Diversification of Units

[Guest TAS17]

Some administration firms use unit accounting pools in which cash is pooled with the ESOP stock. Therefore, diversification becomes problematic because diversification must either occur in units or the units must be converted to shares prior to diversification.

I recently became aware that in the early 90's the diversification/unit accounting issue did receive some fairly widespread consideration in the ESOP community. Can anyone provide further information on whether diversification of units rather than shares is deemed a proper practice by the IRS?

[RLL]

The 1977 ESOP regulations, at Sec. 54.4975-11(d)(2), provide that leveraged ESOPs must allocate shares of employer released from a loan suspense account in "non-monetary units" (not necessarily shares). Accordingly, there should be no reason for not allowing the ESOP diversification election to be effected based on allocation units which include shares of employer stock.

Based upon your facts, each unit would likely represent more than just shares. There should be no problem since the amount available for the diversification election is not less than would be offered if allocations were made in shares.

It's likely that IRS employee plans reviewers would not even understand the issue. I'm certain that an ESOP drafted to provide for diversification as you have described would have no problem in obtaining a favorable determination letter from the IRS.

[Kirk Maldonado]

There is an obscure problem with allocating on the basis of units. I encountered it more than 10 years ago in the context of a publicly traded employer that was purchasing stock for the ESOP in the open market on a regular basis. In that case, the stock price was plummeting. I remember pointing out the issue in a group meeting, and everyone there agreed with my conclusion that it was a serious issue if anybody ever uncovered it, but I've been unable to recall what it was.

[RLL]

Kirk.....a lot has happened in the last ten years. I'm surprised that you're showing signs of aging and will publicly admit it.

[Kirk Maldonado]

Actually, I was hoping that you would have sympathy for me with my feeble memory due to my advanced age and provide the answer to the estoric problem that arises using unit valuation in that context. I'll know better than to try that approach with you again!

Actually, I contacted the other persons who were present at the meeting a number of years ago, and although they remembered the discussion, they couldn't recall any of the specifics. Maybe Alzheimers' is contagious.

Any thoughts as to what this issue could be? This lack of memory is plaguing me so much that I'm willing to bare one of my many foibles in public simply to get it answered.

[RLL]

I think there are no real problems with unit allocations in an ESOP.

There are many ERISA lawyers who always focus primarily on problems (rather than solutions) and raise all kinds of theoretical issues about anything (or nothing), especially when it involves ESOPs. It must be something they teach in law school....or maybe it's typical for frustrated non-litigators who want to argue about something (or everything).

[Kirk Maldonado]

I agree with RLL, I have not found any reason why unit allocations don't work, except for that single situation. Inasmuch as those circumstances have not arisen again in the past ten years, I wouldn't hestitate on using unit allocations.

[Guest TAS17]

I am specifically concerned about unit accounting in the context of diversification of shares under Code Section 401(a)(28). Notice 88-56 specifically provides for the diversification of "shares". If units are diversified, both shares and the cash portion of the unit are being diversified. For example, if the plan provides for distribution as the diversification method, cash will be distributed as well as the shares.

[RLL]

No problem under IRC Sec. 401(a)(28)(B) .....you are allowing for the diversification of the shares represented by (or included within) the units. See my first response (dated 11/24).

Theoretically, you may be allowing for so-called "excess" diversification, but there is no real adverse consequence in doing so. I believe that the IRS will issue a determination letter on ESOP plan provisions which allow what you propose. If so, who can then argue that there is any problem doing what you want?

If the ESOP does not include a money purchase pension plan, there would clearly be no problem in allowing for in-service distributions (in unlimited amounts) after a participant has satisfied the age-55, ten years of participation requirements for the ESOP diversification election. If there is a money purchase plan as part of the ESOP, there could be some minor limitation, but nothing that should be a diversification problem.

Go ahead! Don't worry so much about what you think you can't do. I think you can do it, and I'm sure that the IRS would not object (if they understood the question).

[This message has been edited by RLL (edited 11-30-1999).]