Using Rebalancing to Comply with IRC Section 409(p)
January 30, 2007
If you missed yesterday’s post, we discussed rebalancing (a.k.a. reshuffling). Today we are going to discuss a more recent use or suggested use of rebalancing – using rebalancing as a 409(p) prevention or fail-safe method.
The ESOP Association's Advisory Committee on Legislative and Regulatory Issues had an informative article in the December 2006/January 2007 edition of the ESOP report magazine. One of the primary plan design features discussed was using rebalancing (the authors used the term “mandatory diversification”) to reduce the risk of violating 409(p). Assisting in managing the company’s repurchase obligation and insuring all participants fully participate in the ESOP were both mentioned as additional benefits of using rebalancing.
While using rebalancing sounds like a great idea, there may be a problem with this strategy.
Could Rebalancing Be Considered Discriminatory (Under IRC Section 401(a)(4))?
The above-mentioned article cites a meeting with the Department of Treasury as a reason that 401(a)(4) may not be an issue:
“William Bortz, Associate Benefits Tax Counsel, Department of Treasury, indicated in a recent meeting that if mandatory diversification was a plan design feature, that such design feature would not be seen as discriminatory (under IRC § 401(a)(4)), and would be an acceptable method of reallocating stock in an ESOP plan. This is similar to the unit method of accounting which the IRS has approved for many years.”
However, this statement appears to be contradicted by the following statement in this article, referring to a discussion with the same source (and perhaps at the same meeting):
“One option that does not seem viable, Acheson emphasized, is reshuffling or rebalancing participant accounts, such that S corporation stock held in DQP accounts would be sold within the ESOP. In fact, Acheson said, at a Feb. 22 meeting of the S Corporation Association, William Bortz, associate benefits tax counsel at the Treasury Department, said that Treasury would not approve reshuffling.”
Using rebalancing as a prevention strategy was also discussed in this article. Here is what was said about the discrimination requirements:
“Whatever you do in this regard must satisfy the basic nondiscrimination requirements of ERISA, but since you will most likely be discriminating against the highest-compensated employees to fix these problems, that will most likely not be a problem.”
All of the above articles/discussions were most likely written/conducted prior to the issuance of the final regulations. Let’s take a closer look at thefinal 409(p) regulations:
- “Any methods of preventing a nonallocation year must satisfy applicable legal and qualification requirements, including the nondiscrimination requirements of section 401(a)(4) (including the rules at § 1.401(a)(4)-4 relating to benefits, rights and features), and implementation of these methods must be completed before a nonallocation year occurs.”
This appears to clarify that any rebalancing must be tested under IRC Section 401(a)(4).
- “A commentator described another method of preventing a nonallocation year under which stock of a participant is exchanged for cash or other assets, which are already in the accounts of other participants in order to change the stock holdings among participants before a nonallocation year occurs, but which does not change the overall stock holding of the ESOP trust. This method has been referred to as reshuffling. The commentator requested that relief from the nondiscriminatory availability requirements be extended to this method.”
This appears to clarify that they are specifically addressing rebalancing/reshuffling.
- “The IRS and Treasury Department do not believe that it would be appropriate to provide a special rule that would materially weaken the standard for nondiscriminatory availability of participant rights to a particular investment under the plan.”
This appears to indicate that rebalancing will not receive a "special rule". The 2004 regulations contained a “special rule” stating that “a transfer of the S corporation securities held for the participant under the ESOP into a separate portion of the plan that is not an ESOP or to another qualified plan of the employer that is not an ESOP” will not fail to satisfy the nondiscrimination requirements as a result of the transfer.
Of course, this raises questions about the future of rebalancing. This post discussed an article that raised these questions further.
“In response to a comment, the IRS said that companies could not address a nonallocation year problem by targeted reshuffling (also called rebalancing) of shares within the accounts of the employees whose accounts hold too much stock and replacing it with cash from accounts of other employees. Many ESOPs do this on a plan-wide basis for reasons unrelated to the anti-abuse rules. The IRS, however, said that this involuntary movement out of assets already held by employees, even though they are replaced by other assets with the same value, was, absent special circumstances, a violation of the "current and effective availability" requirements of ERISA. This language only has specific application to how companies deal with anti-abuse issues. The question remains, however, whether the IRS would apply this same logic to any plan that uses rebalancing for other purposes. Experts we consulted generally believe it does not threaten such practices, provided that plan language has already been carefully drafted and submitted to the IRS enabling it, but some experts have always contended that rebalancing violates ERISA.”
As you can see, there are many questions that still need to be answered. If any of the rebalancing information discussed yesterday or today is relevant to your plan, you should contact your ESOP counsel and advisors to discuss further.