To complete my blog series on ESOP distributions, today I’d like to discuss the methods of distributions available to ESOPs. For information on Timing of ESOP Distributions and Forms of ESOP Distributions, please visit my previous blog posts.
While qualified retirement plans have to adhere to the anti-cutback rules of IRC Section 411(d)(6) regarding amending the methods of distributions, ESOPs have an exception to this requirement as long as changes are made in a nondiscriminatory manner.
IRC Section 409(o)(1)(C) states an ESOP can pay lump sum distributions or installments:
in substantially equal periodic payments (not less frequently than annually) over a period not longer than the greater of—
(i) 5 years, or
(ii) in the case of a participant with an account balance in excess of $800,000, 5 years plus 1 additional year (but not more than 5 additional years) for each $160,000 or fraction thereof by which such balance exceeds $800,000.
Additional Installments for Large Account Balances
As noted above, the Plan Sponsor can increase the number of installments paid to participants with large account balances up to an additional 5 years. The IRS announces the updated limits yearly when it issues the cost of living adjustments. For example, the 2012 calendar year eligible account balance must be in excess of $1,015,000 and an additional installment can be added for each $200,000 in excess of the $1,015,000 minimum balance. As a result, if an ESOP participant terminates in 2012 and has an account balance of $1,600,000, the Plan Sponsor could pay out the participant in 8 installments instead of 5.
What is better – Lump Sum vs. Installments?
ESOP companies with terminated participants with vested account balances have to decide what method(s) of distribution they will use. Sometimes a company will use both methods, with the determining factor being the reason for termination. For example, participants that terminate due to death, disability, or retirement will be paid in a lump sum distribution. Participants that terminate for another reason will be paid installments. An alternative approach is to pay lump sum distributions up to a certain dollar threshold and installments to anyone with a balance above the plan defined dollar limit.
Proper planning with performing a repurchase obligation study in conjunction with setting a desired benefit level for the ESOP participants should assist a company in making the appropriate decision for their plan.
There are multiple methods that can be used in the ESOP distribution processing. Creating a written distribution policy to compliment the plan document is an example of a best practice and a good way to communicate the current distribution process to the ESOP participants.