The following piece is a guest blog written by one of our partners, Jason C. Ray of Morgan Lewis and Bockius, LLC.

A common question from ESOP sponsors that has been popping up recently is about the diversification requirements in their plan – not just about who should be given the election, but also about when the election should be given and how to calculate the portion of the account eligible for diversification.  It’s important to keep this requirement in mind and monitor the ESOP participant population year by year, because failing to comply with this requirement can result in a breach of fiduciary duty and possibly jeopardize the ESOP’s tax-qualified status.  Moreover, monitoring this obligation also aids in getting a handle on the company’s repurchase obligation.

ESOP Diversification

Each eligible ESOP participant (“Eligible Participant”) must be provided the opportunity to diversify up to 25% of his or her company stock account each year over a five year period, then increasing to 50% during the sixth and final year.  These percentages are cumulative over the entire election period – – it is not 25% each year in the first 5 years and then 50% in the sixth year.  An Eligible Participant is a current participant or former participant who has attained age fifty-five and completed at least ten years of participation in the ESOP.  The Eligible Participant must be given the right to diversify within 90 days following the end of the plan year in which he or she is eligible to diversify.  If the Eligible Participant elects to diversify his or her account, the shares of company stock must then be diversified within the 90 days following his or her 90-day election period.

All shares of company stock previously diversified are included in calculating the required number of shares available for subsequent years.  In other words, the shares of company stock previously diversified are added back into the account balance, then the applicable percentage (25%, or 50% if in the sixth year of the election period) is applied and the prior amounts are then subtracted from the result.

Valuation Issues

Eligible Participants must make a decision whether or not to diversify a portion of their company stock account within 90 days following the end of the plan year in which they are eligible to diversify.  The trustee of the ESOP then has 90 days to diversify the Eligible Participant’s account. Thus, as you can see, the diversification must be accomplished within 180 days after the end of the plan year.  However, privately-held companies may not have a current valuation within this required time frame in order for the trustee to accurately diversify the Eligible Participant’s account.  In such a situation, the diversification election form that the Eligible Participant completes must contain express language that conveys the following: (i) the number of shares of company stock available for diversification are stated in lieu of a market value; and (ii) the Eligible Participant is hereby notified that the shares of company stock will be diversified based on the prior stock valuation, with an adjustment made when a new value is known.

Satisfying the Diversification Requirement

There are three ways an ESOP can satisfy the diversification requirement:

    1.  Distribute the portion of the Eligible Participant’s account subject to the diversification;
    2.  Offer at least three investment options to each Eligible Participant making the diversification election, and invest the amount diversified as directed by him or her; or
    3.  Offer the Eligible Participant the option to direct the ESOP to transfer (in cash) the portion of the account subject to the diversification election to another qualified defined contribution plan of the employer that offers at least three investment options.

The ESOP does not have to offer all three of these diversification options.  It can offer only one if so desired.  But again, remember that whichever method is used (or elected), it has to be accomplished within the 180-day period after the plan year.

More Liberal Diversification

Nothing in the Internal Revenue Code prohibits more liberal diversification, i.e., requiring nine years of participation instead of ten.  The financial condition of the company may warrant more liberal diversification.  For example, an employer may want to provide for more liberal diversification to address repurchase liability obligations.

If the employer decides to allow for more liberal diversification, the ESOP must be amended to avoid problems of not following the terms of the plan (i.e., an operational failure which would have to be rectified through the IRS’ Voluntary Correction Program).  In other words, a company cannot implement a more liberal diversification requirement through the mere administration of the ESOP without a formal amendment.  In addition, the ESOP’s terms must reflect that the right is currently available on a nondiscriminatory basis.  For example, if the only Eligible Participants allowed to diversify after nine years of participation are highly compensated employees, the new diversification provisions could fail the nondiscriminatory availability requirement.

Years of Participation

A “year of participation” is not defined in the Internal Revenue Code.  However, recent technical guidance released by the IRS states that a definition of “year of participation” used by an ESOP for purposes of Code section 401(a)(28) may not require the completion of more than 1,000 hours of service, and an hour of service requirement is not mandatory.  Therefore, a “year of participation” may be defined under the ESOP as a year in which an individual has an account balance under the ESOP, regardless of whether he or she is actively employed in such year and/or eligible to receive a contribution/allocation under the ESOP for such year.

If the ESOP is a converted profit sharing or money purchase pension plan or the ESOP feature is added to another plan, years of participation under the pre-ESOP plan are counted for purposes of determining eligibility for diversification.  Also, if the ESOP is the vehicle used in a defined benefit plan asset reversion, years of participation under the terminated defined benefit plan are counted for purposes of determining eligibility for diversification.

Part of the Company’s Repurchase Obligation

Diversification should be considered an event that should be taken into account for repurchase planning purposes.  It is part of the repurchase obligation just like with normal distributions that occur when participants terminate employment.  Diversification should be taken into account whenever a repurchase liability study is performed.

When ESOPs are a majority shareholder or when the value of the stock is skyrocketing, substantial cash may be needed to fund distributions and diversifications. Cash requirements for repurchases can vary significantly from year to year because of the demographics of the participant population. Planning for repurchasing the stock due to distributions (diversification or otherwise) is the ESOP sponsor’s responsibility. The ESOP may, but is not required to, use its cash to satisfy diversification elections.  Careful monitoring of the ESOP participant population is key to avoiding “repurchase surprises.”

Guidelines for Diversification

Step 1: Determine participant’s eligibility for diversification.

Step 2: Determine the number of shares held by the Eligible Participant that are available to be diversified.  The calculation involves the sum of the current year’s eligible company stock balance plus all shares held in the account of the Eligible Participant that were previously diversified, multiplied by the appropriate percent (25% or 50%, as applicable) and the sum of all shares previously diversified is then subtracted from the result.  For example, Jane Doe’s second year account balance consists of three hundred shares of company stock.  Last year, Jane elected to diversify fifty shares which was 25% of her balance at that time.  Her current amount eligible for diversification would be 37.50 shares, or (25% of (300 + 50)) – 50.

Step 3: Send Eligible Participants a notice of right to diversify and a diversification election form, along with information regarding investment fund elections, if available, and the tax consequences resulting from the distribution of the amount received from the sale of the diversified shares.  Eligible Participants will have 90 days after the plan year to make an election.  Privately held companies that do not have the current valuation done in time for the Eligible Participants’ election period must contain the necessary language mentioned above.

As the growing number of ESOPs continue to mature, repurchase liability and diversification issues come to the forefront.  ESOP sponsors can never be too diligent in addressing these issues early on.