ESOP Distribution Policy - Timing

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Oct 22, 2013
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ESOP Retirement CheckDo you have an ESOP distribution policy?  If you have ever paid a distribution, then the answer is yes.  All companies that have paid ESOP distributions have adopted some form of a distribution policy and established precedent.  Adopting a written distribution policy is best practice as it helps demonstrate that you are operating your ESOP distribution policy in a nondiscriminatory manner and gives the company more flexibility to modify the distribution policy in the future.

Distribution policies must comply with the statutory minimum requirements from the Internal Revenue Code.

Some plan documents provide for a specific distribution policy within the document and other plan documents provide more flexibility – it is essential that your distribution policy is consistent with the plan document and SPD.

To the extent consistent with regulatory requirements and your plan documents, a written ESOP distribution policy documents the timing, method, and form of how the company processes ESOP distributions.  A written distribution policy can then be modified as needed to ensure the policy continues to meet the objectives of the company, to manage cash flow, and to control the employee benefit level. 

ESOP Distribution Timing: Death, Disability, Retirement

The Internal Revenue Code provides that ESOP distributions to participants that terminate as a result of death, disability, or retirement must begin no later than 1 year after the end of the plan year of the termination date. For example (assuming a 12/31 plan year end), if a participant terminates after meeting the retirement provisions of the plan on August 15, 2012, the participant must begin receiving payments after the December 31, 2012 allocation is completed (which should be sometime in 2013), and the payments must begin by December 31, 2013.

ESOP Distribution Timing: Other Separations of Service

The Internal Revenue Code provides that ESOP distributions to participants that terminate for reasons other than death, disability, or retirement must begin no later than 1 plan year after the end of the 5th plan year after the year of termination. For example (assuming a 12/31 plan year end), if a participant terminates on June 29, 2012, the participant must begin receiving payments after the December 31, 2017 allocation is completed (which should be sometime in 2018), and the payment must begin by December 31, 2018.

ESOP Distribution Timing: Loan Exception

If there is an outstanding ESOP loan, the Internal Revenue Code allows payments to be deferred until the close of the plan year in which the loan is paid in full.

[For S Corporation ESOPs, there is some controversy about the loan exception because the Code only references the C Corporation deduction limit language of IRC Section 404(a)(9). However, many S Corporation ESOPs still utilize the loan exception. To gain more comfort, the loan exception should be included in your plan document so you are able to obtain a determination letter and gain more comfort.]

ESOP Distribution Timing: Latest Commencement Date

In addition to the distribution rules provided for under IRC Section 409(o), ESOPs are also subject to the distribution rules that apply to all qualified retirement plans.  The Internal Revenue Code provides that distributions must generally begin no later than the 60th day after 1) the later of age 65 (or the normal retirement age if earlier), 2) the 10th anniversary of participation in the plan, and 3) termination from service.

The Code also provides that if a participant met all of the early retirement plan provisions (if applicable) except for the age requirement, that they are entitled to the same benefits upon attaining the early retirement age.

Both of these provisions could impact the distribution commencement date. They also supersede the ESOP Loan Exception.

ESOP Distribution Timing: Required Minimum Distributions

Generally participants are required to begin receiving Required Minimum Distributions (RMDs) after reaching age 70½ and terminating service from the company.

ESOP Distribution Timing: Qualified Domestic Relations Order (QDRO)

Depending on the plan rules, a plan may pay the alternate payee of a Handling Qualified Domestic Relations Order (QDRO) before the plan participant is eligible for a distribution.

ESOP Distribution Timing: Mandatory Distributions

Distributions generally cannot be forced by the company and cannot be processed without the written election of the participant. However, a company can make mandatory distribution to terminated participants with an account balance of $5,000 or less.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) amended the Internal Revenue Code to provide that, effective March 28, 2005, involuntary cash-out distributions of more than $1,000 must be automatically rolled over to an IRA. Check your plan document to see if your plan has these plan provisions.  The safe harbor rollover language was incorporated into the 2009 Safe Harbor Notice of Tax Treatment (402(f) Notice).

ESOP Distribution Timing: Diversification

The Tax Reform Act of 1986 established the ESOP diversification rules under IRC Section 401(a)(28) that provide that that a qualified participant (age 55 with 10 years of participation) must be given the opportunity to elect to diversify a portion of their ESOP account during their qualified election period (25% for first five years and 50% in the sixth and final year).

Our next ESOP Distribution Policy article will discuss the form and method of ESOP distributions...


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Topics: ESOP distributions, Employee Stock Ownership Plan (ESOP)

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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