IRS Issues Final Regs on Diversification Requirements for Company Stock

Section 401(a)(35) of the Code was added by section 901 of the Pension Protection Act of 2006 and generally provides that an applicable defined contribution plan allow each individual who is a participant who has completed at least three years of service, a beneficiary of a participant who has completed at least three years of service, or a beneficiary of a deceased participant to elect to direct the plan to divest employer securities allocated to the individual’s account and to reinvest an equivalent amount in other investment options. The regulations say the plan must offer individuals not less than three investment options, other than employer securities, to which the individuals may direct the proceeds from the divestment of employer securities, each of which is diversified and has materially different risk and return characteristics.   

The IRS said a plan does not fail to meet the requirements if it allows individuals to divest employer securities and reinvest the proceeds at periodic, reasonable opportunities occurring no less frequently than quarterly. A plan is not permitted to impose restrictions or conditions with respect to the investment of employer securities that are not imposed on the investment of other assets of the plan, other than restrictions or conditions imposed to comply with securities laws.  

The agency made changes to the proposed regulations in response to comments and also clarified provisions of the regulations. For example, the final regulations provide that, in the case of a multiemployer plan, an investment option will not be treated as holding employer securities to the extent the employer securities are held indirectly through an investment fund managed by an investment manager if the investment is independent of the employer and the percentage limitation rule is satisfied.  

The proposed regulations provided that certain investment funds that include employer securities held indirectly through an investment company registered under the Investment Company Act were treated as not holding employer securities. The final regulations replace the reference to a fund that is an investment company registered under the Investment Company Act of 1940 with a regulated investment company as described in Code section 851(a).   

The IRS said this change extends the types of investment companies to include exchange traded funds, which are unit investment trusts if they satisfy section 851(a). The final regulations also retain the rule from the proposed regulations that allows the Commissioner to designate additional types of funds as eligible for this exception.  

The final regulations also provide that the determination of whether the value of employer securities exceeds 10% of the total value of the fund’s investments – for exception from the diversification rule – is made for the plan year as of the end of the preceding plan year, and can be based on the information in the latest disclosure of the fund’s portfolio holdings (for example, Form N-CSR, “Certified Shareholder Report of Registered Management Investment Companies”) that was filed with the Securities and Exchange Commission in that preceding plan year.  

The final regulations provide that the prohibition on restrictions or conditions with respect to the investment of employer securities applies to any direct or indirect restriction on an individual’s right to divest an investment in employer securities that is not imposed on an investment that is not employer securities, as well as a direct or indirect benefit that is conditioned on investment in employer securities. It also provides clarification with respect to the exception for frozen funds.  

Finally, the final regulations provide that a plan is generally permitted to allow transfers to be made into or out of a stable value fund more frequently than a fund invested in employer securities and expand the list of permitted indirect restrictions to provide that a plan may provide for transfers out of a QDIA more frequently than a fund invested in employer securities.  

The IRS said the regulations will affect administrators of, employers maintaining, participants in, and beneficiaries of defined contribution plans that are invested in employer securities, and will be effective May 19, 2010, when the regulations are published in the Federal Register. The regulations apply for plan years beginning on or after January 1, 2011.