Complying With ESOP Diversification Requirements

By Peter J. Shuler and Mark D. Swanson, J.D.
All employee stock ownership plans (ESOPs) that acquired stock after 1986 must allow qualified participants to diversify a portion of the shares in their accounts during the qualified election period. A qualified participant is a participant who has attained age 55 and has at least 10 years of participation. The qualified election period is the six-plan-year period beginning with the first plan year a participant becomes a qualified participant. During the first five periods, the participant can elect to diversify 25 percent of the shares held in his or her account, reduced by any shares previously diversified. In the sixth year, the participant can elect to diversify 50 percent of his or her shares, less previously diversified shares.

The ESOP can permit a participant to exercise his or her diversification through distribution of shares or cash equal in value to the shares through transfer of cash to another qualified retirement plan (often a 401(k) plan) or through investing in one or more of at least three investment options within the ESOP that have different risk and return characteristics. Given the complexities of recordkeeping and monitoring different investment alternatives within the ESOP, most ESOPs do not use the last option.

The diversification must occur within 90 days after the last day of the annual election period, which is the 90-day period following the end of each plan year. As such, for a calendar-year plan, the annual election period is Jan. 1 through March 31 (for years that are not leap years), and the diversification must occur by June 29, which is 90 days after the end of the annual election period.


Cause and Effect

The diversification deadlines cause numerous administrative issues. In most cases, the number of shares eligible for diversification and the value of those shares are not known in time for a participant to make an informed election within 90 days of the plan year-end. Consequently, creative strategies have been used to meet the requirements and to make sure participants have the information needed to make a meaningful election. Many ESOPs will provide multiple diversification election forms to the same participant. The initial form may simply explain diversification and provide no share or value information, or it may provide the most recently available share and value information, which generally is for the prior plan year-end (for example, Dec. 31, 2014, balances and value may be shown on these initial forms for diversification elections that ultimately will  be made based on Dec. 31, 2015, balances and value). Eligible participants make an initial election based on no or incomplete information. They then are provided with a final election form when the current year-end information is available.

Some ESOPs simply don’t provide election forms until all of the information is available and, thus, do not adhere to the diversification deadlines in the law. No matter how it is handled, complying with the deadline for diversification elections causes administrative burdens or risk of penalty for noncompliance.

The second deadline – the completion of the diversifications – also may be difficult to meet. In some cases, the year-end valuation of the shares is not completed in time to determine the amount to diversify by the June 29 deadline (for calendar-year plans). In such cases, some ESOPs diversify an amount based on the most recent known value, and some ESOPs follow with a true-up diversification once the year-end stock value is determined. Others delay the diversification until the share value is determined. As with diversification elections, complying with the deadline for diversification to be completed causes administrative burdens or risk of penalty for noncompliance.

Recent Developments

Language issued in 2015 by the IRS in the ESOP Listing of Required Modifications and Information Package (LRM) provides some hope that ESOP documents can have terms that will allow for diversification elections to be made within 90 days after the value of the shares subject to diversification is provided to participants and the diversification completed 90-days after the election period ends. This can provide two major benefits. First, eligible participants will be able to make an informed decision – without multiple election forms – when they make a diversification election. They will know exactly how many shares they can diversify and the value of those shares. Second, the ESOP will have a full 90 days to process the diversification elections, and all necessary information will be known at the beginning of that 90-day period.

The ESOP LRM was issued in connection with the IRS’s recent decision to allow ESOPs to use pre-approved plan documents. Pre-approved plans, often referred to as prototype or volume submitter plans, allow adopters to select among the available options and, if the adopters stay within the limits of the available options and meet other requirements, the plan sponsor can obtain a determination letter without submitting the plan to the IRS. A favorable determination letter provides comfort that the plan, in form, meets with IRS approval.

While the IRS has expanded the pre-approved document program to include ESOPs, an ESOP sponsor is not required to use a pre-approved document. Because of desired provisions, some ESOPs will continue to use an individually designed plan document. However, even such ESOPs can benefit from the pre-approved document program. In the ESOP LRM that was published in connection with this program, the IRS provided model language for pre-approved ESOP documents that also is useful for individually designed plans, because it provides insight on terms the IRS will find acceptable.

The ESOP LRM is used as a guide for IRS reviewers when they review documents for a favorable approval letter. As noted previously, the annual election period is the 90-day period following the end of each plan year. The LRM still contains this language but, in a note to reviewers, the IRS states that the plan may provide that the annual election period ends later than the 90-day period. For example, a plan may provide that the annual election period begins the day after the end of each plan year and ends 90 days after the date that the year-end stock value is provided to participants. The IRS expressed that the 90-day period is a minimum time frame that can be extended.

For example, consider a calendar-year plan that amends its diversification provision to define the annual election period as the period starting on Jan. 1, and ending 45 days after the share value has been provided to the participant. The updated value is communicated on May 30, and the participant has until July 14 to make an election. The diversification then must be processed by Oct. 12 (90 days following the end of the annual election period).

Looking Forward

As ESOPs work to comply with diversification requirements, ESOP companies should take into account this additional flexibility. With proper planning, the additional flexibility can help alleviate the struggles many ESOPs have faced in the past.