ESOP Update Phone Forum Recap: Diversification, Rebalancing, and Reshuffling

  

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In preparation for today's call we reviewed the current IRC Section 401(a)(28) ESOP diversification rules.

The Employee Plans News – Summer 2010 Edition provided a recap of the Final IRC Section 401(a)(35) Diversification Regulations:

On May 18, 2010, the IRS and the Treasury Department released final regulations on Code §401(a)(35) investment diversification requirements for certain defined contribution plans with publicly traded employer securities.

DC plans holding publicly traded employer securities are considered "applicable defined contribution plans" and subject to the diversification requirements of Code §401(a)(35). These plans must contain at least three investment options other than employer securities. The diversification requirement applies to:

• employee contributions; and
• employer contributions allocated to participants (or their beneficiaries) with at least three years of service.

A plan can't restrict a participant's right to invest in or to divest employer securities any more than it restricts any other plan investment options. However, the final regulations modify some of the permitted restrictions:

• A plan may have more frequent transfers to and from stable value funds and qualified default investment alternatives than a fund invested in employer securities.
• A plan may not allow reinvestment of divested amounts in the same employer securities account, but may allow investment of those amounts in another employer securities account if the only difference between the two accounts is the Code §402(e)(4) cost or other basis.
• Under a transitional rule, certain leveraged ESOPs may allocate matching contributions to an otherwise frozen employer stock fund.

Exceptions to the diversification requirements include a:

• stand-alone ESOP that does not hold amounts attributable to §§401(k) or (m);
• one-participant retirement plan; or
• plan with an investment fund holding employer securities as part of a broader fund is not treated as holding employer securities if the:
  
  
• investment was independent of the employer;
• employer's securities did not exceed 10% of the fund; and
• employer securities were held indirectly through:
  
  
• an investment company registered under the Investment Company Act of 1940;
• a common or collective trust fund or pooled investment fund maintained by a bank or trust company supervised by a state or federal agency;
• a qualified insurance company's pooled investment fund; or
• any other IRS-designated investment fund.

The final regulations:

• do not treat a multiemployer plan as holding employer securities if they are held indirectly through an investment fund managed by an independent investment manager and do not exceed 10% of the fund;
• extend the types of allowed investment companies to include certain exchange traded funds;
• state that in determining whether the value of employer securities exceeds 10% of the fund's investment's total value for a plan year, use the value at the end of the preceding plan year; and
• provide that if a fund that indirectly holds employer securities doesn't meet the "independent of the employer" requirement, it meets the diversification requirements even if the plan doesn't offer diversification rights to the participants for up to 90 days after it is found to hold employer securities.

The final regulations are effective May 19, 2010, and apply for plan years beginning on or after January 1, 2011. Until then, plans may satisfy Code §401(a)(35) by relying on Notice 2006-107, the proposed regulations or the final regulations.

Here is the text of the ESOP diversification provisions under IRC Section 401(a)(35) - Qualified pension, profit-sharing, and stock bonus plans - Requirements for qualification - Diversification requirements for certain defined contribution plans:

(35) Diversification requirements for certain defined contribution plans.—

(A) In general.— A trust which is part of an applicable defined contribution plan shall not be treated as a qualified trust unless the plan meets the diversification requirements of subparagraphs (B), (C), and (D).

(B) Employee contributions and elective deferrals invested in employer securities.— In the case of the portion of an applicable individual's account attributable to employee contributions and elective deferrals which is invested in employer securities, a plan meets the requirements of this subparagraph if the applicable individual may elect to direct the plan to divest any such securities and to reinvest an equivalent amount in other investment options meeting the requirements of subparagraph (D).

(C) Employer contributions invested in employer securities.— In the case of the portion of the account attributable to employer contributions other than elective deferrals which is invested in employer securities, a plan meets the requirements of this subparagraph if each applicable individual who—

(i) is a participant who has completed at least 3 years of service, or

(ii) is a beneficiary of a participant described in clause (i) or of a deceased participant,

may elect to direct the plan to divest any such securities and to reinvest an equivalent amount in other investment options meeting the requirements of subparagraph (D).

(D) Investment options.—

(i) In general.— The requirements of this subparagraph are met if the plan offers not less than 3 investment options, other than employer securities, to which an applicable individual may direct the proceeds from the divestment of employer securities pursuant to this paragraph, each of which is diversified and has materially different risk and return characteristics.

(ii) Treatment of certain restrictions and conditions.—

(I) Time for making investment choices.— A plan shall not be treated as failing to meet the requirements of this subparagraph merely because the plan limits the time for divestment and reinvestment to periodic, reasonable opportunities occurring no less frequently than quarterly.

(II) Certain restrictions and conditions not allowed.—Except as provided in regulations, a plan shall not meet the requirements of this subparagraph if the plan imposes restrictions or conditions with respect to the investment of employer securities which are not imposed on the investment of other assets of the plan. This subclause shall not apply to any restrictions or conditions imposed by reason of the application of securities laws.

(E) Applicable defined contribution plan.— For purposes of this paragraph—

(i) In general.— The term "applicable defined contribution plan" means any defined contribution plan which holds any publicly traded employer securities.

(ii) Exception for certain esops.— Such term does not include an employee stock ownership plan if—

(I) there are no contributions to such plan (or earnings thereunder) which are held within such plan and are subject to subsection (k) or (m), and

(II) such plan is a separate plan for purposes of section 414(l) with respect to any other defined benefit plan or defined contribution plan maintained by the same employer or employers.

(iii) Exception for one participant plans.— Such term does not include a one-participant retirement plan.

(iv) One-participant retirement plan.— For purposes of clause (iii), the term "one-participant retirement plan" means a retirement plan that on the first day of the plan year—

(I) covered only one individual (or the individual and the individual's spouse) and the individual (or the individual and the individual's spouse) owned 100 percent of the plan sponsor (whether or not incorporated), or

(II) covered only one or more partners (or partners and their spouses) in the plan sponsor.

(F) Certain plans treated as holding publicly traded employer securities.—

(i) In general.— Except as provided in regulations or in clause (ii), a plan holding employer securities which are not publicly traded employer securities shall be treated as holding publicly traded employer securities if any employer corporation, or any member of a controlled group of corporations which includes such employer corporation, has issued a class of stock which is a publicly traded employer security.

(ii) Exception for certain controlled groups with publicly traded securities.— Clause (i) shall not apply to a plan if—

(I) no employer corporation, or parent corporation of an employer corporation, has issued any publicly traded employer security, and

(II) no employer corporation, or parent corporation of an employer corporation, has issued any special class of stock which grants particular rights to, or bears particular risks for, the holder or issuer with respect to any corporation described in clause (i) which has issued any publicly traded employer security.

(iii) Definitions.— For purposes of this subparagraph, the term—

(I) "controlled group of corporations" has the meaning given such term by section 1563 (a), except that "50 percent" shall be substituted for "80 percent" each place it appears,

(II) "employer corporation" means a corporation which is an employer maintaining the plan, and

(III) "parent corporation" has the meaning given such term by section 424 (e).

(G) Other definitions.— For purposes of this paragraph—

(i) Applicable individual.— The term "applicable individual" means—

(I) any participant in the plan, and

(II) any beneficiary who has an account under the plan with respect to which the beneficiary is entitled to exercise the rights of a participant.

(ii) Elective deferral.— The term "elective deferral" means an employer contribution described in section 402 (g)(3)(A).

(iii) Employer security.— The term "employer security" has the meaning given such term by section 407(d)(1) of the Employee Retirement Income Security Act of 1974.

(iv) Employee stock ownership plan.— The term "employee stock ownership plan" has the meaning given such term by section 4975 (e)(7).

(v) Publicly traded employer securities.— The term "publicly traded employer securities" means employer securities which are readily tradable on an established securities market.

(vi) Year of service.— The term "year of service" has the meaning given such term by section 411 (a)(5).

(H) Transition rule for securities attributable to employer contributions.—

(i) Rules phased in over 3 years.—

(I) In general.— In the case of the portion of an account to which subparagraph (C) applies and which consists of employer securities acquired in a plan year beginning before January 1, 2007, subparagraph (C) shall only apply to the applicable percentage of such securities. This subparagraph shall be applied separately with respect to each class of securities.

(II) Exception for certain participants aged 55 or over.—Subclause (I) shall not apply to an applicable individual who is a participant who has attained age 55 and completed at least 3 years of service before the first plan year beginning after December 31, 2005.

(ii) Applicable percentage.— For purposes of clause (i), the applicable percentage shall be determined as follows:

Plan year to which The applicable subparagraph (C) applies:percentage is: 1st 33 2d 66 3d and following 100.