ESOP Diversification Rules and Requirements

An Employee Stock Ownership Plan (ESOP) is a retirement plan that invests primarily in the stock of the employer. This structure allows employees to gain an ownership interest in the company, aligning their financial interests with the firm’s performance. While this can be a powerful wealth-building tool, it also creates a concentration of risk, as a large portion of an employee’s retirement savings is tied to the fortunes of a single entity.

To mitigate this concentration risk, the Internal Revenue Service (IRS) has established rules that permit long-term employees to diversify their holdings as they approach retirement. The specific regulations depend on whether the company’s stock is publicly traded or privately held.

Diversification Rules for Privately-Held Company ESOPs

The diversification rules for ESOPs at privately-held companies allow long-term employees to reduce their investment risk as they near retirement age.

Determining Eligibility for Diversification

To be eligible to diversify, an employee must be classified as a “Qualified Participant.” This designation is granted to an employee who has reached age 55 and completed a minimum of 10 years of participation in the ESOP. The definition of a “year of participation” is determined by the specific ESOP plan documents.

Once an employee becomes a Qualified Participant, they enter the “Qualified Election Period.” This is a six-plan-year window during which they can make diversification elections. The period begins with the first plan year after the employee has satisfied both the age and participation requirements.

Calculating the Diversification Amount

The diversification rules apply to employer stock acquired by the ESOP after December 31, 1986. For the first five years of the qualified election period, a participant has the right to diversify up to 25% of the total shares of post-1986 stock allocated to their account. This 25% limit is cumulative, not annual.

For example, if a participant with 1,000 eligible shares diversifies 100 shares in year one, they can still diversify up to 150 more shares during the next four years.

In the sixth and final year of the qualified election period, the diversification limit increases. During this last year, the participant can elect to diversify up to 50% of their total post-1986 shares, calculated on a cumulative basis. If the participant had diversified 250 shares in the first five years, they could diversify an additional 250 shares in year six to reach the 500-share maximum.

Diversification Rules for Publicly-Traded Company ESOPs

ESOPs that hold publicly traded employer securities are subject to different diversification requirements established by the Pension Protection Act of 2006. These rules are broader and provide diversification rights to more participants, not just those nearing retirement.

Any participant who has completed at least three years of service has the right to diversify the portion of their account funded by both employee and employer contributions. These rules allow participants to direct the plan to divest the employer stock and reinvest the proceeds in at least three other investment options with different risk and return characteristics.

The Diversification Process and Options

The ESOP administrator must provide the participant with a diversification election form within 90 days following the end of each plan year within their election period. Once the election is made, the plan has up to 180 days after the close of the plan year to complete the transaction.

For private company ESOPs, participants have three options for managing the funds they choose to diversify, though availability depends on the specific plan.

• In-plan transfer: The value of the diversified stock can be moved into another qualified retirement plan sponsored by the employer, such as a 401(k). The participant can then invest those funds across the various options offered within that plan. Some ESOPs may also offer at least three distinct investment alternatives within the ESOP itself.
• Direct rollover: The funds can be transferred to an Individual Retirement Account (IRA) or another qualified plan outside of the company. This allows the participant to move the funds into a self-directed account, preserving the tax-deferred status of the retirement savings.
• Cash distribution: The participant can receive a direct cash distribution. This option has significant tax consequences, as the distributed amount is considered ordinary income and is subject to federal and state income taxes. If the participant is under age 59½, the distribution is also subject to a 10% early withdrawal penalty.