Employee stock ownership plans (ESOPs) can be a flexible tool in a company’s compensation package, offering a valuable retirement benefit that can help support business growth, too.
Are you an employee-owner looking for information about in-service distributions?
Every ESOP is unique. As you’ll see in this article, not all plans share the same features, policies, and rules. If you have questions about your ESOP rules and policies, your company’s plan administrator should be your first call.
That versatility can make an ESOP an attractive component of a comprehensive employee benefits package that can balance employee interests with corporate success.
Aside from requirements to allow employees to elect distributions for investment diversification and to meet required minimum distributions (RMDs) for workers over current age thresholds, ESOP distributions generally begin after an employee retires or terminates employment.
But what if a company wants to use a feature like in-service hardship withdrawals to offer workers an added safety net? On the other hand, can an ESOP choose to pay dividends to its employee shareholders to create ongoing, tangible benefits tied to company performance?
Optional features like in-service distributions and dividend payments can enable ESOP companies to tailor their plans to support specific organizational goals and employee needs. This allows an ESOP to be more than just a retirement plan; it becomes an integral part of the company’s strategic approach to employee satisfaction and retention.
What ESOP In-Service Distributions are Optional, and Which are Required?
What is an in-service distribution? This refers to an opportunity for plan participants to receive a disbursement of accumulated ESOP retirement benefits before leaving the company. That’s because typically, ESOP retirement plan benefits are paid to employees after they terminate employment.
Some in-service distributions are not standard across all ESOPs, but can be included in a plan design to meet specific company objectives and/or employee needs. ESOP payout options offer more opportunities to tailor plans than, for example, 401(k) plans.
In-service distribution opportunities that ESOPs are required to offer participants include:
- ESOP diversification — after employees meet certain age and service requirements, and if the employee elects to diversify
- Distributions for employees age 59-½ and older
Required minimum distributions (RMDs) for employees over age 73 (increasing to age 75 in 2033), on the other hand, are a regulatory requirement.
Should Your ESOP Allow Hardship Withdrawals?
Hardship withdrawals are allowed, though not required — and in fact, they’re rare among ESOPs. Unlike 401(k) plans, most ESOPs don’t hold assets in forms other than company stock. That would make it complicated for the plan to provide cash to a participant; and hardship withdrawals cannot be repaid to a plan by the employee, for yet another reason so few plans consider allowing them.
And because hardship withdrawals are only permitted in the case of an immediate and heavy financial need, the amount of cash they would call for also contribute to their rarity. A few examples of “immediate and heavy financial need” include:
- Medical care expenses for the employee, their spouse, or dependents, or beneficiary
- Payments necessary to prevent eviction from the employee’s principal residence
- Certain expenses to repair damage to the employee’s principal residence
- Funeral expenses for the employee, their spouse, children, dependents, or beneficiary
Dividend Payments
Dividend payments are another less common plan feature among ESOPs — though they’re not as rare as hardship withdrawals.
ESOPs are allowed to directly pay employees stock dividends on the shares in their ESOP accounts. Internal Revenue Code Section 404(k) allows an ESOP-owned C corporation to take a tax deduction for dividends paid on the stock if the dividends are:
- Paid to plan participants directly or through the ESOP within 90 days of the end of the plan year,
- Paid to participants or reinvested in employer stock, or
- Used to pay a loan that was taken to purchase company shares
Dividend payments made to plan participants are based on the number of shares they hold. Paying dividends to employee-owners can be a strategic decision to bolster an employee ownership culture, to tie benefits more directly to company performance, to align employee incentives with organizational goals, and to further employees’ opportunities to build wealth. The tax benefits mentioned above can make dividends a tax-efficient way to distribute profits to employees.
Including dividends in your ESOP plan document and distribution policy is optional.
An ESOP Plan Document Involves Strategic Decision-Making
Significant control over in-service distributions rests within your ESOP plan document and your company’s distribution policy. This control allows every ESOP company to design a plan that aligns with its financial position and strategic objectives. For example, the plan can set terms for dividend payments and/or define eligibility criteria and limits for hardship distributions.
This flexibility is a powerful tool that’s best put to use with the guidance of trusted expert advisors, both to ensure your choices support your business objectives and plan sustainability while addressing employees’ possible urgent financial needs.
While they may be beneficial for employees in dire financial need, in-service distributions can strain company liquidity, especially if the need arises frequently or disbursements are significant. This can limit investments in growth and over the long term, it can impact the ESOP’s value — and that impacts all plan participants. A thoughtful approach considers employee needs while ensuring plan viability.
Designing Your ESOP to Work as Intended
Company leadership and ESOP plan administrators need to carefully weigh the pros and cons when deciding whether, and which, in-service distribution opportunities to include in a plan document and distribution policy. Plan policies can have a clear impact on employee ownership culture, long-term employee retention, and overall satisfaction.
They can also have a major impact on the plan’s financial health, so care must be taken to ensure optional distributions wouldn’t place a strain on company resources. That means getting expert help reviewing the pros and cons of including them, as well as professional guidance establishing eligibility criteria and limits.
With guidance from knowledgeable, experienced advisors, your ESOP plan documents can be thoughtfully designed to offer meaningful employee benefits without compromising your plan’s sustainability. The end result? An ESOP that works as intended — serving the interests of the business and its employee-owners. Get started learning about the basics of building an ESOP distribution policy. Click below for our free ebook.
