- Pension Protection Act Also Affects ESOPs
- November 14, 2006 | Author: Angela M. Bohmann
- Law Firm: Leonard, Street and Deinard, [incorporation phrase format]Professional Association - Minneapolis Office
The PPA contains provisions that affect employee stock ownership plans (ESOPs). These changes include new diversification requirements and faster vesting for employer contributions to ESOPs.
The Pension Protection Act of 2006 (“PPA”) also contains provisions that affect employee stock ownership plans (ESOPs). Among the changes are the following:
Diversification Requirements. Under the PPA, ESOPs of employers with publicly traded stock must offer participants accelerated diversification rights. Under present law, participants who have reached age 55 with at least 10 years of plan participation are permitted to diversify their accounts. Under the PPA, ESOPs of employers with publicly traded securities must allow all participants to diversify plan contributions that are attributable to employee elective deferrals (401(k) contributions) and employee after tax contributions and that are otherwise invested in employer stock. Non-elective employer contributions and employer matching contributions are subject to the diversification requirement for participants who have completed at least three years of vesting service. Participants with a diversification right must be given a choice of at least three different investment options other than employer stock with different risk and return characteristics. Diversification must be allowed at least quarterly and at least as frequently as other investment changes are allowed under the plan.
Excepted from the diversification requirements are ESOPs of publicly traded employers that are “stand-alone” ESOPs. A stand-alone ESOP is one that does not have a 401(k) feature and is not combined with any plan that has employee contributions or employer matching contributions. An ESOP (other than a stand-alone ESOP) of an employer that has issued some publicly traded shares must also meet the diversification requirement even if the shares held by the ESOP are not publicly traded. Because “employer” is determined on a controlled group basis, this means that an ESOP of a subsidiary whose parent has publicly traded stock will be subject to the new rules.
The new rules are generally effective for plan years beginning on or after January 1, 2007, with a delayed effective date for plans maintained under a collective bargaining agreement. Generally speaking, the rules phase in over three years for participants under age 55 for stock held in an ESOP as of the general effective date.
Notice of Diversification Rights. Employers must give participants at least 30 days’ advance notice of the participants’ right to diversify their ESOP accounts. The Internal Revenue Service is supposed to prepare a model notice within 180 days after the adoption of the law (February 16, 2007) that can be used by employers to explain diversification rights and the benefits of diversification. However, the first diversification notices are required to be given to participants before that date. We can hope that the Internal Revenue Service issues early guidance on this issue since a failure to provide the notice can be subject to penalties of up to $110 per day.
EGTRAA Changes Made Permanent. Newly permanent provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) will also affect ESOPs. Among the more important changes is the increase in the annual additions limitation to 100% of a participant’s compensation but no more than $40,000 (2007 limit). Also, the rules that prohibit allocations in an ESOP of an S-corporation to certain participants who are also holders of equity interests in the corporation [tax code section 409(p)] are made permanent. The provisions that permit employers to deduct certain dividends paid on ESOP stock that are reinvested in the ESOP are also made permanent.
Faster Vesting. PPA has accelerated vesting requirements for all employer contributions to defined contribution plans, including ESOPs. Under the new vesting rules effective for contributions made for plan years beginning after December 31, 2006, an employer can use a cliff vesting schedule, where a participant is 0% vested until attaining three years of vesting service, at which point the participant must be 100% vested, or a graduated vesting schedule in which the participant must be at least 20% vested after two years, increasing 20% a year until the participant is 100% vested in year six. Employers with longer vesting schedules will need to change them to conform to the new schedules. However, an ESOP with an outstanding securities acquisition loan in effect on September 26, 2005, can defer compliance with the new vesting rule until the earlier of the date the loan is repaid or the date the loan was scheduled to be repaid as of September 16, 2005.
Employers with ESOPS should review their plan designs to determine the extent to which changes will need to be made to comply with the PPA. Although plan amendments are not required until the last day of the plan year beginning in 2009, the plan must be operationally compliant by the effective dates discussed above. Employers with questions about the effect of the PPA on their ESOP may contact any member of the Compensation and Benefits group.