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      ESOP Diversification Myths and Misunderstandings

      The special diversification rules that apply to ESOPS often are misunderstood by plan sponsors, fiduciaries, participants and plan administration professionals.  Small wonder.  Even when coming from ESOP experts, the information can be contradictory and confusing.  So it's not surprising that the diversification rules in practice can differ from what the Internal Revenue Code (Code) and IRS guidance literally require.[1]  But failing to comply with the diversification requirements can result in a fiduciary breach and cost the ESOP its tax qualified status.  A better understanding and monitoring of the rules can help avoid these pitfalls.  A good start toward that understanding is a look at the five myths surrounding ESOP diversification.  But first a little background.

      The Code and the Three Roads to Diversification Satisfaction

      The Code provides that each "qualified participant" may elect, within 90 days after the close of each plan year, to direct the plan as to the investment of at least 25% of the participant's stock account in the first five years of a qualified election period.  In the sixth and final year of the qualified election period, the stock account balance subject to the diversification election is increased to 50%.  The diversification must be accomplished no later than 180 days after the end of the plan year for which the election was made (i.e., 90 days after the end of the 90-day election period).

      A "qualified participant" is an employee age 55 or over who has participated in the plan for at least 10 years.

      The "qualified election period" is the six-plan year period beginning with the later of the first plan year:

      • In which the employee (or in some instances, former employee) first becomes a qualified participant; or,
      • Beginning after December 31, 1986.

      There are three ways a plan can satisfy the diversification requirement:

      • Distribute the portion of the participant's account subject to the diversification in cash or in stock, subject to the ESOP put option provisions (depending on the terms of the plan);
      • Offer at least three investment options to each participant making the diversification election, and invest the amount diversified as directed by the participant; or
      • Offer a participant the option to direct the plan to transfer (in cash) the portion of the account subject to the diversification election to another qualified defined contribution plan of the employer that offers at least three investment options.

      Myth No. 1:  The company doesn't have to plan for diversification because it's 10 years down the road.

      There are multiple issues here.  From the company's perspective, diversification should be viewed as a liquidity event that should be taken into account for financial planning purposes when the ESOP is formed and when an ESOP transaction occurs.  It is part of the repurchase obligation that goes hand in hand with distributions that occur when participants terminate employment, and it should be taken into account and periodically monitored as part of the ESOP's repurchase liability study.

      In ESOPs that own a majority or all of the company stock or when the value of the stock is appreciating rapidly, substantial cash may be needed to fund distributions and diversifications.  Cash requirements for repurchases can vary significantly from year to year because of the demographics of the employee population.  Many companies estimate their annual repurchase obligations and set aside funds to help meet the cash flow needs taking into account the distributions they anticipate due to retirements or other terminations and diversification elections.  Providing liquidity for repurchasing the stock due to distributions (diversification or otherwise) is the plan sponsor's responsibility.  The ESOP may, but is not required to, use its cash to satisfy diversification elections.

      Myth No. 2:  The plan sponsor failed to notify or allow a qualified participant to elect diversification for a plan year, but it can skip diversification for that year and make it up next year.

      No. Diversification is one of the annual administrative requirements for an ESOP.  You must be able to demonstrate compliance every year on the right numbers – the number of shares in the account and the correct percentage of shares eligible for diversification.  The diversification requirements not only are the law (it's in the Code), the plan document likely contains either the minimum statutory requirements or more liberal requirements that must be followed.  Failing to comply with the statutory requirements or operate the plan in accordance with its terms could jeopardize the tax-qualified status of the plan and result in a breach of fiduciary duty.  If you miss the diversification notice, election and distribution periods, it's a bad idea to ignore it.  Taking steps to comply is recommended.

      Depending on the facts and circumstances of the omission or failure, the plan sponsor may be able to correct the failure to meet the diversification requirements through the Employee Plans Compliance Resolutions System (EPCRS), either by filing an application with the IRS under the Voluntary Correction Program or through self-correction.  Any correction must be documented by the proper plan fiduciaries, including the plan sponsor, trustee and plan administrator.  Fiduciary resolutions should memorialize the correction process, which can include providing a diversification election form to the participant even though the election period has passed.  The participant should be made whole.  The Department of Labor's Voluntary Fiduciary Correction Program earnings calculator can be used to calculate lost earnings.  In some instances, depending on the length of time involved and the fluctuation of the stock price, an updated appraisal may be advisable.

      Myth No. 3:  During the Qualified Election Period, 25% of the participant's stock balance must be diversified each year.

      Not exactly. The 25% and 50% of the qualified participant's stock account balance is cumulative over the entire six-year qualified election period.  It's not 25% and 50% of the current stock account balance each year.  If a participant diversifies the maximum 25% in any year during the qualified election period, subsequent elections are not available unless the participant's stock account balance increases, or it is the sixth and final year of the qualified election period, and the participant can diversify up to 50% (instead of 25%) in the aggregate.  Additional shares of stock typically are allocated to participant accounts when (1) distributions are made to other participants and shares are recycled in the ESOP; (2) forfeitures are allocated; (3) additional shares are purchased by or contributed to the ESOP; (4) the ESOP is leveraged and a loan payment (based on dividends or a contribution) is made and shares are released from the suspense account.

      Myth No. 4:  The participant must be offered the right to diversify no matter how small his or her stock account is.

      It depends.  There is an exception to the diversification requirement for accounts that are $500 or less (de minimus rule).  Be sure to check your plan document, summary plan description (SPD) and your diversification notices and distribution election forms to ensure that they are consistent and identify this exception.

      Myth No. 5: You don't have to provide an election notice to participants until the annual valuation is completed.

      True, but only recently!  The Code requires that participants be allowed to make a diversification election within 90 days following the end of each plan year during the six-year election period and that elections may be modified or revoked, or a new election may be made, anytime during that 90-day election period.  However, in 2015, the IRS provided guidance that the diversification election period may be stretched out to 90 days following the date on which the participant is provided with the prior year's share value.  This guidance was needed relief for participants and administrators who struggled to comply with a rule that required participants to make a diversification election often without knowing the current share price.  

      You can design or amend your plan to allow other options.  If you do, be sure to understand the interplay of the "statutory" diversification requirements and the "enhanced" or "nonstatutory" diversification requirements under the plan.  You may be creating a "right or feature" in your plan that may only be amended out on a prospective basis and must be administered in addition to the statutory diversification requirements.  Additional diversification options may also be overlooked or improperly administered and trip you up in your legal compliance.  

      What To Do

      The best defense is a good offense.  By the time you reach that tenth year, your ESOP administration should be running like a well-oiled machine.  Strive to have management, your TPA and your ESOP appraiser work together to meet the diversification timeline: notice and election 90 days after the stock value for the plan year to which the election applies is provided to the participant; executing the diversification no later than 90 days after the last day of the election period.

      To make sure your diversification elections are handled properly, be proactive and talk to your TPA to ensure that you know who is responsible for what.  For instance, who is responsible for tracking which and when participants are eligible for diversification?  Who will monitor the election/revocation period and distribution period?  Who will provide timely notices to participants for elections and who will make distributions?  Who will monitor completion of the annual administration and annual valuation in order to meet the diversification timeline?

      Make sure your TPA is familiar with the diversification provisions in YOUR plan.  "Standard forms" may not incorporate the same provisions that are in your plan document.  Review your SPD and distribution notices and forms to ensure that they are accurate.  If you are using standard forms provided by your TPA, have your legal counsel who drafted the plan review the forms for accuracy and consistency, or ask your lawyer or plan document provider to prepare diversification and distribution forms tailored to the provisions of your plan.

      Also remember, practicalities don't trump the Code.  You do not need to know the value of the shares when the election notice is given, but the participant does need to know how many shares are in his or her account and subject to diversification.  It's not 25% of the value of the company stock account that the participant may or may not elect to diversify, it is a cumulative number of shares.  If it's impossible to provide complete and accurate information within the timing requirements, provide your best estimate or use the prior year's information with a caveat to participants that the actual diversification will reflect the final administration amounts.  This caveat, however, does not extend the statutory election period or distribution period.

      When mistakes happen (and they are inevitable from time to time – we're all human), don't ignore the omission or oversight.  Give the participant the right to elect diversification even though it's late.  Participants may not elect to diversify their accounts, but if they do, evaluate whether each participant is owed lost earnings due to the mistake, and document the corrections process through fiduciary resolutions and plan amendments, if necessary.

      Editor's Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government's rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660.

      [1] This article is limited to diversification requirements that apply to stand alone ESOPs with non-publicly trade stock.