So, let’s say you’ve decided an employee stock ownership plan (ESOP) is an attractive option for transitioning away from owning your business, and you’ve discovered that your company is a great candidate for employee ownership.
You like the idea of leaving a thriving company in place. An ESOP’s flexibility available in terms of financing the transaction works for you, and you’re satisfied knowing you can get fair market value for your business.
Plus, the idea of moving ownership over to the loyal employees who’ve helped your business grow and thrive over the years … Let’s say it just feels like the right thing to do.
So, what comes next?
As you design your company’s ESOP, eligibility requirements are among the details that need to be decided and documented. In order to satisfy Internal Revenue Service (IRS) nondiscrimination guidelines, the plan needs to meet minimum age and service requirements, but there may be other factors you’ll want to consider.
In this article, we’ll review how ESOP eligibility requirements factor into developing and documenting your plan.
ESOP Minimum Age and Service Conditions
As a qualified retirement plan, an ESOP is required to cover a substantial percentage (70%) of non-highly compensated employees who are at least 21 years old and who have completed a year of service. That makes basic eligibility rules pretty straightforward:
- You can require, if you choose, for employees to be at least 21 years old before they can be eligible for ESOP participation; you can extend eligibility to younger employees, but you may not require a minimum age that is higher than 21
- You can allow employees to become plan participants immediately, or you can require a waiting period that’s as long as one year of service or 1,000 hours of service within 12 months, with exceptions for breaks in service under IRC Section 410(a)(5)
- Plan entry can be delayed by an additional year, to two years, under the condition that employees are immediately fully vested at two years of service
The eligibility requirements you select can make your ESOP simpler or more complicated to administer. For example, companies that hire seasonal employees, or that experience a lot of turnover, may benefit from extending the eligibility period to two years — but it’s vital to understand that any employee meeting the eligibility requirement must be immediately and fully vested at the two-year mark.
It’s also important to understand that creating stricter eligibility requirements may impact an ESOP’s coverage of employees, which can have an effect on nondiscrimination testing (an IRS condition of qualified retirement plans).
How many covered employees does it take to make an ESOP work? There are a few — very few — plans with fewer than 10 employees, and quite a few more with 10-20 employees, but most have at least 15 to 20 plan participants. Typically, the goal is to achieve a balance between covering that IRS-required substantial percentage of non-highly qualified employees without making the ESOP too complicated, costly, or difficult to administer.
Employees Who May Be Excluded from ESOP Participation
ESOP plan documents commonly exclude certain individuals from participating in the ESOP, even though they otherwise meet participation requirements under IRC Section 410(a). Among commonly excluded employees are the following individuals:
- Leased employees; excludable leased employees are defined in IRC Section 414(n)
- Employees of related employers, also known as “affiliated employers”
- Independent contractors, which are not defined as employees and whose remuneration is reported on an IRS Form 1099-MISC, and not an IRS Form W-2
- Collective bargained employees, also known as union employees, since union agreements typically negotiate retirement benefits that do not include ESOP participation
- Nonresident aliens, who are neither U.S. citizens nor lawful permanent residents allowed to work without restriction in the U.S.
Plan Entry Date Requirements for Participating Employees
Once an employee has met your ESOP eligibility requirements, the plan document will indicate the entry date when the employee has become a participant. According to IRC Section 410(a)(4), eligible employees must commence participation no later than:
- The first day of the first plan year after they reach eligibility, or
- The date 6 months after they reach eligibility
— whichever comes first (unless the employee separates from service in the period between attaining eligibility and the required date of participation).
Learn about Diversification Eligibility: How to Ensure Compliance With ESOP Diversification Requirements
Protect Your ESOP’s Qualified Plan Status
One of the most important things to remember about an ESOP is that, as a qualified retirement benefit, regulatory compliance is essential. That means, should your plan exclude any of the above described individuals who perform work for your organization, make sure that your coverage testing accurately reflects the individuals who need to be included in the test.
Keeping up with important filing deadlines is another critical practice that helps protect your plan. Our free Month-by-Month Calendar for Annual ESOP Planning can help you meet this objective. Just click below to download your copy.