DIVERSIFICATION AND CURRENT TRENDS

Iowa-Nebraska ESOP Chapter ConferenceFebruary 27, 2014

Doubletree Hilton HotelOmaha, NE

Dawn Hafner Keith T. Peters

Diversification and Current TrendsThe Basics

What are the Statutory Requirements for Diversification?

Example of Calculating Shares AvailableCurrent Trends

Changing the DefinitionsBeyond the Statutory RequirementsOptions for Shares Diversified

Sticky PointsTiming ConstraintsYears of ParticipationCalculation and Allocation IssuesDistributions – Installments, RMD, Lump Sum +

DiversificationRehires

2Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams

Diversification Basic Rules - GuidanceIRC section 401(a)(28)IRS Notice 88-56

Has not been updated since 1988Contains procedural requirements that have

been recognized by the ESOP industry as unworkable with closely held ESOPs

Technical Assistance RequestsYour ESOP Document

Many just mimic the notice requirementsSome additional definitions may be provided


Diversification – The BasicsEligibility

Age 55 AND10 years participation in the ESOP------- Diversification election begins the year AFTER

the participant becomes eligible


Diversification – The BasicsElections

Qualified Participants have the election for a 6-year period to diversify up to certain % of Post-86 company stock in their ESOP AccountYears 1-5: 25%Year 6: 50%Year 7+: election not available

Age 55 Diversification is not required for Pre-87 stock, but it is allowed

Election opportunity not required (but still permitted) if shares in stock account have market value of $500 or less


Diversification – The BasicsCalculations

Each year’s calculation takes into account prior year diversifications

Example – participant diversifies in years 1 & 2:Year 1 – 800 shares in ESOP Account

800 X 25% = 200 shares diversified800 – 200 = 600 ending balance shares

Year 2 – 40 additional shares allocated600 year 1 ending balance + 200 add back previous

diversification = 800 shares800 shares + 40 additional shares allocated = 840 shares840 X 25% = 210 shares eligible for diversification210 – 200 shares already diversified = 10 shares

diversified600 + 40 additional – 10 diversified = 630 year 2 ending

balance shares


Diversification – The BasicsCalculations


Diversification – The BasicsDiversification Alternatives

Cash distribution to ParticipantTaxed as ordinary incomeSubject to 10% penalty for pre-age 59½ distributions

Stock distribution (subject to put option if closely held company)Taxed as ordinary incomeSubject to 10% penalty for pre-age 59½ distributions

Transfer to company’s 401(k) or profit-sharing planRollover to IRAOffer 3 or more investment alternatives in ESOP


Diversification – The BasicsTiming for Notice & ImplementationElection must be made within 90 days after

end of plan year in which participant becomes eligible to diversify and each of the next 5 years

Distribution/transfer must be completed within 90 days after end of participant’s 90-day election period

Participant may revoke, modify or submit new diversification election any time during 90-day election period


Diversification – Current TrendsChanging the Definitions

Changing the criteria for Qualified ParticipantsAmending definition of Qualified Participant

Old: A Participant age 55 with 10 Years of Participation New: An Employee age 55 with 10 Years of Participation

Amending definition of Year of Participation Old: A Participant with an account balance in the Plan New: An employed Participant with an account balance

in the Plan New: A Participant eligible to share in the allocation of

Employer contributions and forfeitures

Transitions from old to new – what to do?


Diversification – Current TrendsBeyond the Statutory Requirements

Plan Sponsors are incorporating more flexible diversification provisions in Plan documents.

Although labeled ‘diversification’ these provisions are outside of the statutory requirements and are technically in-service withdrawals for those still employed.



Why are we seeing Early or Extended Diversification?

Plan Sponsors may allow expanded diversification

Permit diversification beyond the six year statutory period

Permit diversification earlier thanAge 5510 Years of ParticipationOr Both

May allow diversification % greater than 25/50May allow diversification of pre-1987 shares



Why are we seeing Early or Extended Diversification?

Older ESOPs – no (or few) additional shares available to purchase from Plan SponsorAssist Plan Sponsor in managing repurchase obligationEnables newer participants to receive an allocation of

shares (the Have/Have Not dilemma)Demographics of the Plan Sponsor

Economic reasons – Plan Sponsor experiencing a decrease in stock value and opts to allow qualifying participants an opportunity to diversify early

Employee Retention – By allowing withdrawal of a portion of the ESOP balance some Plan Sponsors may mitigate potential attrition



Traditional ESOP Diversification



25% Election (no Add-Back)



25% Election Age 50 + 10 YOP (Add-Back)

16*See next slide for explanation

Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams


25% Election Age 50 + 10 YOP

17

* Based on the literal interpretation of the Internal Revenue Code using highest historical balance at the beginning of the statutory period. The following reflects the calculation of the shares included in statutory diversification without regard to amounts received under expanded diversification.

YearAge

BEGINSHRS

+ NEWSHRS

+PREV DIV SHRS

SUB-TOTAL x 25/50%

-PREVDIV

SHRSAVAILSHRS

DIVRSSHRS

ENDSHRS

1Age 53 760 40 0 800 0 0 0

(200 shrs withdrawn) 800

2Age 54 800 40 0 840 0 0 0

(160 shrs withdrawn) 840

3Age 55 840 40 0 880 220 0 220 220 660

4Age 56 660 40 220 920 230 220 10 10 690

5Age 57 690 40 230 960 240 230 10 10 720

6 and 7Age

58/59 720 80 240 1,040 260 240 20 0 800

8Age 60 800 45 240 1,085 542.5 240 302.5 302.5

182.5(actual)

Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams

Diversification – Current TrendsOptions for Shares Diversified

Many Plan Sponsors are being more specific in the Plan document regarding distributions resulting from diversified shares.

Diversification for Active (employed) Participants Automatic rollover to 401(k) plan Very few offer directed investment funds within ESOP

Diversification for Terminated Participants Rollover to IRA or another qualified plan Taxable


Diversification – “Sticky Points”Timing Constraints

Stock valuation and year-end allocations often are not completed within 90/180 day timeframe

Potential options to meet this requirement:Have valuation completed within given timeframeIssue a preliminary election form for completion within

the 90-day election period (could make this revocable)Implement preliminary election with respect to stock

balance from the most recent allocation and/orSend out final diversification elections (to those who

made preliminary election) once year-end allocation is completed and process distribution/transfer as soon as possible


Diversification – “Sticky Points”Timing Constraint - Impact

What happens if you don’t notify participant that they are eligible? Provide election opportunity to them as soon

as possibleMake them “whole” if stock value declined

Any correction for lost earnings or updated value needed if past 180 day period?Discuss with ESOP Counsel and Trustee


Diversification – “Sticky Points”Years of Participation Determination

Plan Document should define - Carefully read definitions and “definition within the definition”

Eligibility definition, year of service definition and year of participation definition are not all the same

Technical Assistance #2 – November 2009 provided some further guidance (indicated you cannot be more restrictive than what document currently states) May use participation (any year with account balance) May use a year of service (i.e., require 1,000 hours or less)


Diversification – “Sticky Points”Years of Participation Determination

For mid-year entrants when is a year credited? One day worked = year of participation or anniversary date is one year?

Do years of participation accrue for former participants? Plan document should define What happens if participant met age 55/10 before

termination and then terminates?Years of Participation for Short plan years?

Discuss with ESOP counsel as different viewsParticipation in other plan counted (merger or use of

assets)? Participation should be counted if assets from the plan

were used to purchase ESOP shares or if ESOP is added to or merged within existing plan


Diversification – “Sticky Points”Diversification Calculation/Election Issues

What is definition of “Ever Allocated”? – Include +/-? (In-service, RMD’s, installments)

Reduce by past withdrawals outside of diversification?

Distribution restrictions apply to 401(k) and Safe Harbor money sources Need to use other sources to diversify or utilize a

non-distribution optionExcess diversification

Participant can elect to receive in shares (not required if S-corporation or by-law exception)

May need to do discrimination testing


Diversification – “Sticky Points”Allocation Issues

“Guidance” indicates that must preclude shares being diversified being returned to accounts

Are shares a participant diversified able to be reallocated back to them?

Are they precluded from receiving stock due to other rebalancing or reshuffling (such as converting terminated participants’ accounts or repurchases)?

Rebalancing is an acceptable practice as long as it is not discriminatory and the shares rebalanced do not “undo” the diversification.

Reshuffling may also be acceptable as long as there is a definite allocation formula, the result is non-discriminatory and the participant’s diversification is not “undone”


Diversification – “Sticky Points”What if Eligible for Diversification and Payout?

A participant could be eligible for both a distribution and diversification

How to determine what they can receive? Pay both? Pay one and then update balance and pay other? One can satisfy the other? Greater of both? Make sure not to overpay

Timing requirements for diversification need to be met

Best to define in Plan Document and/or Distribution Policy



Example:Mary has 1,000 shares in her account when she

separates in Year 0.Distributions are handled via 5 annual

installments of 200 shares; she receives an installment distribution of 200 shares in each of Years 1, 2 and 3, leaving 400 shares in her account at the end of Year 3.

In Year 4, she is eligible for an installment distribution of 200 shares

Assume she is also first eligible in Year 4 to diversify 25% of the shares “ever allocated” to her ESOP account (i.e., 1,000 * 25% = 250 shares).

The distribution shares (200) and diversification shares (250) sum to 450 shares, yet there are only 400 shares in her account?



How do you pay out the participant? Prorate the 400 equally (i.e., distribute 200

and diversify 200) Diversify the 250 first, and distribute the

remaining 150 Make a timely distribution of the 200 shares

and allow this to offset the 250 available for diversification, resulting in a net diversification amount of 50 shares


Diversification – “Sticky Points”Rehires

How to count years of participation?Keeping counting while they have a balance?Don’t count in years they are not employed?If paid out, counter stops while they are gone

and resumes when rehired?If paid out in full, do you add back past

shares paid out or start over?


QUESTIONS?


Documents

DIVERSIFICATION AND CURRENT TRENDS