United States: A Primer On ESOP Distribution Rules

This article will present a brief overview of the rules relating to when and how a participant in an Employee Stock Ownership Plan (ESOP) is paid out. Note that the ESOP distribution rules discussed below are set forth in the tax code as minimum standards. In other words, an ESOP’s distribution rules must meet these requirements, but it is also acceptable for an ESOP to be designed so that its distribution provisions are more liberal.

The most important three issues involving distributions from an ESOP are commencement, duration and form of payment. "Commencement" relates to determining when an ESOP must begin to make benefit payments. "Duration" relates to determining over what period of time the participant’s entire benefit must be paid out once payment begins and "Form" relates to the different types of payment that are required or permitted.

The "Commencement" rules are controlled in large part by the circumstances under which the ESOP participant terminates employment. The "Duration" rules are very flexible and will depend greatly on an ESOP’s liquidity. The "Form of Payment" requirements center on a participant’s right to demand distribution in shares of employer stock and the circumstances under which this stock demand right can be eliminated.

This article deals with comment, duration and form of payment from an ESOP if the participant has terminated employment, and addresses in-service distributions of taxation of all ESOP distributions.

I. When The Participant Terminates Employment

1. Commencement. A retirement plan that is "tax qualified," like an ESOP, generally provides for benefits to be paid to a participant when employment terminates with the plan’s sponsor (usually, the employer) on account of retirement, disability, death, or resignation.

In determining when a participant’s ESOP benefits will commence, there is a critical distinction between (1) the employee who retires, dies, or becomes disabled ("Employee #1"), and (2) an employee who terminates employment for some other voluntary (or involuntary) reason ("Employee #2"). The general rule is as follows:

Employee #1: Generally, an ESOP must begin to distribute vested benefits for this employee during the plan year following retirement, disability, or death.

Employee #2: Generally, an ESOP must begin to distribute vested benefits no later than the end of sixth plan year after the plan year in which the participant’s termination occurred (there are separate rules that apply if the participant is rehired before the end of that period).

Remember that these are minimum standards. For example, an ESOP would be free to begin commencement of Employee #1’s benefits immediately after retirement, disability, or death. Likewise, an ESOP could commence Employee #2’s benefits at any time between termination of employment and the latest date set forth above. In all events, however, the ESOP should have a distribution policy under which it treats similarly terminated employees in the same or similar fashion.

2. Exceptions to General Commencement Rule. As with anything else, there are exceptions to the commencement rules. An ESOP may delay the commencement of distributions mentioned above in two notable situations. First, if the ESOP has borrowed money to acquire any of the shares in a terminated participant’s account, the ESOP may restrict those shares from being distributed (or cashed-out) until the end of the plan year during which the loan that was used to acquire those shares is completely paid off. Second, an ESOP is permitted to restrict the distribution of stock that was acquired by an ESOP before 1987 until after a participant reaches retirement age.

These requirements are intended to work in tandem with the generally applicable qualified plan distribution rules to accelerate an otherwise applicable commencement date for benefits. For example, assume that a non-leveraged ESOP has a normal retirement age of 65, and that an individual began participating in that ESOP at age 60 and works until normal retirement age, at which time he becomes fully vested in his benefit. Under general qualified plan distribution rules, a plan could be drafted to delay his distribution until 10 years after he began participating in the plan, i.e., when he was 70. The ESOP distribution rules discussed above will accelerate the distribution and allow the participant to a distribution from the ESOP no later than one year after the end of the plan year in which the participant retired, i.e., at age 66. On the other hand, if there was an outstanding ESOP loan involved (assume the loan is to be totally repaid in the year that the participant attains the age of 75), then the general qualified plan distribution rules would provide for a distribution at age 70. This "trumps" the exception for financed shares discussed above. The important thing to note is that a participant must receive his distribution at the earliest commencement date provided for by law.

3. Duration and Form. Once ESOP distributions commence, they may be made in a lump sum or in substantially equal payments (not less frequently than annually) over a period no longer than five years. The five-year period can be extended an additional year for each $155,000 or fraction thereof by which a participant’s benefit exceeds $780,000 (for 2001). The "extension" can add a maximum of five (5) additional years to the duration of the distribution. ESOP distributions can be made in the form of cash or stock.

II. When The Participant Is Still Employed

In certain circumstances, a participant may receive benefits from the ESOP while still employed:

• ESOP participants may "diversify" their accounts after a certain period and receive cash or stock directly (this can also be done "inside" the ESOP);
• The employer may choose to pay dividends directly to participants on company stock allocated to their ESOP accounts;
• An ESOP must generally begin distributing benefits to an ESOP participant who owns at least 5% of the company stock after the participant reaches age 70½, even if still employed.
• Other circumstances may also warrant an in-service distribution from an ESOP, such as after a fixed number of years, upon attainment of a specified age, or upon "hardship."

III. Taxation Of ESOP Distributions

No tax is paid on benefits that a participant accrues in an ESOP account until the participant receives a distribution. The distribution is subject to ordinary income tax on the full amount of cash received; shares of stock distributed to a participant are taxed as ordinary income to the extent of the ESOP’s cost basis in such shares, unrealized appreciation in the shares is taxed at capital gains rates when the shares are ultimately sold by the participant (normally immediately following distribution). There is an additional 10% penalty on top of the income tax if the participant takes a distribution other than on account of death or disability and he or she is younger than age 59½ (or age 55 following termination of employment). The income tax and/or the penalty can be avoided if the participant rolls the benefit over into an Individual Retirement Arrangement or, if the participant works for another employer, that employer’s qualified retirement plan. If the money is rolled over into an IRA or successor plan, the employee pays no tax until the money is withdrawn; at which point it is taxed as ordinary income.