What is Diversification?
Section 401(a)(28)(B) of the Internal Revenue Code creates a requirement for ESOPs holding employer securities to allow for the diversification of a participant’s stock account once they become a Qualified Participant. Generally, a Qualified Participant is defined as a participant who has reached age 55 and completed 10 years of participation in the Plan. Satisfying these requirements triggers the beginning of the Qualified Election Period, which is generally defined as the 6-year period beginning with the first day of the plan year following becoming a Qualified Participant.
A Qualified Participant may elect to diversify up to 25% of his stock account in years 1 through 5, and up to 50% in year 6. While diversification is only required for stock acquired by the ESOP after 1986, if your plan has been in existence longer than that, check your ESOP document to confirm whether diversification applies to all shares or only post-1986 shares.
The specific language contained in your ESOP plan document for the definition of a Qualified Participant can vary. In addition, some plans may allow for “excess diversification” either by allowing diversification up to a higher percentage or allowing for a longer time period over which to diversify. Please make sure to review your plan document and consult with SES or ESOP counsel if you have questions regarding your plan’s provisions.
What do I have to do as plan sponsor?
As plan sponsor, you have three main responsibilities regarding diversification. First, you must decide how diversification will be offered. The Internal Revenue Code allows three methods for satisfying diversification. Your plan document may allow for all three with the discretion left to you as to which of the methods you will offer to participants; or your plan document may only allow for one or two of the methods, thereby limiting which methods you can offer. Following are the three options available:
- Offer at least three distinct investment options within the ESOP (requires quarterly participant statements)
- Offer to distribute the election proceeds (can be taxable or a rollover, most common option)
- Offer to transfer election proceeds to another defined contribution plan with at least three distinct investment options (usually company’s 401(k) plan)
Second, you must provide an annual notice to participants eligible for diversification in the first 90 days of the plan year (March 31 for calendar year plans in years that are not leap years). For many ESOPs, the number of shares eligible for diversification and the value of those shares are not known by the end of this 90 day period. In the past, plan sponsors have attempted to comply with this notification in various ways including issuing multiple notices (a preliminary notice during the first 90 days and a final notice when the annual allocations are complete) or waiting and issuing one notice when the allocations are complete.
The last step is to process the diversification election within 90 days of the initial notice deadline. For calendar year plans, this deadline is June 29. If account balances have not been determined by June 29 in order to process diversification, complying with this deadline may also be an issue.
In 2015, the IRS issued sample plan document language to assist in the creation of pre-approved ESOP documents, including diversification timing. This language allows for the 90-day notice period to be extended and if extended, the 90-day period for processing the diversification does not begin until after the close of this extended election period, even if this results in diversifications being processed well beyond the 180th day of the plan year. Plan sponsors should review their plan document and procedures and consult with SES and ESOP counsel on best practices on meeting the diversification and processing requirements for diversification.
Diversification Calculation Example
Joe is a participant in the ABC ESOP. His date of birth is December 3, 1960 and he became a participant on January 1, 2004. His post-86 stock account consists of 1,000 shares of ABC Company stock and his annual allocation is 200 shares. The plan year end is December 31.
Question: When does Joe become a Qualified Participant?
Answer: Joe turns 55 on December 3, 2015 and reaches 10 years of participation on December 31, 2013, so his Qualified Election Period begins January 1, 2016.
Question: What is Joe’s eligible diversification amount for 2016?
Answer: Joe is eligible to diversify 25% in years 1 through 5, so Joe is eligible to diversify 250 shares in 2016.
Question: What happens in years 2-6?
Answer: Diversification is calculated using all post-86 shares ever allocated to a participant, so the formula looks like this:
(Shares at end of plan year + previously diversified shares) x 25% – previously diversified shares.
Year 2: (950 + 250) x 25% – 250 = 50 shares
Year 3: (1,100 + 300) x 25% – 300 = 50 shares
Year 4: (1,250 + 350) x 25% – 350 = 50 shares
Year 5: (1,400 + 400) x 25% – 400 = 50 shares
Year 6: (1,550 + 450) x 50% – 450 = 550 shares
Notice that diversification in years 2 through 5 is equal to 25% of the new shares acquired during the year. After the 6th year, Joe has diversified 1,000 of the 2,000 shares allocated to his account.
If you have any questions regarding the above information, or would like to have SES assist in your ESOP’s diversification processing, please contact your SES administrator.