Practical Tips for Handling Diversification Distributions
By Barbara Clough
Code Section 401(a)(28) provides the regulatory details with respect to diversification of stock balances in an ESOP participant’s account. Plan sponsors are required to provide participant notifications and process diversification payments to participants. From a practical standpoint plan sponsors should keep in mind that plan participants may only diversify the stock portion of their account balance. The statute provides diversification to plan participants who have attained age 55 and completed 10 years of participation as of the last day of the plan year be allowed the opportunity to divest 25 percent of their account balance. The amount available for diversification is a cumulative amount meaning that previously diversified shares are included in the calculation. In the sixth diversification year the percentage allowed is increased to 50 percent. Following is an example of the calculation:
The regulations allow plan sponsors three methods to satisfy diversification payments: (1) payment directly to participant subject to required withholding or payment to participant’s rollover account; (2) transfer to another plan sponsored by the employer subject to the requirement that three essentially diverse options are available; or (3) transfer within the ESOP to participant directed investment options available within the plan. From a practical standpoint, most plan sponsors choose not to utilize the third option due to fiduciary concerns with respect to investment option choices as well as regulatory requirements where plan sponsors must provide quarterly statements to participants within 45 days from the end of each calendar quarter, which can be costly from an administrative standpoint as well as difficult to meet the timing constraints.
Plan sponsors should work closely with service providers to identify those participants who will be eligible to diversify and to determine the number of shares available for diversification. Within 90 days of the close of the plan year, plan sponsors must notify those participants who are eligible to diversify of their right to diversify. The notification should include a best estimate of the shares available for diversification as well as the stock value as of the previous plan year-end. The notification can be simply a notice of rights or alternatively a "survey says" approach where participants indicate whether they may choose to receive payment; this approach works well for plan sponsors who are trying to quantify a potential liability. Within 180 days of the close of the plan year the regulations stipulate that the participant must receive the diversification distribution. Oftentimes the stock value is not available or the allocations and compliance testing have not yet been completed. From a practical standpoint plan sponsors may elect to delay distribution until the year-end updates have been complete, with the understanding that this could be questioned in the event of a governmental audit. Another option is to process a partial payment and true up once the year-end work is complete. It is prudent for plan sponsors to be consistent in their approach as well as discussing their logic and processes with counsel.
Barbara Clough, director, Plan Administration
Blue Ridge ESOP Associates