ESOP Eligibility: Who’s In, and Who’s Out?

Employee Stock Ownership Plans (ESOPs) offer unique opportunities for employees to become owners of their company and share in its success. Understanding the rules surrounding ESOP eligibility and properly determining which employees are eligible for participation are crucial for sponsoring employers. In this client update, we will outline the rules for determining which employees must be allowed to participate in an ESOP, including IRS rules regarding eligibility, permissible exclusion criteria, and plan entry date requirements. 

The IRS has established the following eligibility guidelines to prevent discrimination in ESOP participation: 

• Age:

  Employers can require employees to be at least twenty-one-years old to be eligible to participate in the ESOP, but they cannot impose a higher age requirement. Employers can lower the eligibility age below twenty-one (for example, age eighteen). They may not cap the eligibility age (e.g., not allowing participation in the ESOP upon turning sixty-five-years-old).  

• Service: Employers

  may require employees to have completed a year of service before they may participate in the ESOP. A year of service is typically measured as 1,000 hours in a year, although IRS rules allow employees to count hours based on actual hours worked or an equivalency calculation based on days, weeks, or months worked. Employers may allow employees to participate in the ESOP before their first year of service has been completed, but these limitations can be helpful if the company has a high turnover.  

While permissible service requirements may prevent certain part-time employees from participation, employers should not broadly exclude part-time employees from participation without first considering the minimum service requirements.  

Employees exclusions: Certain categories of employees may be categorically excluded from participation, even if they otherwise meet participation requirements: 

• Independent contractors are individuals who perform services for a company but are not employees receiving a Form W-2 from the company.  
• Collectively bargained employees, also known as union employees, are individuals whose employment terms and conditions are determined through negotiations between a labor union and an employer. Their retirement benefits in union agreements typically do not include participation in an ESOP. 
• Nonresident aliens are those who are neither U.S. citizens nor lawful permanent residents allowed to work without restriction in the U.S. Nonresident aliens may be excluded from the ESOP if they receive no U.S.-source income from the sponsoring employer.  

In addition to following these mandatory guidelines, ESOP companies should consider how restrictive eligibility criteria may impact their ability to pass plan coverage and non-discrimination testing. Restricting participation to a narrower group of more seasoned employees may indirectly cause the plan to fail to pass testing measuring whether the plan benefits a broad cross-section of the employee population in a fair and non-discriminatory manner.  

In addition to describing applicable eligibility criteria, a Plan Document should specify the date on which an eligible employee becomes an active participant, commonly referred to as the entry date. Once an employee has satisfied the plan’s eligibility criteria, they must enter the plan no later than the first day of the initial plan year following their eligibility or within six months after attaining eligibility, whichever occurs earlier. Employers may delay this entry date by providing immediate vesting after two years of service.  

An error relating to eligibility criteria can arise from (1) a Plan Document adopting more stringent eligibility criteria than those permitted under IRS Regulations; or (2) employer practices of excluding employees from participation who should be allowed to participate per the terms of the Plan Document. The correction for this type of an error typically includes the following: 

• Amend the Plan Document to reflect permissible eligibility and entry date criteria (potentially retroactively), if applicable; 
• Add improperly excluded employees to the ESOP; and 
• Make a corrective contribution reflecting amounts improperly excluded employees would have had contributed to the plan had they been treated properly under the Plan Document and IRS Regulations.  

At BrownWinick, our experienced ESOP team is dedicated to guiding you through every step of establishing and maintaining your ESOP. We are well-equipped to provide comprehensive services that cover plan formation and compliance. If you have any questions regarding your plan’s eligibility criteria or practices relating to adding new employees to your plan, visit our webpage bwesop.com or contact your BrownWinick ESOP attorney.