A distribution policy is a helpful tool for ESOP companies to comply with distribution requirements while retaining maximum flexibility. In a prior article, we reviewed the rules governing ESOP distributions. In this article, we discuss how ESOP companies can implement and utilize distribution policies to best manage distributions within the confines of these rules.

What is a distribution policy?

A distribution policy is typically a separate document focused solely on distributions made from an ESOP. Unlike the plan document, a distribution policy is intended to be a living document that can be more easily revised and updated on a regular basis by the plan administrator without the same level of formality required of a plan amendment. Ideally, if a distribution policy will be used, the terms of the plan will set forth the statutory distribution provisions subject to the terms of the distribution policy. A distribution policy is most useful when it describes the primary distribution requirements in straightforward terms and presents the plan administrator with a menu of options and features that can be changed with fill-in-the-blank or check-the-box simplicity.

Although a distribution policy is a separate document from the plan document, it is an integral part of the plan. As such, it is advisable that the distribution policy and any related selection forms be approved by the plan administrator, signed by an authorized representative, and retained with the plan records. Government agencies clearly have the authority to request a copy of any distribution policy, and participants likely do as well. 

What are the key features of a distribution policy?

• Timing of Distributions: The Internal Revenue Code (IRC) generally dictates only the latest dates by which distributions must begin and be made, but it generally does not limit the ability of an ESOP to provide for earlier distributions following termination of employment. Thus, a distribution policy may be used to begin distributions sooner than what is required under the IRC. For example, instead of waiting until the following plan year to distribute the account of a participant who is deceased, the distribution policy could provide for the distribution to be made in the year of the participant’s death.

• Lump Sum Threshold: If a “lump sum threshold” is established, account balances that are equal to or less than the lump sum dollar threshold are distributed in a single lump sum. Account balances that exceed the threshold are distributed in installments. Different lump sum thresholds may be established for different types of distributions. For instance, a lump sum threshold may be established for distributions made to participants who terminate employment after reaching retirement age but not for other distributions.

• Number of Installments: As noted in our prior article, installments must be substantially equal and generally made over no longer than a five-year period. For distributions that are made in installments, the distribution policy can establish how many installments will be made. For example, instead of distributions in five annual installments, the distribution policy may provide for three annual installments.

• Minimum Annual Installment Threshold: When a minimum annual installment threshold is established, the remainder of an account balance that began payment in installments will be paid out fully once it falls below the stated dollar threshold. Typically, when a lump sum threshold is used, a minimum annual installment threshold will be set to the same amount.

• Extension for Large Balances: The distribution policy can be designed to impose or not impose the permissible extension of the maximum five-year installment distribution period for large balances.

• Loan Repayment Delay: If the ESOP is eligible to delay distributions with respect to company stock that was acquired with the proceeds of a securities acquisition loan, the distribution policy can be designed to impose or not impose the permitted delay and may do so only with respect to certain types of distributions.

How may a segregation provision impact a distribution policy?

If the ESOP has a segregation provision under which stock in the accounts of participants are converted to cash, the company may want to address how that provision affects distributions and the distribution policy. Typically, to the extent the account is segregated, the company will allow for a lump sum distribution (or, if a distribution is not made, the account balance will be transferred to the company’s 401(k) plan). If the company does not allow for a distribution to be made, then the regular distribution provisions will apply, but the company will have to determine how the funds will be invested, taking into account fiduciary considerations.

What is an example of how a distribution policy is used?

Assume that “Acme ESOP,” which provides for the use of a distribution policy, has always made distributions in accordance with the statutory requirements and has not imposed any loan repayment delay. That is, distributions have been made in five annual installments beginning either in the first or sixth year following the year of the employee’s termination, depending on the age of the participant and the reason for the termination. No account balances are large enough for the large account balance extension to be available.

This year, Acme Inc. wants to use some of its available cash to accelerate distributions and avoid the liability to fund these distributions in the future, which will grow if the accounts remain invested in company stock and the stock value increases. Once the value of company stock is determined as of the end of the prior plan year, Acme Inc.  determines how much cash it is willing to use to fund distributions this year. Based on the stock value and available cash, Acme Inc. adopts a distribution policy and determines that the following selections will accelerate distributions to the greatest extent possible without exceeding the available cash: (i) begin distributions this year for all participants who terminated last year, regardless of reason or age, (ii) set a lump sum threshold of $50,000, (iii) pay in three annual installments, and (iv) set a minimum installment threshold of $50,000.

John, Jack, and Diane all terminated employment last year with vested account balances of $40,000, $70,000, and $180,000, respectively. Because John’s account balance is less than the lump sum threshold, he will receive a distribution of $40,000 this year. Because Jack’s account balance exceeds the lump sum threshold, he will receive installments, beginning with the minimum $50,000 installment this year. Next year, because Jack’s remaining balance of $20,000 is less than the minimum annual installment, he will receive a final distribution of $20,000. Diane’s account balance of $180,000 will be paid in three annual installments, beginning with a distribution of $60,000 this year.