As the adage goes, you don’t want all your eggs in one basket, and the same is true for your retirement accounts. An employee stock ownership plan (ESOP) is designed to invest primarily in company stock. Diversification is the ability of an active ESOP participant to exchange company stock held in their ESOP account for cash or other investments. Having a diverse retirement portfolio can help reduce an employee’s financial risk. To avoid having most of their retirement savings invested in just one company, ESOP participants who meet certain eligibility requirements may elect to cash in a portion of their ESOP stock account to diversify their investments.
Under Internal Revenue Code Section 401(a)(28), a “qualified participant” is any employee who has reached age 55 and completed at least 10 years of participation in the ESOP. A plan sponsor may choose to have more generous provisions within the plan but must at least meet these minimum requirements. For example, an ESOP could allow any participant who has reached age 53 and completed five years of service to diversify.
The qualified participant must be allowed to make their diversification election within 90 days of each “qualified election period.” Many ESOPs may not know the final stock allocation or stock value by the end of this 90-day period. In general, the ESOP should provide a qualified participant with information and a revocable election to diversify within the 90-day period (preliminary diversification). After the total share value is known, the ESOP should provide the participant with an updated notice and an opportunity to change their initial election (final diversification). To provide some relief, the IRS issued IRS Revenue Procedure Letter 15-36, which states the initial 90 days can start at the point the valuation is communicated to participants. This effectively eliminates the need for preliminary diversification and cuts down on the administration costs of diversification.
The qualified election period is the six-plan-year period that begins with the first plan year in which the participant becomes a qualified participant. During the first year of the qualified election period, an ESOP participant may elect to diversify up to 25% of the cumulative shares of employer stock that have been allocated to their account after 1986. Diversification elections are cumulative in nature, meaning any amount diversified in a given year reduces the total number of shares eligible for diversification in subsequent years. For example:
- Kate becomes a qualified participant in 2023 and has 400 shares in her ESOP account.
- Kate elects to diversify the full 25% in 2023 (400 shares x 25 percent = 100 shares).
- For the next four years, Kate decides not to diversify any shares.
- In 2028—Kate’s final year of eligibility for diversification—she has 600 shares in her ESOP account and chooses to diversify the full 50%.
- The amount of shares Kate can diversify is calculated as follows:
|Shares as of January 1, 2028||600|
|Plus shares previously diversified||100|
|Cumulative shares that have been allocated||700|
|Total shares eligible for diversification (700 x 50 percent)||350|
|Less shares previously diversified||(100)|
|Total shares eligible for diversification 2028||250|
Note that there’s a de minimis exception to the diversification requirement. If the fair value of the employer stock allocated to the qualified participant’s account is $500 or less, the ESOP isn’t required to offer diversification. This amount is measured on the valuation date immediately preceding the diversification election.
Three options can be used to satisfy an ESOP’s diversification requirement:
- The ESOP may make a distribution directly to the participant. The participant may then choose to reinvest the funds on their own. One thing to note with this option is that unless the distributed funds are rolled over into an IRA or another qualified plan, the individual may be subject to income tax or early withdrawal penalties on the amount distributed.
- The ESOP may establish at least three diversified investment funds with the plan in which participants can choose to invest.
- The diversified funds could be transferred to another qualified retirement plan maintained by the employer, such as a 401(k) plan, as long as that plan offers at least three distinct investment options.
As with any plan matter, it’s important to understand the diversification provisions included within your specific plan document. From a company perspective, it’s critical for management of ESOP-owned companies to understand the diversification requirements and plan for the cash needed to fund diversification elections.
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