ESOP design: Eligibility basics

Josh Goldbeck, ESOP Relationship Manager, Principal®

Eligibility applies to multiple plan features. First, there can be age and/or service requirements just to be eligible to participate. In order to enter the plan, an employee must be there on the date he becomes eligible. Once in the plan, there are eligibility requirements for the participant to share in the company’s contribution. And once a share of the contribution is allocated to a participant’s account, there is criteria to determine how soon the participant’s account is vested. Because “eligibility requirements” apply to multiple plan features, there is often confusion by plan sponsors in these areas, and even more confusion by plan participants.

Requirements by the IRS

Minimum age and service eligibility requirements for all qualified retirement plans are set forth in the Internal Revenue Code (Code). This means that a plan sponsor cannot impose stricter eligibility conditions in a plan on their employees. In general, for an employee to become eligible to participate, the plan cannot require that an employee complete a period of service extending beyond the later of:

  • the date the employee reaches age 21; or
  • the date the employee completes one year of service.

The Code also has rules for plan entry dates (the dates when an eligible employee must begin participation). A plan will not satisfy Code requirements (and could lose its qualified plan status) unless it provides that an employee who is otherwise eligible to participate in the plan begins participation no later than the earlier of:

  • the first day of the first plan year beginning after the date the employee satisfied the minimum age and/or service requirements; or
  • 6 months after the date the employee satisfied the minimum age and service requirements.1

Summarizing current law, a plan sponsor can design a plan that uses minimum age and service requirements to satisfy eligibility, with a service period as short as one hour of service or as long as two years.

It is common to confuse “eligibility” for participating in the plan with becoming vested. These are two separate concepts. While the requirements and eligibility periods are often the same, they can be different for each. It’s important to know that if eligibility to participate in the plan is longer than 1 year, vesting must be full and immediate upon entry. Generally, the rules under the Code are maximum requirements, and a plan sponsor usually has the option to be more liberal in designing the plan.

Most common approach for ESOPs

The most common approach we see for ESOP’s is one year of service for eligibility, with entry occurring either retroactively for an entire plan year or prospectively from the date the criteria are met. The difference between retroactive and prospective entry dates can have a significant impact on new participants, especially for new ESOPs.

Once a participant is in the plan, a separate measurement occurs for contributions. For a participant to be eligible for the company’s contribution, it is typical to require a minimum number of hours of service “worked” during the year (the Code provides that you cannot require more than 1,000 hours of service in a year) and that the participant is employed on the last day of the plan year.

From a pure recordkeeping perspective, longer eligibility periods can simplify the administration of the plan. This is mainly due to the lower probability of turnover and rehire situations that occur the longer an employee has been with the company. If the resulting payroll is sufficient, and there is no need for an extended vesting schedule, a two-year requirement can be a way for simplifying the process.

Another item to note is there is no requirement that the eligibility criteria in the ESOP must remain unchanged. If the original eligibility written in your plan document is not working for your purposes as expected, a plan amendment can fix that. It is not uncommon for a plan sponsor to make the change from a strict eligibility provision to more liberal criteria, or vice versa, two or three years after an ESOP transaction. However, it is important to understand what your options are, their limitations, the pros and cons of each, and how they will impact other plan design decisions as well as the employees. It is also important to remember that when a plan provision is changed, it must be communicated to plan participants.

Example and resulting outcome

Let’s take a look at Pat Johnson, who just started at XYZ Company in July of 2015. The ESOP year end is December 31 and vesting is immediate. Below are the criteria for entering the XYZ Company ESOP.

  • 1,000 hours of service in a 12-month period
  • Age 21
  • Plan entry is annually on January 1 of the year entry requirements are met (retroactive entry)
  • Sharing in annual company contributions require 1,000 hours of service and being employed on the last day of the plan year

Pat’s friend, John Andrews, started with LFN Corp in July of 2015, which is also an ESOP company. The LFN Corp ESOP functions on a calendar year with immediate vesting as well. However, the LFN Corp ESOP was designed with slightly different plan entry requirements, outlined below.

  • 1,000 hours of service in a 12-month period
  • Age 21
  • Plan entry is semi-annually on January 1 or July 1 after meeting the entry requirements (prospective entry)
  • Sharing in annual company contributions require 1,000 hours of service and being employed on the last day of the plan year

Both Pat and John worked 1,000 hours during the first three calendar years of employment (2015, 2016, and 2017). However, Pat enters the XYZ Company ESOP on January 1, 2016 and receives an allocation for 2016 since he remained employed through the end of the year. Pat receives his first ESOP statement in the summer of 2017, approximately two years after his original hire date. Meanwhile, John enters the LFN Corp ESOP on January 1, 2017 and receives his first allocation in 2017 since he remained employed through the end of the year. John receives his first ESOP statement in the summer of 2018, approximately three years after his original hire date.

Graphic which depicts when two different people would receive their first ESOP statement based upon whether the ESOP uses retroactive or prospective entry.

It’s important for key decision makers to understand how each of the ESOP’s provisions impacts both active and new employees. Let’s assume that John was proactively recruited to join LFN’s leadership team and the ESOP was touted as a significant benefit. However, when John meets with HR after not receiving an ESOP statement in the summer of 2017 (after two years at the company), it is explained to him he will not receive a statement until the 2017 plan work is complete. Without accurate and proactive communication, John may feel short-changed by the LFN Corp ESOP in the short-term. Keeping in mind your workforce, your ownership goals, and your administration needs, you can design your plan’s eligibility to work best for you.

1 A Guide to Common Qualified Plan Requirements

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