ESOP Diversification
The January 1, 2007 effective date of the new investment
diversification rules for ESOPs with publicly traded stock got us
thinking about the diversification rules that extend to companies whose
stock is not publicly traded. These rules include some rather difficult
timing requirements for most ESOP companies.
The
Internal Revenue Code (“IRC”) requires that “Eligible Participants” be
given an election to diversify up to 25% of their Company Stock Account
balances each year during a five year “Election Period” and up to 50%
of their Company Stock Account balance in the 6th and final
year of the Election Period. An Eligible Participant is one who is at
least age 55 and has completed at least 10 years of participation in
the ESOP.
The IRC requires that Eligible Participants be given an election to
diversify during the first 90 days of the plan year. In addition, the
IRC requires that any elections to diversify in the first 90 days be
implemented, that is, the change in investment or the distribution,
must occur, within a second 90-day period.
Two problems will arise for most ESOP companies:
First, the Company will likely not have completed its allocations
for the prior year and the Trustee will not have received the new
annual valuation from the appraiser before the end of the first 90-day
period. So, an election form that is sent to Eligible Participants
asking for their investment instructions will not inform them of: (a)
the number of shares eligible for the diversification election, or (b)
the fair market value that will be used to convert shares to cash. Two
critical pieces of information needed for an informed decision!
Second, a significant number of ESOP companies will not have
completed their annual valuations even by the end of the second 90-day
period, and will not be able to convert electing participants’ accounts
to cash in time to meet the second deadline.
What to do?
Let’s say your calendar year company’s December 31 valuation is not
ready until July 15 of the following year. You’ve sent the first
revocable notice out as described above. Now, the Company sends a
second notice out around July 31, giving participants 30 days to elect
a distribution. The ESOP is now in technical violation of IRC
401(a)(28)(B). For a possible solution, we look to the IRS correction
program, known as the Employee Plans Compliance Resolution System
("EPCRS"). EPCRS provides taxpayers with the ability to self correct
qualification defects in their plans without risking loss of the plan’s
tax-qualified status under Section 401(a) of the IRC.
The correction principles of EPCRS would first look to place
participants into the position they would have been in had the
qualification defect not occurred. That is, as if the company had
followed the terms of the ESOP plan document requiring implementation
of elections by June 30th (for a calendar year
company). Since the company’s stock value is determined only once per
year, the amount of the distribution the participant should have
received on or before June 30th is the same as the actual distribution he received on August 31st. One
could argue that the only additional action required of the company is
to provide the participant with the lost earnings opportunity for the
period from July 1st to August 31st. While EPCRS
does not specifically address, the situation, it does provide guidance
on determining lost earnings for other purposes.
EPCRS does not provide a complete solution, because EPCRS looks to
address inadvertent or unintentional errors that occurred for a plan,
despite the plan having in place adequate procedures to guard against
such errors. In the case of ESOP diversification, the IRS might take
the position that the lateness of the election is not inadvertent or a
violation of the plan’s regular operating rules. The good news,
however, is that the violation does not appear to be one that is
specifically excluded from EPCRS. For example, EPCRS specifically
states that it is not available for egregious violations, such as for a
plan that is providing excessive benefits to the highly compensated
employees.
Conclusion
The first timing problem identified above can readily be addressed
by using a two-step revocable election form process. The second timing
problem can also readily be solved by completing the stock valuation
within the first 4 to 5 months of the new year. For companies unable to
work within that time frame, the ESOP company can look to the EPCRS
model for a workable resolution. Perhaps, given the commonality of this
problem, the IRS will one day provide additional guidance to ESOP
companies.
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