ESOPs have their own special set of rules regarding the timing of distributions to terminated participants with vested account balances. IRC Section 409(o)(1)(A) instructs the distribution of the participant’s account balance in the plan will commence not later than 1 year after the close of the plan year—
(i) in which the participant separates from service by reason of the attainment of normal retirement age under the plan, disability, or death, or
(ii) which is the 5th plan year following the plan year in which the participant otherwise separates from service, except that this clause shall not apply if the participant is reemployed by the employer before distribution is required to begin under this clause.
As an example, John Doe terminates employment on November 15, 2012 for a reason other than normal retirement, disability, or death. If the ESOP has a calendar year plan year, John needs to begin receiving a distribution of his vested account balance no later than December 31, 2018. To meet this requirement, the plan administrator should allow John to receive a distribution after the December 31, 2017 recordkeeping is completed in 2018, so the distribution can be processed by December 31, 2018.
Sounds simple, right? If it were only that easy. There are a number of exceptions to the timing rules above that an ESOP administrator needs to understand and monitor.
Financed Securities Exception
IRC Section 409(o)(1)(B) allows an ESOP to implement a special delay of distributions related to the stock balances in a terminated participant’s account that were purchased with an exempt loan. A distribution of those shares does not need to occur until the close of the plan year in which such loan is repaid in full.
While this clause can be applied to all terminated participants, plan documents normally limit it to terminated participants other than retired, deceased and disabled participants. Most plan sponsors do not want to apply the extra delay for retired, deceased, and disabled participants. The ESOP plan document must indicate who this provision applies to in order for it to be applicable in the administration of the plan.
Required Minimum Distributions (RMDs)
ESOPs must comply with the Required Minimum Distribution rules of IRC Section 401(a)(9).
General Qualified Plan Distribution Requirements
ESOPs must comply with the distribution commencement rules of IRC Section 401(a)(14) that apply to all qualified retirement plans.
Death Benefits 5-Year Rule
As stated in IRC Section 401(a)(9)(B)(ii), in some cases the entire interest of the deceased participant must be distributed to the beneficiary within 5 years after the death of the participant. This requirement supersedes the Financed Securities Exception, which is another reason to not use the loan delay option for deceased participants.
There can be flexibility built into the timing of ESOP distributions. Creating a written distribution policy to compliment the plan document and further define the timing of distributions to plan participants is a best practice and a good way to communicate the current distribution process to the ESOP participants.