DIVERSIFICATION AND CURRENT TRENDS

1. DIVERSIFICATION AND CURRENT TRENDS Iowa-Nebraska ESOP Chapter Conference February 27, 2014 Doubletree Hilton Hotel Omaha, NE Dawn Hafner Keith T. Peters

2. 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

3. 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

4. Diversification – The BasicsEligibility • 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

5. Diversification – The BasicsElections • 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

6. Diversification – The BasicsCalculations • 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

7. Diversification – The BasicsCalculations Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams

8. Diversification – The BasicsDiversification 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

9. Diversification – The BasicsTiming 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

10. Diversification – Current TrendsChanging 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

11. Diversification – Current TrendsBeyond 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

12. Diversification – Current TrendsBeyond the Statutory RequirementsWhy 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

13. Diversification – Current TrendsBeyond the Statutory RequirementsWhy 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

14. Diversification – Current TrendsBeyond the Statutory RequirementsTraditional ESOP Diversification Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams

15. Diversification – Current TrendsBeyond the Statutory Requirements25% Election (no Add-Back) Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams

16. Diversification – Current TrendsBeyond the Statutory Requirements25% Election Age 50 + 10 YOP (Add-Back) *See next slide for explanation Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams

17. Diversification – Current TrendsBeyond the Statutory Requirements25% 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. Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams

18. Diversification – Current TrendsOptions 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

19. 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

20. 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

21. 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

22. 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

23. 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 non-distribution option • Excess diversification • Participant can elect to receive in shares (not required if S-corporation or by-law exception) • May need to do discrimination testing Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams

24. 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

25. 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

26. 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

27. 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

28. 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

29. QUESTIONS? Dawn Hafner, Verisight, Inc. ● Keith T. Peters, Cline Williams