Employee Benefits-IRS Provides Relief From The Anti-Cutback Requirements Of Section 411(d)(6) For Certain ESOP Amendments

In Notice 2013-17, the Internal Revenue Service (the “IRS”) provides relief from the anti-cutback requirements of section 411(d)(6) of the Internal Revenue Code (the “Code”) for plan amendments that eliminate a distribution option, described in section 401(a)(28)(B)(ii)(I) of the Code, from an employee stock ownership plan or “ESOP” which becomes subject to the investment diversification requirements of section 401(a)(35) of the Code.

By way of background, under section 401(a)(28)(B)(i), an ESOP must provide certain participants the opportunity to elect to direct the plan as to the investment of at least 25 percent of the participant’s account. The election must be available to a participant during the 90-day period following the close of each plan year in the 6-plan-year period beginning with the first plan year in which the participant has both attained age 55 and completed 10 years of participation. Section 401(a)(28)(B)(ii)(I) allows an ESOP to satisfy the foregoing diversification requirements by distributing the portion of a participant’s account that is covered by the election within 90 days after the period during which the election may be made. Section 401(a)(28)(B)(v) provides that the foregoing diversification requirements do not apply to plan which become subject to the diversification requirements, with respect to employer securities, of section 401(a)(35) of the Code.

Section 401(a)(35) was added to the Code by the Pension Protection Act of 2006. Unlike section 401(a)(28)(B), the section 401(a)(35) diversification requirements cannot be satisfied by distributing a portion of the participant’s account. Section 401(a)(35) will apply to an ESOP if: (1) it holds employer securities that are readily tradable on an established securities market, and (2) either (i) it is not a separate plan for purposes of section 414(l) of the Code, but rather is a portion of a larger plan, or (ii) it holds contributions that are or were subject to section 401(k) or 401(m) of the Code. An ESOP described above must satisfy the diversification requirements of section 401(a)(35)) as of the section’s effective date, that is, in plan years beginning after 2006 (or if later the first date on which section 401(a)(35) applies to the ESOP). If and when section 401(a)(35) becomes effective for and applies to an ESOP, the distribution option of section 401(a)(28)(B)(ii)(I) is no longer available. The issue becomes how to amend the ESOP to eliminate the option without violating the anti-cutback rules of section 411(d)(6). That is where Notice 2013-17 provides relief.

The Notice provides that the amendment to eliminate the section 401(a)(28)(B)(ii)(I) distribution option will not violate the anti-cutback rule, if: (1) the amendment is made effective no earlier than first day of the first plan year starting after 2006 (or if later the first date on which section 401(a)(35) applies to the ESOP), (2) the plan is operated as if the amendment was in effect as of the amendment’s effective date and (3) the amendment is adopted by the last day of the first plan year beginning after 2012 (or if later by the deadline for adopting an “interim amendment” to reflect the requirements of section 401(a)(35)).