We have recently discussed some of the statutory ESOP distribution rules:
- ESOP Distribution Timing: Death, Disability, Retirement
- ESOP Distribution Timing: Other Separations of Service
- ESOP Distribution Timing: Loan Exception
- ESOP Distribution Timing: Latest Commencement Date
- ESOP Distribution Timing: Required Minimum Distributions
- ESOP Distribution Timing: Qualified Domestic Relations Order (QDRO)
- ESOP Distribution Timing: Mandatory Distributions
- ESOP Distribution Timing: Diversification
Generally, an ESOP plan document will provide for the maximum statutory distribution rules mentioned above. In addition to the statutory requirements, the company also needs to manage cash flow and the annual employee benefit level to ensure that the company and ESOP remain sustainable in the long-term. To provide more flexibility, the company may implement a separate ESOP distribution policy. While some companies initially implement an informal unwritten distribution policy, especially in the early years of the ESOP, a best practice is to implement and maintain a separate written ESOP distribution policy document and make sure that it remains consistent with the way that distributions are processed.
The IRS Wants to Review Your ESOP Distribution Policy discusses how the IRS has decided to begin reviewing the ESOP distribution policy as part of the determination letter submission process and still recommends that a separate document be maintained:
Until this year, the IRS reviewed the ESOP plan document to verify that the maximum statutory distribution provisions were contained in the plan, but did not require submission of the ESOP's distribution policy details. Now, however, the IRS has decided to review the detailed distribution provisions of each ESOP. While this new requirement might make you think about incorporating the detailed distribution rules into the plan document, a separate distribution policy likely remains the best approach because this document can more easily be modified as needed to accommodate the company's cash flow and employee benefits objectives.
Regardless which terms and provisions form the ESOP distribution policy, the company's cash flow requirements and repurchase liability planning likely will require changes to the distribution policy throughout the life of the ESOP. While each change to the ESOP distribution rules could be made in the form of a formal amendment to the ESOP plan document, changes to the ESOP distribution policy (which usually is only 1-3 pages in length) generally are much simpler and can be made much more easily. For this reason, most plan sponsors have elected to make use of a distribution policy separate from the plan document.
While maintaining a separate ESOP distribution policy is considered by many to be a best practice, we previously discussed some things to consider before implementing a separate distribution policy in a discussion on ESOP Distribution Issues to Avoid with Plan Documents, Distribution Policies, and Distribution Paperwork.
Also remember that IRC Section 411(d)(6)(C) - Accrued benefit not to be decreased by amendment - Special rule for ESOPs generally provides that your distribution policy may be modified in a nondiscriminatory manner.