3821 / What requirements regarding diversification of investments apply to Employee Stock Ownership Plans (“ESOPs”)?

An ESOP generally must provide for diversification of investments by permitting a plan participant (including one who has already separated from service with the employer) who has completed 10 years of participation in the plan and attained age 55 to elect to direct the investment (allowing at least three investment options) of a portion of his account balance. (This requirement does not apply to plans subject to the diversification requirement explained at Q 3732.)¹

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Planning Point: The IRS has issued relief from the anticutback rules of Section 411(d)(6) for a plan sponsor who amends a nonexempt ESOP to eliminate a distribution option that had previously satisfied the diversification requirements of Section 401(a)(28)(B) if the amendment occurs no later than the last day of the first plan year beginning on or after January 1, 2013 or by the deadline for the plan to satisfy Section 401(a)(35), if later.²

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In the case of an ESOP that had not existed for 10 years, the IRS permitted a plan participant to count years of participation in a terminated predecessor ESOP to meet the 10 years of participation requirement.³

The diversification election must be made within 90 days after the close of each plan year in the six-plan-year period, which begins with the plan year in which the employee becomes eligible to make the election. Generally, at least 25 percent of the account balance attributable to employer securities acquired by or contributed to an ESOP must be subject to the election; but in the last year of the six-plan-year period the 25 percent is increased to 50 percent.⁴

The amount that must be subject to the election at the end of a given year is generally equal to (1) 25 percent (or 50 percent in the last year) of the total number of shares of employer securities acquired by or contributed to the plan that have ever been allocated to the participant’s account on or before the most recent plan allocation date, minus (2) the number of shares previously diversified.⁵ Employer securities may not be one of the three investment options.⁶

A plan may meet this diversification requirement by distributing the portion of an account for which an election is made.⁷ The diversification requirement can also be satisfied by allowing a participant to transfer that portion of an account for which an election is made into a qualified defined contribution plan which provides for employee directed investment and in which the required diversification options are available.⁸

Any form of diversification elected (i.e., the distribution, transfer, or implementation of an investment option) must be completed within 90 days after the close of the election period.⁹ An election to diversify may be revoked or amended, or a new election made, at any time during the 90 day election period.¹⁰