Over their years of work at a company that sponsors an employee stock ownership plan (ESOP), participants accumulate stock share allocations in their ESOP accounts.
An ESOP is designed so that when a vested participant leaves the company, the value of the ESOP account is distributed to that former employee. The ESOP trust (or company) repurchases the employee’s shares and the employee receives payment, which they can choose to roll over into an individual retirement account (IRA) within a stipulated time limit, or pay income tax (along with an additional 10% excise tax if under age 59-½) and use as they would any other income.
The payout process is determined by the ESOP document and the distribution policy effective for the plan. In most cases, when an employee terminates, they must start receiving their distributions in the year that follows termination, and distributions must be completed within five years, as substantially equal payments that take place at least annually. Distributions of very large ESOP balances can be extended even longer.
But what happens when, rather than retire or leave the company, the ESOP employee dies? How does the employee’s death impact the distribution of their ESOP account balance?
Let’s take a look.
Internal Revenue Code Regulates ESOP Distributions
U.S. Title 26, Internal Revenue Code (IRC), Section 409, covers qualifications for tax credit employee stock ownership plans in detail, and spells out regulatory requirements for distributions that an ESOP must meet. Meeting these regulatory requirements is of fundamental importance in order for the plan and sponsoring company to merit an ESOP’s tax advantages.
IRC Section 409(o)(1)(A)(i) states:
(o) DISTRIBUTION AND PAYMENT REQUIREMENTS
A plan meets the requirements of this subsection if —
(1) DISTRIBUTION REQUIREMENT
(A) In general
The plan provides that, if the participant and, if applicable pursuant to sections 401(a)(11) and 417, with the consent of the participant’s spouse elects, 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 …
In simpler terms, ESOP distribution requirements after death of a fully vested employee include the following:
- The ESOP must begin distribution of the deceased participant’s account balance no later than one year after the close of the plan year in which the participant dies. For example, if the employee passes away before the end of this year, beneficiaries must begin receiving distribution payments before the end of next year.
- Those payments can be made as substantially equal installments over a period up to 5 years, longer for very large account balances. In 2022, the maximum ESOP account balance subject to a 5-year distribution period is $1,230,000. The 2022 dollar amount used to determine the lengthening of the distribution beyond 5 years is $245,000.
- As a qualified retirement plan, an ESOP provides the benefit payable to the beneficiary or beneficiaries designated by the plan participant. For this reason, it is fundamentally important that the sponsoring employer ensures current, executed ESOP beneficiary forms are on file for every ESOP participant. It’s especially important for employees to review beneficiary designations in the case of marriage, divorce, the birth of a child, or other significant life events.
- If a participant wishes to designate a non-spousal beneficiary, the spouse must consent in writing. Most ESOPs’ plan documents include a Spousal Consent to Beneficiary Designation form or Spousal Waiver form, which the employee’s spouse would execute and notarize to indicate their consent for the participant to select (an)other individual(s) — and not the spouse — as beneficiary.
Beneficiaries may wonder about how to claim an ESOP distribution after the death of the participant. Those lump-sum payments are typically subject to normal income tax rates.
A Written Distribution Policy is an ESOP Best Practice
Whether your ESOP has a written distribution policy or not, if it has ever paid a distribution, the plan has created a precedent and adopted an ad hoc policy.
A better practice is to ensure all contingencies are covered and clarified in plan documents. This not only helps make sure all plan stakeholders are aware of policies and requirements; it also helps your ESOP demonstrate for regulatory purposes that it’s operating in a nondiscriminatory way. By having a written policy, you also reserve the right to review and revise the policy in the future.
Learn more about ESOP distribution requirements and how to meet them when you download our free eBook, ESOP Distribution Policy – Timing, Form and Method. Just click the link below to claim your free copy.