Employee stock ownership plans (ESOPs) have unique restrictions and special flexibility when making distributions. ESOP companies that understand these limitations and options are in the best position to comply with the distribution rules while also effectively managing repurchase liability and the participant experience. In this article, we summarize the distribution rules applicable to ESOPs. In a future article, we will discuss distribution policies and why they can be helpful tools in managing distributions.
Why Do ESOPs Have Different Rules?
ESOPs are unique for many reasons, including that an ESOP company typically has a direct and significant financial interest in how and when distributions are made. Although distributions may be made in the form of company stock, for most ESOP companies, they are typically made directly or indirectly in cash. This is because employers usually do not want former employees to hold company stock and enjoy potential appreciation after they terminate employment and cease creating value for the company. Likewise, former employees usually want cash over company stock because company stock held by ESOPs is usually illiquid with little or no marketability. Additionally, company stock may be volatile in comparison to alternative investments that could be obtained with cash. Thus, to achieve this mutually desired outcome, the ESOP company must have cash to purchase the stock from the participant or to effectively allow the ESOP to do so.
The Internal Revenue Code (IRC) recognizes the need for ESOP companies to have flexibility in managing distributions and the resulting demands on cash. However, this need is balanced by the retirement needs of participants who may be best served by accessing and diversifying their retirement funds tied up in company stock sooner rather than later.
What Special Distribution Rules Apply to ESOPs?
IRC Section 409 sets forth the special rules governing ESOP distributions, including:
- Method of Distribution: An ESOP distribution generally may be made in a lump sum or in substantially equal installments over a period of up to five years.
Special Rule for Large Balances - If the value of the account exceeds $1.38 million (indexed for inflation), the distribution period may be extended by one year (but not more than five additional years) for each $275,000 (indexed for inflation) by which the value of the account exceeds $1.38 million.
- Timing: The timing parameters for distributions are dictated by the reason for, or timing of, the participant’s termination of employment. If the participant terminates employment after reaching normal retirement age or due to death or disability, distributions must begin by the end of the plan year following the plan year of termination. Otherwise, distributions must begin by the end of the sixth plan year following the plan year of termination.
Special Rule for Leveraged ESOPs - Notwithstanding the general rule, the distribution of company stock acquired with the proceeds of a securities acquisition loan generally may be delayed until the close of the plan year in which the loan is repaid in full. It is important to note that this exception only clearly applies to ESOPs sponsored by S corporations and does not override other generally applicable distribution rules such as those discussed further below.
- Form of Distribution: An ESOP sponsored by an S corporation or a corporation with a charter or bylaws that restrict substantially all stock ownership to employees or a qualified trust may make distributions in cash or stock. An ESOP sponsored by a C corporation with no such charter or bylaws restriction may also make distributions in cash or stock, but the participant has a right to demand that the distribution be made in stock.
Special Rule for S Corporation or Corporation with Charter/Bylaws Restriction - An ESOP sponsored by such a corporation may make distributions in company stock, subject to a requirement that the participant immediately resell the stock to the company.
Special Rule for Private Company Stock - If an ESOP distributes company stock that is not immediately repurchased and the company stock is not readily tradeable on an established market (i.e., a public company), the participant has a right to require that the sponsor repurchase the stock. This is referred to as a “put option” and must be provided for a period of at least 60 days after the stock is distributed and, if not exercised at that time, for another period of at least 60 days during the following plan year.
- Diversification: ESOPs must permit participants who have reached age 55 and completed 10 years of participation in the ESOP the opportunity to begin diversifying their investment in company stock. While this is not strictly a distribution rule, many ESOPs satisfy this requirement by distributing any amounts that a participant elects to diversify under this rule.
What General Distribution Rules Apply to ESOPs?
In addition to the special rules above that apply exclusively to ESOPs, other distribution rules that apply generally to all defined contribution plans also apply to ESOPs, including:
- Age 65, Termination, or 10th Anniversary: Notwithstanding any distribution rule to the contrary (including the special rule for leveraged ESOPs noted above), ESOPs must allow participants to take a distribution no later than the 60th day following the last day of the plan year in which the latest of the following events occur: (1) the participant reaches age 65 (or, if earlier, the plan’s normal retirement age); (2) the 10th anniversary of the participant’s commencement of participation in the ESOP; or (3) the participant’s termination of employment.
- Required Minimum Distributions: Notwithstanding any distribution rule to the contrary, a participant generally must begin receiving distributions no later than April 1 following the calendar year in which the participant attains the “applicable age,” or, if later, terminates employment. The applicable age is currently 73.
- Small Amount Cash-Outs: ESOPs may require that participants who terminate employment with accounts valued at $7,000 or less receive a mandatory lump sum distribution. This rule is optional but very common.
- Distributions Without Consent: ESOPs may make distributions without the participant’s consent upon the participant reaching the later of age 62 or normal retirement age. ESOPs may also make distributions to the beneficiaries of a deceased participant without consent of the beneficiary. Consent is generally not required for distributions under a qualified domestic relations order, except as provided in the order. Furthermore, the consent requirement does not apply to required minimum distributions.
As illustrated above, there are overlapping and intertwining rules dictating how distributions must be handled by an ESOP. Understanding these rules is key to maximizing the flexibility to manage distributions and the cash demands on the company, including the company’s repurchase liability.
If you have questions about ESOP distributions, please contact one of the attorneys in the Employee Benefits and Executive Compensation Practice Group at Bradley.