ESOP Excess Diversification

[Guest edman]

If an ESOP permits participants to diversify 100% of their account prior to becoming a qualified participant under Code Section 401(a)(28)(B) and a participant elects to do so, what consequences could there be once the participant becomes a qualified participant upon attaining age 55? See below for background and some hypotheticals to introduce the question in more detail.

Background

A client is considering amending their stand-alone ESOP (no outstanding loans and no active contributions) to permit all participants to diversify their entire account balance invested in employer securities by transferring the portion the participant elects to diversify to the client's 401(k) plan, which is subject to ERISA 404©.

Notice 88-56, A-11 generally permits excess diversification (diversification of amounts beyond what is required pursuant to Code Section 401(a)(28)(B)), subject to certain stipulations. Specifically, the excess diversified amounts are not treated as (i) available for diversification or (ii) diversified pursuant to Code Section 401(a)(28)(B). A simple take-away from this is that a participant would still be entitled to receive a distribution in the form of employer securities pursuant to Code Section 409(h) of the excess diversified amounts. This is not a concern. We are, however, somewhat concerned about a different situation.

Hypotheticals

In this regard, let me propose two hypotheticals. For both hypotheticals, assume that all shares in the ESOP are post-86 shares and that no contributions or dividends have been made for the past 10 years.

Hypothetical 1: Participant A has 100 shares in his account and is 50 years old and has never had more than 100 shares of employer securities in his account. Participant A elects to diversify 10% of his account (10 shares). The cash value of such shares are transferred to the 401(k) plan and invested pursuant to the participant's investment elections in the 401(k) plan. When Participant A attains age 55 he becomes a qualified participant. Since the 10 shares he previously diversified are not treated as available for diversification or as diversified, the participant is still entitled to diversify 25% of the 100 shares that were previously in his account. Accordingly, Participant A is now entitled to diversify an additional 25 shares and elects to do so, thereby bringing his total diversified shares to 35 (25 of which are diversified pursuant to Code Section 401(a)(28)(B) and 10 of which are an excess diversification).

Hypothetical 2: Participant B also has 100 shares in his account and is 50 years old and has never had more than 100 shares of employer securities in his account. Participant B elects to diversify 100% of his account (all 100 shares). The shares are sold and the cash is transferred to the 401(k) plan and invested pursuant to the participant's investment elections in the 401(k) plan. When Participant B attains age 55 he becomes a qualified participant. Since the 100 shares he previously diversified are not treated as available for diversification or as diversified, the participant is still entitled to diversify 25% of the 100 shares that were previously in his account. Accordingly, Participant B is now entitled to diversify 25 shares. Participant B, however, does not have any shares in his account because he previously elected to diversify the entire balance of his account. In this hypothetical, can the administrator re-classify 25 of the previously diversified shares as diversified pursuant to Code Section 401(a)(28)(B) with the remaining 75 as excess diversification? Or, is the amendment permitting 100% diversification a qualification failure with respect to Code Section 401(a)(28)?

Any thoughts would be appreciated. Thanks.