Iowa-Nebraska ESOP Chapter Conference
February 27, 2014
Doubletree Hilton Hotel
Omaha, NE
Dawn Hafner
Keith T. Peters
Diversification and Current Trends
 The Basics
 What are the Statutory Requirements for Diversification?
 Example of Calculating Shares Available
 Current Trends
 Changing the Definitions
 Beyond the Statutory Requirements
 Options for Shares Diversified
 Sticky Points
 Timing Constraints
 Years of Participation
 Calculation and Allocation Issues
 Distributions – Installments, RMD, Lump Sum +
Diversification
 Rehires
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification Basic Rules Guidance
 IRC section 401(a)(28)
 IRS Notice 88-56
 Has not been updated since 1988
 Contains procedural requirements that have been
recognized by the ESOP industry as unworkable with
closely held ESOPs
 Technical Assistance Requests
 Your ESOP Document
 Many just mimic the notice requirements
 Some additional definitions may be provided
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
3
Diversification – The Basics
Eligibility
Age 55
AND
10 years participation in the ESOP
------
Diversification election begins the year AFTER the
participant becomes eligible
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – The Basics
Elections
Qualified Participants have the election for a 6-year
period to diversify up to certain % of Post-86 company
stock in their ESOP Account
 Years 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
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – The Basics
Calculations

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 diversified
 800 – 200 = 600 ending balance shares
 Year 2 – 40 additional shares allocated
 600 year 1 ending balance + 200 add back previous diversification =
800 shares
 800 shares + 40 additional shares allocated = 840 shares
 840 X 25% = 210 shares eligible for diversification
 210 – 200 shares already diversified = 10 shares diversified
 600 + 40 additional – 10 diversified = 630 year 2 ending balance
shares
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – The Basics
Calculations
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – The Basics
Diversification Alternatives
 Cash distribution to Participant
 Taxed as ordinary income
 Subject to 10% penalty for pre-age 59½ distributions
 Stock distribution (subject to put option if closely held
company)
 Taxed as ordinary income
 Subject to 10% penalty for pre-age 59½ distributions
 Transfer to company’s 401(k) or profit-sharing plan
 Rollover to IRA
 Offer 3 or more investment alternatives in ESOP
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – The Basics
Timing for Notice & Implementation
 Election 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
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – Current Trends
Changing the Definitions
 Changing the criteria for Qualified Participants
 Amending 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?
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – Current Trends
Beyond 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.
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – Current Trends
Beyond the Statutory Requirements
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 than
 Age 55
 10 Years of Participation
 Or Both
 May allow diversification % greater than 25/50
 May allow diversification of pre-1987 shares
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – Current Trends
Beyond the Statutory Requirements
Why are we seeing Early or Extended Diversification?
 Older ESOPs – no (or few) additional shares available to
purchase from Plan Sponsor
 Assist Plan Sponsor in managing repurchase obligation
 Enables 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
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – Current Trends
Beyond the Statutory Requirements
Traditional ESOP Diversification
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – Current Trends
Beyond the Statutory Requirements
25% Election (no Add-Back)
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – Current Trends
Beyond the Statutory Requirements
25% Election Age 50 + 10 YOP (Add-Back)
*See next slide for explanation
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – Current Trends
Beyond the Statutory Requirements
25% Election Age 50 + 10 YOP
* 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.
-PREV
Year
BEGIN + NEW +PREV DIV
SUBDIV
AVAIL
DIVRS
END
Age
SHRS
SHRS
SHRS
TOTAL x 25/50%
SHRS
SHRS
SHRS
SHRS
1
Age 53
760
40
0
800
0
0
0
(200 shrs
withdrawn)
800
2
Age 54
800
40
0
840
0
0
0
(160 shrs
withdrawn)
840
3
Age 55
840
40
0
880
220
0
220
220
660
4
Age 56
660
40
220
920
230
220
10
10
690
5
Age 57
690
40
230
960
240
230
10
10
720
6 and 7
Age
58/59
720
80
240
1,040
260
240
20
0
800
8
Age 60
182.5
800
45
240
1,085
542.5
240
302.5
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
302.5
(actual)
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Diversification – Current Trends
Options 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
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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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 timeframe
 Issue 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/or
 Send out final diversification elections (to those who made
preliminary election) once year-end allocation is completed
and process distribution/transfer as soon as possible
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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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
possible
 Make 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
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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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)
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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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 views
 Participation 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

Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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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 nondistribution option
 Excess diversification
 Participant can elect to receive in shares (not required if Scorporation or by-law exception)
 May need to do discrimination testing
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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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”
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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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
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – “Sticky Points”
What if Eligible for Diversification and Payout?
 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?
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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Diversification – “Sticky Points”
What if Eligible for Diversification and Payout?
 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
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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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?
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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QUESTIONS?
Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams
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