The Pension Protection Act and Employer Stock Divestiture
Rev. 10/06/06, E-mail Alert 2006-20

PPA introduces new rules for the divestiture of employer stock in a qualified plan.

Overview of the Pension Protection Act Divestiture of Employer Stock Rules.
Beginning with the 2007 plan year, certain plans holding employer stock must permit participants to immediately divest employer securities purchased with elective deferrals (or other employee contributions) and diversify the proceeds into other plan investment options. If the employer securities in those plans were purchased with employer contributions, the plans must allow participants to divest after they have completed three years of service. A three-year phase-in period applies to employer contributions in existing plans. Deferrals and after-tax employee contributions have an immediate right of divestiture.
This divestiture requirement does not apply to an Employee Stock Ownership Plan (ESOPs) that is maintained as a separate plan for purposes of the plan merger rules and does not permit elective deferrals, after-tax employee contributions, or matching contributions. Thus, not all plans with investments in employer securities will be subject to these new rules. However, these plans are still subject to the existing age 55 and 60 diversification rules. The IRS has been directed to issue a model participant notice within six months after August 17, 2006.

Explanation of Provisions

In general
Certain defined contribution plans with investments in employer securities will be required to provide diversification rights with respect to amounts invested in employer securities to continue to satisfy the plan qualification requirements of the Code and the vesting requirements of ERISA. Such plans must permit "applicable individuals" to direct that the portion of his or her account that consists of employer securities be invested in alternative investments. An applicable individual includes:

1. any plan participant; and
   
2. any beneficiary who has an account under the plan with respect to which the beneficiary is entitled to exercise the rights of a participant.
   

The time when the diversification requirements apply depends on the type of contributions invested in employer securities.

Elective deferrals and after–tax employee contributions
In the case of amounts attributable to elective deferrals and employee after-tax contributions that are invested in employer securities, the applicable individual will have an immediate right to direct that such amounts be invested in alternative investments.

Other contributions
In the case of amounts attributable to employer contributions that are invested in employer securities, an applicable individual who is a participant and has completed at least three years of service (as defined under the rules for vesting), a beneficiary of such a participant, or a beneficiary of a deceased participant will have the right to direct that such amounts be invested in alternative investments.

Transition Rule
A transition rule applies to amounts attributable to employer contributions invested in employer securities acquired before the first plan year for which the new diversification requirements will apply. Under the transition rule, for the first three years during which the new diversification requirements apply to the plan, the applicable percentage of amounts subject to the diversification requirement is shown in Table 1, below. The applicable percentage applies separately to each class of employer security in an applicable individual’s account. The transition rule does not apply to plan participants who have three years of service and who have attained age 55 by the beginning of the first plan year beginning after December 31, 2005. Thus, those who have three years of service and have attained age 55 would have thave an immediate right to direct that employer contributions invested in employer securities be invested in alternative investments.

Transition Rule Example
Suppose that the account of a participant with at least three years of service held 120 shares of employer common stock contributed as matching contributions before the diversification requirements became effective. In the first year for which diversification applies, 33 percent (i.e., 40 shares) of that stock is subject to the diversification requirements. In the second year for which diversification applies, a total of 66 percent of 120 shares of stock (i.e., 79 shares, or an additional 39 shares) is subject to the diversification requirements. In the third year for which diversification applies, 100 percent of the stock, or all 120 shares, is subject to the diversification requirements. However, 100% of employer stock held in the participant's account that is attributable to elective deferrals and employee after-tax contributions will be subject to the diversification requirements, as will any new stock contributed to the account regardless of contribution source.

Rules relating to the election of investment alternatives
A plan subject to the diversification requirements is required to give applicable individuals a choice of at least three investment options in addition to employer securities. Each of the addition investment options must be diversified and have materially different risk and return characteristics. It is intended that any other investment options generally offered by the plan also must be available to applicable individuals.

The plan may limit the times when the participant may direct divestment and reinvestment to "periodic, reasonable opportunities" that occur at least quarterly. Generally, affected participants must be given the opportunity to make investment changes with respect to employer securities on the same basis, except in unusual circumstances, as they would have in making other investment changes. For example, investment changes related to employer securities must be permitted with the same frequency and implemented within the same time frame as afforded to other investments with, unless circumstances require different treatment. Thus, the quarterly rule does not apply if the plan allows daily changes of other investments.

Further, except as provided in regulations, a plan may not impose restrictions or conditions with respect to the investment of employer securities that are not imposed on the investment of other plan assets (other than restrictions or conditions imposed by reason of the application of securities laws). An example of such a prohibited restriction or condition would be a plan provision under which a participant who divests his or her account of employer securities will receive a less favorable treatment (such as a lower rate of employer contributions) than a participant whose account remains invested in employer securities. However, a plan could legitimately impose participant fees with respect to reinvestment in the other investment options available in the plan, even if fees are not imposed with respect to investments in employer securities.

Plans subject to requirements
The diversification requirements generally apply to an “applicable defined contribution plan,” which means a defined contribution plan holding publicly-traded employer securities (i.e., securities issued by the employer or a member of the employer’s controlled group of corporations that are readily tradable on an established securities market. [For this purpose, “controlled group of corporations” has the same meaning as under section 1563(a), except that, in applying that section, 50 percent is substituted for 80 percent].) This is similar to the controlled group rule for Code Section 415 purposes where 50% is similarly substituted for 80%.

Generally, a plan holding employer securities that are not publicly traded is also treated as being an applicable defined contribution plan if the employer (or any member of the employer’s controlled group of corporations) has issued a class of stock that is a publicly traded employer security. However, the diversification requirements will not apply to a plan maintained by a member of such a controlled group, provided that neither the employer nor a parent corporation of the employer has issued any publicly–traded security or any special class of stock that grants particular rights to, or bears particular risks for, the holder or issuer with respect to the controlled group member that has issued publicly–traded stock. The Secretary of the Treasury has the authority to provide other exceptions in regulations. For example, an exception may be appropriate if no stock of the employer maintaining the plan (including stock held in the plan) is publicly traded, but a member of the employer’s controlled group has issued a small amount of publicly traded stock.

One-participant plans excluded from diversification.
The new diversification requirements also do not apply to a one–participant retirement plan. For these purpose, a one–participant retirement plan is defined as a plan that:

1. on the first day of the plan year, either covered only one individual (or the individual and his or her spouse) and the individual owned 100 percent of the plan sponsor (i.e., the employer maintaining the plan), whether or not incorporated, or covered only one or more partners (or partners and their spouses) in the plan sponsor;
   
2. meets the minimum coverage requirements without being combined with any other plan of the business that covers employees of the business;
   
3. does not provide benefits to anyone except the individuals and partners (and spouses) described in (1);
   
4. does not cover a business that is a member of an affiliated service group, a controlled group of corporations, or a group of corporations under common control; and
   
5. does not cover a business that uses the services of leased employees.
   

A “partner” is defined as including an owner of a business that is treated as a partnership for tax purposes. In addition, it includes a two-percent shareholder of an S corporation.

Effective Date
The provision is effective for plan years beginning after December 31, 2006.

Collectively Bargained Plan Effective Date
In the case of a plan maintained pursuant to one or more collective bargaining agreements, the provision is effective for plan years beginning after the earlier of (1) the later of December 31, 2007, or the date on which the last of such collective bargaining agreements terminates (determined without regard to any extension thereof after the date of enactment), or (2) December 31, 2008.

Special ESOP Rule
Other limited effective date exceptions apply to certain ESOPs that existed on September 17, 2003 and consisted of preferred stock.

Bill Grossman, QPA