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      Resource Center

      ESOP Plan Design and Document Drafting

      In "How An ESOP Program Is Put Together – Some Assembly Required," we provide an overview of how to put together an ESOP program for a closely held company.  This article explains how to approach the task of designing and drafting the ESOP plan document.  We'll explain how to take into account the special features that make ESOPs different from other retirement plans.  We'll also look at ESOP transaction issues that affect plan design for a privately held corporation (as opposed to a publicly traded company).  For third party administrators (TPAs) who might attempt to prepare ESOP documents using a "mail order document," this article identifies some of the options that might be available in the document and some of the "boilerplate" provisions that need to be read and perhaps edited to achieve the right plan design.

      ESOP design and drafting issues fall into the following five categories:

      • Administration driven issues;
      • Multiple plan design issues;
      • Fiduciary duties;
      • ESOP design alternatives; and
      • ESOP peculiarities.

      Administration Driven Issues

      Eligibility and Entry 

      Starting at the beginning, the eligibility and entry provisions for an ESOP are typically different than for a 401(k) or other type of retirement plan. Since ESOPs typically seek to cover the largest number of employees possible, their eligibility provisions are often more generous.  Eligibility may be simply any plan year or twelve-month period in which a participant has 1,000 hours of service.  The entry date provisions for an ESOP usually do not follow the multiple entry date pattern that most 401(k) plans use.  Instead of quarterly or monthly entry dates it makes sense to "enroll" ESOP participants only once a year.  In keeping with the objective of covering a large number of employees, simply enrolling those employees retroactively as of the first day of the year in which they become eligible is often the simplest and most effective plan design.  This garners the largest eligible compensation base in any given year.  While some employers' plans call for participation on the next following entry date, the first day of the plan year is the simplest to administer and achieves the broadest base of participation.

      Crediting Service for Eligibility and Vesting

      When adopting a new ESOP, the employer will often wish to credit hours of prior service so that as many people as possible participate in the plan in the first year of the plan's existence.  Thereafter, a "one year of service" criteria is applied to all newcomers to the plan for eligibility purposes.

      Crediting service for vesting, however, is another matter. An ESOP often will not credit service prior to the effective date of the plan for vesting purposes.  This is partly because rewarding long-term employees over newer employees is usually a primary objective for an ESOP.  It is also partly because ESOPs typically receive larger contributions than other defined contribution plans (for companies of a similar size) and the employer has to raise the necessary liquidity to pay for the stock benefits.  Crediting prior service for vesting accelerates that need to raise liquidity.  There are exceptions to this approach, such as ESOPs that have never been or will never be leveraged (meaning, they didn't borrow money to buy stock).  However, most ESOPs are leveraged and most start vesting "from scratch."

      All of this wisdom holds true unless the employer is adopting an ESOP which is an amendment of an existing non-ESOP plan, or where the employer has terminated an existing defined contribution plan within the five years prior to adopting the ESOP.  In either of these situations, the ESOP will be considered a "successor plan" to the other plan and will be required to credit service for vesting and eligibility.  In some situations, this is not detrimental and may be desirable, but, it is something to watch out for.  The employer may have to freeze the existing plan or leave the existing plan in place for a number of years to permit the ESOP to be written the way the employer desires.

      Vesting Schedules

      There are several vesting schedules available to ESOPs.  The preferred choice depends on the situation.  Most defined contribution plans use a six- or seven-year "graded" vesting schedule in which the participant vests in some percentage of their account each year until they are 100% vested by the end of the sixth or seventh year.  Most ESOPs can also use a five year "cliff" schedule.  Under this schedule, participants do not vest at all until they have five years of vesting service at which time they are 100% vested.  This schedule typically favors long-term employees of a company.  Participants who leave in years one through four leave behind their account balance for the long-term employees, who receive a reallocation of the forfeited unvested balances.

      Allocation Formulas

      The allocation formulas that an ESOP can use are limited.  Integrated allocation formulas (those that are "integrated" with the employer's social security contributions and which provide greater benefits to employees whose compensation exceeds the social security taxable wage base) are not available and, therefore, the vast majority of ESOPs (with only a few exceptions) allocate employer contributions in proportion to participants' compensation.

      Even with these limited allocation alternatives, ESOPs can use some creative contribution rates and formulas to achieve their employee ownership objectives. For example, matching contributions or employer discretionary contributions in employer stock may be made in different amounts to employees of different divisions or subsidiaries in a controlled group of corporations (based on corporate performance), as long as these contributions pass the applicable discrimination tests on an overall basis. It is also possible to allocate ESOP benefits using a formula that is, for example, weighted to take into account service or age, even though the safe harbor rules cannot be used to establish that the allocation meets the nondiscrimination rules.  Allocations in an ESOP may also be different for designated groups of employees.

      Multiple Plan Design Issues

      Coordinated Limits 

      If the employer has another plan in addition to the ESOP (for example, a 401(k) plan), the terms of the two plans must be carefully coordinated.  First, the limit on annual additions to participants' accounts under Internal Revenue Code (Code) section 415 must be coordinated.  It must be clear which plan's allocations are reduced in order to avoid excess annual additions.  For example, the 401(k) plan's annual administration will often be completed prior to the ESOP's administration.  In this case, it may make sense to provide that the ESOP contribution will be limited to coordinate the overall annual addition between the two plans.  On the other hand, if the ESOP is part of a KSOP, it may be better to distribute 401(k) deferral amounts that would otherwise cause a participant to exceed the Code section 415 limit.  If this approach is taken, it must be clearly communicated to participants that their deferrals may be subject to limitation and refund.  Alternatively, the potential funding for both plans can be calculated, a cap on elective deferrals can be established, and a limit on the ESOP contributions can be made to "fail safe" the plan against Code section 415 excesses.

      On the subject of excess allocations, ESOP share forfeitures are reallocated within the plan at fair market value.  Forfeitures must also be included in the annual addition calculation under Code section 415.  Forfeitures of unvested ESOP shares should be watched carefully to determine their impact on the overall Code section 415 limit.  They may not be dramatic in the early years due to deferred vesting, but room must be made for them in the administration of the plan accounts.  This is particularly true if the ESOP has a five-year cliff vesting schedule.

      Top Heavy Coordination

      Generally, a plan is "top heavy" when at least 60% of the plan's assets are in the accounts of key employees.  Because ESOPs are broad-based plans and include many employees, it is not typical for ESOPs to be top heavy.  However, it is possible for an ESOP to be top heavy when aggregated with another plan of the employer.  The two plans must be coordinated as to which plan will receive the top heavy contribution.  This can be a particular problem in the first year of the ESOP if the existing plan is top heavy.  Plan years must be coordinated so that the employer is not put in a position of having to contribute to both plans if that is not intended.

      Safe Harbor 401(k) Plans

      Some positive effects can result from the coordination of an ESOP and a Safe Harbor 401(k) plan.  If the employer is maintaining a complex 401(k) plan and an ESOP, the relatively high contributions to the ESOP can be used to qualify for the 401(k) nonelective contribution safe harbor.  The only design change that may be required would be fully vesting the three percent 401(k) Safe Harbor contribution that is made as part of the ESOP contributions.  For companies with existing ESOPs with significant funding that wish to start a 401(k) plan, the advanced vesting of the participants in the ESOP may make this a no additional cost alternative for getting a free pass from the complexities of ADP testing in the 401(k) plan.

      On the subject of 401(k) plan coordination, an ESOP can also be used as the vehicle for receiving matching contributions in the form of employer stock.  A formula can be written into the ESOP to permit the employer to match the employee contributions in stock in proportion to the elective deferrals that the employees make in the other plan.  This allows the employer to make a cash-less matching contribution and potentially a larger match than they would otherwise fund in the 401(k) plan and thus encourage 401(k) participation by the rank and file employees.

      Fiduciary Duties

      This is where most "boilerplate" mail order ESOP documents will cause problems if they are not carefully tailored, amended and edited.  The fiduciary issues of an ESOP are unlike those of any other plan.  For closely held corporations, the issues relating to holding employer stock are complex, create conflicts of interest, and are highly charged issues for both plan participants and the regulators at the Internal Revenue Service (IRS) and the Department of Labor.  No effort should be spared in ensuring that the fiduciary provisions accurately reflect the proper allocation of fiduciary responsibilities and functions.

      The corporation should never be named or left to be the "default" plan administrator.  An administrative committee should be selected or an individual should be named as plan administrator of the ESOP.  Many "outside" corporate directors who are not involved in the ESOP's operation would be surprised and chagrined to learn that they are personally liable for the acts of the plan administrator because the corporation became the plan administrator by default.  The typical form plan provision says "if the corporation does not name an administrative committee the corporation will be the plan administrator." This may seem harmless except that at least in the Ninth Circuit, there is no corporate shield for fiduciary liability for the actions and responsibilities defined under ERISA and directors are personally liable for fiduciary acts of the corporation.  Corporate directors may find that their directors and officers liability policy does not cover them for the acts of whoever improperly denied a participant's benefit claim on behalf of the corporation as plan administrator.

      Be clear and precise as to who has the authority for reviewing and approving the appraisal report.  Similarly, be clear as to who has authority and responsibility for responding to participants' requests for information, disclosure of documents or disputes over benefits.  Finally, be clear as to who has responsibility for determining the funding policies for the plan (i.e., the amount of cash to contribute for things like repurchase liability).  In each situation, if the wrong party is exercising discretion, then complex, annoying and expensive entanglements often ensue.  For example, it may not be difficult for a participant to establish in court that a denial of benefits was arbitrary and capricious where the wrong party acted to deny the claim.  Both the consultant or lawyer drafting the document and the client should read the fiduciary provisions and ensure that they understand how they work and who is doing what.

      ESOP Design Alternatives

      ESOPs can be drafted as simple stock bonus plans with ESOP provisions or as combinations of other types of plans.  An ESOP can contain a money purchase pension plan component. ESOPs also can be combined with 401(k) plans. These are often referred to as KSOPs.  Almost without exception, we recommend that 401(k) plans and ESOPs be kept in separate documents.  ESOPs and 401(k) plans are very different for almost all of the reasons listed above.  If all of the needs of the 401(k) plan and all of the needs of the ESOP are to be accommodated, you will essentially have two plans in a single document.  This is cumbersome, if not unintelligible.  Dual sets of entry provisions, dual sets of distributions provisions and maybe dual sets of fiduciary provisions could result.

      ESOPs are also amended and restated on different schedules than 401(k) plans, due to the IRS's handling of determination letters and regulations each time the law changes (although, this concern is going away with the IRS's repeal of the required plan determination letter cycles).  Finally, 401(k) plan administrators often have a preference for their own volume submitter or prototype documents with familiar 401(k) language that may be difficult to find in some attorney's ESOP hybrid plan documents.  These caveats for separate ESOP and 401(k) plan documents may fall by the wayside if the ESOP is in a publicly-traded corporation or the ESOP is going to contain a "401(k) plan sweep" feature that allows deductible dividends paid on ESOP stock to be "swept" into a 401(k) plan on a pre-tax basis (perhaps the subject of another article in the future).

      ESOP Peculiarities

      Diversification Election

      At the heart of the character of ESOPs lies a handful of required ESOP provisions that do allow for some creativity.  The way these features are viewed varies from ESOP drafter to ESOP drafter.  Plan sponsors should discuss with their advisor how best to use these ESOP features.  For example, handling the required stock account diversification election (required for participants over age 55 with ten years of ESOP participation) can vary significantly.  If the employer has a 401(k) plan, the three required investment options can be offered in the 401(k) plan.  However, if the employer does not have another plan and the stock is not publicly traded, the simplest choice may be to provide a cash distribution option to get the diversification account amount out of the ESOP.

      Voting Rights

      ESOP voting rights also provide design options even though some rights are required by statute.  The law requires non-publicly traded ESOP stock to be voted by participants only in extreme situations (e.g., merger, reorganization, liquidation, recapitalization or sale of substantially all of the assets of the company's trade or business).   However, it is possible to design the ESOP to permit participants to vote on every matter before the shareholders.  It is also possible to design a one-person-one-vote provision into the ESOP documents if the desire is a "people's republic" approach to corporate governance.  It is important for the fiduciaries and the board of directors to understand what the ESOP plan document says in any event.


      ESOP distribution rights and requirements differ greatly from those of other plans.  There are required distribution timelines for certain events such as death, retirement and disability.  For other events, there is some flexibility.  For example, an ESOP can suspend all distributions (other than those related to death, disability or retirement) until an ESOP loan is repaid.  An ESOP can be designed to make participants wait up to six years after they leave the company (if they quit or are fired) before they begin receiving distributions, and then pay them out over a five-year period of time.  There is a lot of room for creativity and flexibility within these parameters.  However, the starting point for the drafter is to sit down with the client and show them the comparative treatment under the statutory distribution rules so that they can make an informed design decision.

      Often, distribution timing will be driven by the funding of the plan and the size of the benefits that are anticipated to flow from the ESOP.  The distribution provisions can also be changed in the future, if need be.  However, since there is some controversy over the scope of the ESOP exception to the "anti-cutback rule," caution should be exercised in designing the distribution provisions at the outset to provide flexibility for the future without running afoul of the participants' rights to forms of distribution under ERISA.

      Finally, on the cutting edge of ESOP distribution design, some drafters provide for pre-distribution segregation accounts. That is, in the six-year waiting period between termination of employment and actual distribution of the benefits, some ESOP documents call for transferring the participant's accrued benefits into a non-stock account where the participant is credited "interest" or is invested in a secure form of investment.  The rationale for this ranges from "former participants should be protected from the stock's 'volatility'" to "the growth in the stock should be preserved for participants who stay with the company."  Under either rationale, caution should be exercised in how and when the segregation accounts are employed to avoid fiduciary mishaps. Unfortunately, we have seen segregated accounts that were not actually funded at all, but were simply bookkeeping entries that were required to be funded in the future by the employer.  This may seem to work fine (for the company) when the stock value is going up, but can cause havoc if the stock value declines or if the plan is terminated and these "phantom" accounts must be funded.  (Just try explaining to an IRS representative reviewing the determination letter filing why "liabilities exceed assets at termination.")

      What to Do?

      This is not an exhaustive treatment of all the issues that go into drafting an ESOP document.  However, hopefully this article gives employers and TPAs a feel for the multiple levels of issues that need to be addressed when designing and drafting an ESOP.  In the event you are working with a "mail order document," take the time to understand the complexity of the task at hand.  ESOPs, more than any other employee retirement plan, are actually read by participants and plan administrative committees, and need to be understood by all those involved and responsible.  The plans need to work within the company's employee benefits program and fit within the finance objectives of the corporation.  Of course, from our perspective, the best plan documents are built from scratch by someone who does what it takes to get a plan document that works the way the company needs it to work.

      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.