and those shares were accounted for separately, the ESOP document is allowed to limit diversification to post-1986 shares. In addition, diversification is allowed, though not required of participants. Let’s break down the rule above into its parts:
- Qualified participants are required to have the opportunity to elect to diversify a portion of their account.
- If they elect to diversify, the diversification must take place within the qualified election period.
- They are allowed to diversify 25% of eligible shares during the first five years of the election period.
- They are allowed to diversify an additional 25%, to bring their diversified portion to 50%, in the sixth and final year of the qualified election period.
How Does an ESOP Participant Qualify for Diversification?
A qualified plan participant is an employee who has completed at least 10 years of participation under the plan and who has attained age 55.
While plan participant age is straightforward, the 10-year participation requirement is less clearly defined. In cases where an employer is interested in diversification options before employees reach the 10-year participation mark, expert guidance is recommended to ensure the plan follows its own terms. Amendments may be needed to avoid an operational failure.
It should also be noted that there is a $500 de minimis exception for diversification. In other words, if the fair market value of the qualified participant’s account is less than $500, the ESOP does not have to offer the diversification opportunity to that participant.
What is the Qualified Election Period for ESOP Diversification?
The qualified election period is a period of six years after the participant becomes qualified, as described above.
The ESOP must offer the initial opportunity within 90 days after the close of the plan year during which the participant becomes qualified. The amount the participant elects to diversify must be distributed within 180 days of the close of the plan year.
While the 90-day requirement is easy for plans to satisfy, compliance with the 180-day distribution requirement can create administrative challenges for many ESOP companies. A closer look at the diversification process clarifies why.
How Does ESOP Diversification Work?
When an eligible, qualified plan participant elects to diversify, the ESOP trustee is required to complete the diversification within the 180-day period. In some cases, privately held companies may not yet have their annual valuation results by that deadline. IRS guidance provided in 2015 (IRS Revenue Procedure Letter 15-36) updated the understanding that the “initial 90 days” can start at the point the valuation is communicated to plan participants. This creates an opportunity to begin the 180-day period after the valuation update is shared with the participant. The ESOP document must be written or amended to begin counting at the value date instead of the plan year.
Many ESOP plan sponsors meet the initial 90-day requirement by providing a preliminary, non-binding election form to qualified plan participants, and a second, binding election form when current year balances and amounts to diversify are finalized.
The diversification calculation is cumulative, meaning all previously diversified shares are included in calculating the number each subsequent year. In other words, the stock balance consists of the number of eligible shares that have ever been allocated to the qualified participant’s account after subtracting any previously distributed, transferred, or diversified shares. (The resulting number may be rounded to the nearest whole integer.)
The ESOP can satisfy the diversification requirement in three ways:
- A distribution to the eligible participant (this can be taxable or rolled over to another retirement account)
- A direct transfer to another qualified plan (typically the company’s 401(k) plan)
- Offer at least three investment options and invest the diversified amount as directed by the qualified participant (certain requirements apply)
The ESOP is not required to offer all three options; it only has to offer one — but any of these diversification methods has to be completed within the 180-day period.
It’s important to understand that if your ESOP has ever paid a distribution to a participant, it has established your ESOP distribution policy — whether or not you have articulated and documented that policy. A clear, documented policy is an ESOP best practice that helps your plan demonstrate compliance with nondiscrimination rules. Learn more about distribution policies by claiming your copy of our eBook. Just click below to download yours today.
