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When an unforeseen event happens that disables a participant from continuing employment, the termination may provide additional ESOP benefits to the former employee.  Question is... do you know how your ESOP defines disability?

The ESOP plan document will dictate the definition of disability for purposes of the ESOP administration.  Participants meeting the disability definition as stated in the ESOP may share in ESOP allocations they otherwise would not share in, as well as additional vesting.  In addition, they will be eligible for an earlier distribution than other participants that terminate for reasons other than death, disability, or normal retirement under the plan.

Common Disability Definitions

Since the law does not require a specific definition for disability, plan documents are drafted with optional definitions.  The three common disability definitions found in ESOP documents are as follows:

  1. Determined by the Plan Administrator.  This definition provides the Plan Administrator the greatest amount of authority in determining if an employee is disabled, as they are the deciding factor if a participant is disabled or not.

  2. Determined by a Physician.  Plan documents can be written to state if a doctor determines a participant is disabled, they meet the disability requirements of the plan.  The plan document may state the physician has to be selected or approved by the Plan Administrator.

  3. Social Security Definition.  A plan using this definition will not deem a former participant disabled until they are considered disabled per the U.S. Social Security Administration

"Disability" under Social Security is based on your inability to work. We consider you disabled under Social Security rules if:

      • You cannot do work that you did before;

      • We decide that you cannot adjust to other work because of your medical condition(s); and

      • Your disability has lasted or is expected to last for at least one year or to result in death.

Taxation of Benefits

Regardless of what definition is used in the ESOP plan document, the IRS has defined disability to determine if a participant is excluded from the 10% additional tax on early distributions from qualified retirement plans.  A participant who receives a taxable disability distribution before age 59 ½ is not subject to the early withdrawal penalty if they met the IRS disability definition as stated in IRC §72(m)(7):

Meaning of disabled

For purposes of this section, an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.


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