SERVICE PROVIDES TEMPORARY GUIDANCE ON ESOP DIVERSIFICATION REQUIREMENTS.

Notice 88-56

This notice provides guidance, in the form of questions and answers, with respect to certain provisions of the Tax Reform Act of 1986, concerning the diversification of investments requirement applicable to employee stock ownership plans (ESOPs) under section 401(a)(28) of the Internal Revenue Code of 1986 (Code) and the rules governing the taxation of qualified plan distributions under section 72.

Until further guidance is published, the guidance provided by these questions and answers may be relied upon by taxpayers to design and administer plans and to determine the tax treatment of plan distributions. The Service will apply the questions and answers in issuing determination letters, opinion letters, other rulings and in auditing returns with respect to taxpayers and plans. If future guidance is more restrictive than this notice, such guidance will be applied without retroactive effect. No inference should be drawn, however, regarding issues not addressed in this notice which may be suggested by a particular question and answer or as to why certain questions, and not others, are included. Retroactive protection will not necessarily be afforded with respect to any such inferred guidance.

A. CODE SECTION 401(a)(28)

Q-1: Which employer securities held by an ESOP or a tax credit ESOP are subject to the diversification of investments requirement of section 401(a)(28) of the Code?

A-1: Employer securities acquired by or contributed to an ESOP or a tax credit ESOP after December 31, 1986, are subject to the diversification of investments requirement of section 401(a)(28). Thus, for example, dividends paid to an ESOP after December 31, 1986, with respect to employer securities acquired by or contributed to the plan on or before such date are subject to the diversification requirement of section 401(a)(28) if such dividends are either paid in the form of employer securities or paid in cash or other property that is subsequently used to acquire employer securities. However, employer securities acquired by or contributed to an ESOP on or before December 31, 1986, are not subject to the diversification requirements. See Q&A-7 and Q&A-8 for an exception to section 401(a)(28) for certain de minimis amounts of employer securities.

Q-2: In what circumstances are employer securities actually acquired by or contributed to a tax credit ESOP after December 31, 1986, treated as acquired by or contributed to the tax credit ESOP on or before December 31, 1986?

A-2: Employer securities (within the meaning of section 409(1)) acquired by or contributed to a tax credit ESOP after December 31, 1986, are deemed, for purposes of section 401(a)(28), to be acquired by or contributed to the ESOP before January 1, 1987, if: 1) with respect to such securities, a tax credit was calculated under section 41(a) of the Internal Revenue Code of 1954 with reference to compensation paid or accrued before January 1, 1987, by the employer to employees under a tax credit ESOP; 2) the securities were acquired or contributed within the time period provided in section 404(a)(6) plus such additional time period allowed for contributions to a tax credit ESOP under section 41(c)(2) and 41(c)(4) of the Internal Revenue Code of 1954; and 3) the securities were allocated as of a date no later than the last day of the plan year ending within the employer's first taxable year ending on or after December 31, 1986. Thus, such employer securities are not subject to the diversification requirements of section 401(a)(28).

Q-3: In what circumstances are employer securities actually acquired by an ESOP or tax credit ESOP after December 31, 1986, treated as acquired by or contributed to the ESOP or tax credit ESOP on or before December 31, 1986?

A-3: Employer securities acquired by an ESOP or tax credit ESOP after December 31, 1986, will be deemed, for purposes of section 401(a)(28), to have been acquired by or contributed to the ESOP on or before December 31, 1986, in the following circumstances:

A) Cash or other assets derived from the disposition of employer securities pursuant to a corporate reorganization or acquisition attempt (whether or not successful) which are used to purchase other employer securities will be treated as acquired by or contributed to the ESOP on or before December 31, 1986, if the period between the disposition and the reinvestment does not exceed 90 days or such longer period as may be granted by the Commissioner under rules similar to those of Treas. Reg. section 1.46- 8(e)(10). For dispositions after June 8, 1988, no extensions will be granted unless applied for within 90 days after the disposition.

B) Employer securities acquired by an ESOP or tax credit ESOP after December 31, 1986, which were purchased with contributions made to the ESOP in cash on or before December 31, 1986 (including employee contributions) will be treated as acquired by or contributed to the ESOP on or before December 31, 1986, if such contributions were used to purchase employer securities within 60 days after the date of the contribution.

C) Employer securities acquired by an ESOP or tax credit ESOP after December 31, 1986, which were purchased with earnings or dividends paid in cash to an ESOP on or before December 31, 1986, will be treated as acquired by on contributed to the ESOP on or before December 31, 1986, if such earnings or dividends were used to purchase employer securities within 60 days from the date of payment to the ESOP.

D) Employer securities acquired by an ESOP after December 31, 1986, which were purchased with the proceeds of an exempt loan (under section 4975) received by the ESOP in cash on or before December 31, 1986, will be treated as acquired by or contributed to the ESOP on or before December 31, 1986, if such proceeds are invested in employer securities within 60 days of the receipt of the proceeds by the ESOP.

E) Employer securities acquired by an ESOP after December 31, 1986, which were purchased with amounts transferred to an ESOP on or before December 31, 1986, pursuant to a section 4980 transaction will be treated as acquired by or contributed to the ESOP on or before December 31, 1986, if the amounts are used to purchase employer securities within the time period prescribed in section 4980(c)(3)(B).

Q-4: If an ESOP does not account for employer securities acquired by or contributed to the plan after December 31, 1986, separately from employer securities acquired by or contributed to the plan on or before December 31, 1986, how are the employer securities subject to diversification determined?

A-4: Solely for purposes of section 401(a)(28), it is presumed that unless a plan separately accounts for employer securities acquired by or contributed to the plan after December 31, 1986, the employer securities allocated to participants' accounts after December 31, 1986, consist, first, of those employer securities acquired by or contributed to the plan after December 31, 1986, and second, of employer securities acquired by or contributed to the plan on or before December 31, 1986.

Q-5: Do special rules apply for determining employer securities subject to diversification for an ESOP or tax credit ESOP which adopts model plan amendments?

A-5: If the sponsor of an ESOP or tax credit ESOP adopts the applicable model plan amendments contained in Notice 87-2, 1987- 2 I.R.B. 17, on or before the date specified in section 1140 of the Tax Reform Act of 1986, the portion of a qualified participant's account balance attributable to employer securities acquired by or contributed to the ESOP after December 31, 1986, may be determined under either Q&A-4 of this notice or by multiplying the number of shares of employer securities allocated to a qualified participant's account by a fraction, the numerator of which is the number of shares of securities acquired by or contributed to the plan after December 31, 1986, and allocated to participant accounts, and the denominator of which is the total number of shares held by the plan at the plan valuation date nearest to the date on which the participant becomes a qualified participant.

In addition, see Q&A-17 in the case of a plan which determined the employer securities subject to the diversification requirement in conformity with the model plan amendments on or before June 8, 1988.

Q-6: May an ESOP or tax credit ESOP allocate employer securities acquired by or contributed to the ESOP after December 31, 1986, to participant's accounts on a different basis than employer securities acquired by or contributed to the ESOP before January 1, 1987?

A-6: Yes. However, the plan's allocation method must meet the requirements of section 401(a)(4). Thus, an ESOP or tax credit ESOP that allocates among participants both employer securities acquired by or contributed to the ESOP after December 31, 1986, (post-86 securities) and employer securities acquired by or contributed to the ESOP before January 1, 1987, (pre-87 securities) will fail to satisfy section 401(a)(4) if such plan uses an allocation method that disproportionately allocates post-86 securities in favor of the employees described in section 401(a)(4).

Q-7: What amount of employer securities held by an ESOP or tax credit ESOP constitutes a de minimus amount of employer securities that is not subject to the diversification of investments requirement of section 401(a)(28)?

A-7: If the fair market value (determined at the plan valuation date immediately preceding the first day on which a qualified participant is eligible to make a diversification election) of the employer securities acquired by or contributed to an ESOP after December 31, 1986, and allocated to a qualified participant's account is $500 or less, then such employer securities will be considered to constitute a de minimis amount of employer securities that is not subject to the diversification of investments requirement of section 401(a)(28). A plan may elect to use a de minimis amount of less than $500.

For purposes of determining whether the amount of employer securities acquired by or contributed to an ESOP after December 31, 1986, and allocated to the account of a qualified participant exceed the de minimis amount described above, employer securities held in accounts of all ESOPs or tax credit ESOPs maintained by an employer corporation and by members of the controlled group of corporations (within the meaning of section 414(b), (c), (m) or (o)) which includes the employer corporation shall be considered as held by the same plan.

Q-8: What amount of employer securities held by an ESOP or tax credit ESOP is subject to diversification if the fair market value of the employer securities acquired or contributed after December 31, 1986, exceeds the de minimis amount?

A-8: If the fair market value of the employer securities acquired by or contributed to the plan after December 31, 1986, and allocated to the account of a qualified participant exceeds the de minimis amount for any year of a participant's qualified election period, then all shares allocated to the account of a qualified participant which were acquired or contributed after December 31, 1986, shall be subject to the diversification requirements of section 401(a)(28) in each remaining year of a participant's qualified election period.

Q-9: What portion of a qualified participant's account is subject to the diversification of investments requirement?

A-9: The portion of a qualified participant's account subject to the diversification election in all years in the qualified election period, other than the final year of such period, is equal to : (1) 25 percent of the total number of shares of employer securities acquired by or contributed to the plan after December 31, 1986, that have ever been allocated to a qualified participant's account on or before the most recent plan allocation date; less (2) the number of shares of employer securities previously distributed, transferred, or diversified pursuant to a diversification election made after December 31, 1986. See Q&A-7 and Q&A-8 regarding the exception for de minimis amounts. The resulting number of shares may be rounded to the nearest whole integer. With respect to a qualified participant's final diversification election, "50 percent" is substituted for "25 percent" in determining the amount subject to the diversification election.

The following examples illustrates the rules of this Q&A:

Employee (E), a participant in a calendar year ESOP maintained by Corporation X, is first eligible to make a diversification election in 1989. The fair market value of X corporation stock was $10 per share on December 31, 1988. As of December 31, 1987, E's account contains 100 shares of X stock which were contributed to the plan after December 31, 1986 (post-86 stock). The X stock in E's account is subject to the diversification requirements of section 401(a)(28) because the fair market value of the post-86 stock exceeds $500 (See Q&A-7, supra). The ESOP must permit E to elect to diversify up to 25 shares of the post-86 stock allocated to his account (25% of 100 shares). E must be eligible to make this election through March 31, 1989. E elects prior to April 1, 1989 to receive a distribution of 25 shares of X stock.

During 1989, X corporation contributed X stock to the ESOP. E's account receives an allocation of 10 shares of X stock with respect to the 1989 employer contribution. As of December 31, 1989, E's account contains 85 shares of post-86 stock (110 shares -- 25). The portion of E's account subject to diversification following the 1989 plan year is calculated as follows: 25% of 110 shares is subject to the diversification election (27 1/2 shares). This amount is then reduced by the number of shares E has previously elected to diversify. Thus, E must be able to elect diversification with respect to an additional 2 1/2 shares of post-86 stock (27 1/2 less 25) through March 31, 1990. This number may be rounded to 3 shares of post-86 stock.

Q-10: Which shares of employer securities must be diversified pursuant to a diversification election?

A-10: The shares of employer securities that are diversified pursuant to a diversification election need not consist of securities acquired by or contributed to the ESOP after December 31, 1986. This is the case even though the determination of the number of shares that must be available for diversification under section 401(a)(28) is based on the number of employer securities acquired by or contributed to the ESOP after December 31, 1986 (See Q&A-9).

However, the shares of employer securities that are diversified pursuant to a diversification election must consist of employer securities that, immediately prior to diversification, are subject to the requirements of section 409(h). Also, in the case of an ESOP that permits participants to receive distributions of employer securities that have been held by the plan for at least 84 months in circumstances other than those described in section 409(d)(1)-(3), section 401(a)(28) overrides the 84 month rule of section 409(d) only to the extent that the shares of employer securities allocated to a qualified participant and diversified pursuant to a diversification election actually consist, first, of employer securities that have satisfied the 84-month rule and, thereafter, of employer securities that continue to be subject to the 84-month rule and have been held by the plan for longer periods of time than other employer securities subject to the 84-month rule.

Q-11: May an ESOP permit the diversification of amounts in excess of those required by section 401(a)(28)(B)?

A-11: Yes. However, amounts in excess of the minimum amount required to be available for diversification under section 401(a)(28)(B) are not treated as available for diversification or as diversified pursuant to section 401(a)(28)(B). Thus, employer securities subject to section 409(d) and in excess of the minimum amount required to be available for diversification under section 401(a)(28)(B) may not be diversified to the extent that such securities may not be distributed under section 409(d). Also, amounts subject to the requirements of section 409(h) and in excess of the minimum amount required to be available for diversification under section 401(a)(28)(B) remain subject to section 409(h) even if such amounts are diversified.

Notwithstanding the foregoing, if a plan permitted the diversification of amounts in excess of the minimum amount required by section 401(a)(28) with respect to employer securities acquired by or contributed to the plan after December 31, 1986, such excess diversification will be treated as required by section 401(a)(28)(B) for purposes of applying sections 409(d) and 409(h) if such diversification was implemented no later than June 8, 1988, reflected a reasonable interpretation and of section 401(a)(28).

Q-12: When is a participant eligible to make diversification elections with respect to his ESOP account?

A-12: Pursuant to section 401(a)(28)(B), a qualified participant must be able to elect to diversify the appropriate portion of his ESOP account balance (as determined under Q&A-9 of this notice) within 90 days after the close of each plan year during the participant's "qualified election period." A "qualified participant" (as defined in section 401(a)(28)(B)(iii) means any employee who has completed at least ten years of participation under the plan and has attained 55 years of age.

Generally, a participant's qualified election period consists of the 5 plan year period beginning with the plan year after the plan year in which the participant first becomes a qualified participant. However, the qualified election period of any employee who became a qualified participant before January 1, 1987, shall not begin before the first plan year beginning after December 31, 1986 and shall continue thereafter for a complete 5 plan year period.

For example, a participant in an ESOP (which uses a calendar plan year) who becomes a qualified participant during 1987 will first be eligible to make a diversification election within the first 90 days of 1989 (within 90 days following the close of the first plan year beginning after 12/31/87). The qualified participant's qualified election period begins in the 1988 plan year and ends with the 1992 plan year. The qualified participant's last diversification election will be within the first 90 days of 1993.

Similarly, for example, in the case of an employee who first became a qualified participant in 1986 or any prior year, the participant's qualified election period would begin with the 1987 plan year and close with the 1991 plan year. The qualified participant must first be given a diversification election within the first 90 days of 1988.

Notwithstanding the foregoing, in the case of an employee who became a qualified participant before January 1, 1987, a plan will not fail to meet the requirements of section 401(a)(28)(B) if such qualified participant is eligible to make the first diversification election no later than September 6, 1988. In addition, for purposes of this paragraph, an employee who became a qualified participant in 1987 and who was treated under the plan, prior to April 9, 1988, as eligible to make the first diversification election on or before June 8, 1988, may be treated as an employee who became a qualified participant before January 1, 1987.

Q-13: What methods can be used by an ESOP or a tax credit ESOP in order to satisfy the diversification of investments requirement with respect to a qualified participant?

A-13: An ESOP or tax credit ESOP will be treated as satisfying the diversification of investments requirement of section 401(a)(28) if:

A) the portion of the participant's account balance that is subject to the diversification election under section 401(a)(28)(B)(i) is distributed to the participant (or made available for distribution under Q&A-15) within 90 days after the last day of the period during which the election can be made;

B) the plan offers at least 3 distinct investment options (which are not inconsistent with regulations prescribed by the Secretary) with respect to the portion that is subject to the diversification election to each participant making an election under section 401(a)(28)(B)(i) and any investment option selected by the participant is implemented no later than 90 days after the last day of the period during which the election can be made; or

C) the plan offers the option to direct the plan to transfer the portion of the participant's account that is subject to the diversification election to another qualified defined contribution plan of the employer that offers at least 3 distinct investment options in accordance with B) above, provided that the transfer is made no later than 90 days after the last day of the period during which the election can be made. Such transfer must comply with applicable qualification requirements, including sections 414(1), 411(d)(6) and 401(a)(11).

The diversification of investments requirement for a year will be satisfied if the number of employer securities distributable under the plan during the 90 days after the last day of the period in which a diversification election can be made equals or exceeds the number of employer securities subject to diversification for the year. Thus, for example, if a tax credit ESOP provides for distribution of employer securities 84 months after allocation, and such employer securities are distributed during the 90 days after the last day of the period in which a diversification election can be made, such distribution may be used to fulfill the diversification requirement if it is equal to 25% (50% for the last year) or more of the employer securities subject to diversification under section 401(a)(28)(B).

Q-14: To what extent is a distribution in satisfaction of a participant's diversification election subject to certain other provisions of the plan or Code governing distributions?

A-14: Amounts that are required to be available for diversification and are diversified by means of distribution, as permitted under A-13(A), generally are treated as amounts that are not held by an ESOP. Thus, a distribution in satisfaction of a diversification election is not subject to the right to demand employer securities requirement of section 409(h) and may be made notwithstanding the 84 month holding period requirement of section 409(d). However, a distribution in satisfaction of a diversification election is subject to the provisions of section 409(h) concerning the exercise of a put option by participants to the extent that the distribution consists of employer securities. Also, see Q&A-10 for special rules applicable to the interaction of sections 401(a)(28) and 409(d). Finally, a distribution in satisfaction of a diversification election does not fail to satisfy section 411(d)(6) merely because it is not available in the form of employer securities or it is available only as a single sum distribution.

However, a distribution or transfer in satisfaction of a diversification election is eligible for the special exception for ESOP benefits under section 401(a)(11)(C). See, however, Q&A-16 with respect to the inapplicability of this special ESOP benefit exception for distributions of amounts previously diversified pursuant to section 401(a)(28) in accordance with either Q&A-13(B) or Q&A-13(C).

Finally, a distribution in satisfaction of a diversification election must satisfy section 411(a)(11) concerning the consent of the participant to a distribution, but is not subject to the rules, under section 401(a), restricting the distribution of plan benefits before the termination of employment (in the case of a pension plan) or the occurrence of certain other events (in the case of a profit-sharing plan).

Q-15: Has a plan satisfied the distribution option described in A-13(A) of this notice with respect to a qualified participant's diversification election for a given year if the qualified participant does not elect to receive a distribution from the plan?

A-15: Yes. An ESOP or a tax credit ESOP has satisfied the diversification of investments requirement with respect to a qualified participant for a given year when the plan has made available to a qualified participant a distribution of the portion of the qualified participant's account subject to the diversification election (as determined under Q&A-9 of this notice) regardless of whether the qualified participant actually elects to receive a distribution of employer securities. Thus, the diversification election has been satisfied where a distribution to a qualified participant has not been made solely because of the failure of a participant to elect such distribution (or of a participant's spouse to consent to the distribution if such consent is required). This result is the same as the result under A-13(B), which requires only that the ESOP offer 3 distinct investment options (and not that a qualified participant actually elect to diversify).

Q-16: To what extent is a distribution of amounts previously diversified pursuant to section 401(a)(28) in accordance with either Q&A-13(B) or Q&A-13(C) subject to certain other provisions of the plan or Code governing distributions?

A-16: Amounts that have been diversified pursuant to section 401(a)(28) in accordance with either Q&A-13(B) or Q&A-13(C) are treated as amounts that are not held under an ESOP. Thus, section 409(h) does not apply to a distribution of such amounts. Similarly, section 411(d)(6) is not violated if such amounts are not available for distribution in the form of employer securities. Finally, in the case of an ESOP that is a money purchase pension plan, amounts that have been previously diversified in accordance with either Q&A-13(B) or Q&A-13(C) may not be distributed prior to the participant's separation from service and fail to qualify for the special ESOP benefit exception under section 401(a)(11)(C).

Q-17: Has an ESOP failed to satisfy the requirements of section 401(a)(28) with respect to diversification elections offered to qualified participants before the issuance of this notice if it offered such elections in accordance with a reasonable interpretation of section 401(a)(28)?

A-17: No. An ESOP which offered diversification elections which do not fully conform with this notice before the issuance of this notice has not failed to satisfy the requirements of section 401(a)(28) where: 1) the non-conforming diversification election was first offered to qualified participants before June 8, 1988, and 2) the non-conforming diversification election was based on a reasonable interpretation of the statute. However, any diversification election offered after June 8, 1988, must be in compliance with the requirements of this notice. An ESOP which offered qualified participants a diversification election before June 8, 1988, which did not comply with the requirements of this notice, may offer qualified participants a diversification election which conforms to the requirements of this notice within the period ending on September 6, 1988. For purposes of this provision, operation in conformity with the model plan amendments contained in Notice 87-2, 1987-2 IRB 17, will be treated as based on a reasonable interpretation of the statute.

In addition, a calendar year ESOP which offered, within the first 90 days of 1988, a diversification election to a person who became a qualified participant during the 1987 plan year will be treated as operating on the basis of a reasonable interpretation and therefore has not failed to comply with section 401(a)(28)(B) even though such a participant is not require to be given a diversification election pursuant to the statute until the first 90 days of 1989.

B. CODE SECTION 72(t)

Q-18: For purposes of section 72(t)(2)(C), when have a majority of assets in an ESOP, or benefits distributed to participants, been invested in employer securities for the five plan year period preceding a distribution?

A-18: For purposes of determining whether a plan has had a majority of its assets invested in employer securities (as defined in section 409(1)) for the preceding five plan year period under section 72(t)(2)(C)(i), or for purposes of determining whether a distribution is a "qualifying ESOP distribution" (See Q&A-21 of Notice 87-13) under section 72(t)(2)(C)(ii), assets of the plan will not fail to be treated as invested in employer securities solely because of the transactions described in this Q&A-18.

A) Cash or other assets derived from the disposition of employer securities pursuant to a corporate reorganization or acquisition attempt (whether or not successful) which are used to purchase other employer securities will be treated as invested in employer securities at the time acquired by the plan if the period between the disposition and the reinvestment does not exceed 90 days or such longer period as may be granted by the Commissioner under rules similar to those of Treas. Reg. section 1.46-8(e)(10). For dispositions after June 8, 1988, no extensions will be granted unless applied for within 90 days after the disposition.

B) Cash contributions made by the employer to a tax credit ESOP will be treated as invested in employer securities at the time acquired by the plan if such contributions are used to purchase employer securities within the time periods after contribution provided by the applicable statutory or regulatory provisions governing the requirements for the tax credit.

C) Any other contributions made to an ESOP in cash (including employee contributions) will be treated as invested in employer securities at the time acquired by the plan if such contributions are used to purchase employer securities within 60 days after the date of the contribution.

D) Earnings or dividends attributable to employer securities paid in cash to an ESOP will be treated as invested in employer securities at the time acquired by the plan if such earnings or dividends are used to purchase employer securities within 60 days from the date of payment to the ESOP.

E) Proceeds of an exempt loan (under section 4975) received by the ESOP in cash will be treated as invested in employer securities at the time acquired by the plan if such proceeds are invested in employer securities within 60 days of the receipt of the proceeds by the ESOP.

F) Amounts transferred to an ESOP pursuant to a section 4980 transaction will be treated as invested in employer securities at the time acquired by the plan if the amounts are used to purchase employer securities within the time period prescribed in section 4980(c)(3)(B).

In addition, benefits held in cash or cash equivalents are to be treated as invested in employer securities to the extent that the value of such benefits allocated to a participant does not exceed 2 percent of the value of the employer securities allocated to such participant under the ESOP or tax credit ESOP.

RELIANCE

This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.

DRAFTING INFORMATION

The principal author of this notice is John T. Ricotta, of the Office of the Chief Counsel, Employee Benefits and Exempt Organizations Division. For further information regarding this notice please contact the Employee Plans Technical and Actuarial telephone assistance service between the hours of 2 p.m. and 4 p.m., Eastern Time, Monday through Friday at (202) 566-6783/6784 (not a toll-free call). Mr. Ricotta can be contacted at (202) 566-3459 (not a toll- free call).