The Internal Revenue Service wants to develop regulations explaining how employers and retirement plan advisors should implement new defined contribution plan investment diversification rules.

Members of Congress added the rules, given in Section 401(a)(35) of the Internal Revenue Code, when they adopted the Pension Protection Act of 2006.

The section encourages employees of publicly traded companies to diversify holdings of employer stock.

The proposed regulations are based on IRS Notice 2006-107, a batch of guidance issued in December 2006 that gives the IRS interpretation of Section 401(a)(35).

The draft regulations deal with topics such as the definition of “publicly traded employer security” and the types of restrictions and conditions that plans can impose on the sale and purchase of publicly traded employer securities

The Internal Revenue Code section requires a plan to give plan participants who buy publicly traded employer stock with their own money to sell the stock and reinvest the proceeds in other plan investments.

If employers give participants employer stock, participants who have at least 3 years of service must have divestment rights.

The law exempts one-person retirement plans and stand-alone employee stock ownership plans from the diversification requirements.

The law also exempts employers with stock that is not readily tradable on an established securities market, IRS officials write in the notice of proposed rulemaking, which appears today in the Federal Register.

A U.S. security traded on a securities exchange that is registered under Section 6 of the Securities Exchange Act of 1934 would count as a readily tradable domestic security.

A foreign security traded on a foreign national securities exchange that is officially recognized, sanctioned or supervised by a governmental authority would count as a readily tradable foreign security, officials write.

Notice 2006-107 treated employer securities held by an investment company as not treated as being held by the plan.

The proposed regulations would flesh out that exception.

“Under the proposed regulations, in order to be exempt from the diversification requirements, the pooled investment vehicle must be 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 pooled investment fund of an insurance company that is qualified to do business in a state, or an investment fund designated by the [internal revenue] commissioner in revenue rulings, notices, or other guidance published in the Internal Revenue Bulletin,” officials write in the preamble to the draft regulations.

To be exempt from the diversification requirements the “pooled investment fund that holds the employer securities must have stated investment objectives and the investment must be independent of the employer and any affiliate thereof,” officials write.

If the employer securities held by a fund amounted to more than 10% of the total value of all of the fund’s investment, then the fund would not be considered to be independent of the employer, officials warn.

Moreover, although Section 401(a)(35) prohibits plans from restricting an individual’s employer stock divestiture rights, an employer could discourage rapid trading by limiting an employee’s ability to buy employer securities within a short period of time after selling employer securities, officials write.

Employers also could impose fees on investment options other than employer stock that they do not impose on investments in employer securities, officials write.

In most cases, the proposed regulations would be effective for plan years beginning on or after Jan. 1, 2009.

Public comments on the draft regulations are due April 2, 2008.

A copy of the notice is available