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The Employee Ownership Update

Corey Rosen

September 24, 2003

(Corey Rosen)

Senate Finance Committee Bill Requires Diversification Rights in 401(k) Plans; Allows Distributions to Repay S ESOP Loan

On September 17, the Senate Finance Committee unanimously passed the "National Employee Savings and Trust Equity Guarantee Act" ("NESTEG"-even Congress has a sense of humor). The bill contains a variety of reforms of defined benefit and contribution plans. One provision provides that in 401(k) plans in public companies employees with three years service must be able to diversify out of employer stock for shares contributed by the company and immediately for shares they purchased. The provision does not apply to closely held companies or, generally, to stand-alone ESOPs funded entirely by employer contributions. However, if an ESOP is used to make matching contributions (as in an ESOP that is used to match 401(k) contributions) or has nonelective employer contributions used to meet special anti-discrimination test rules, it would be subject to these new diversification rules. If an ESOP is subject to the new rules, it would not have to meet current, less strict, diversification rules. Closely held companies include any plans not holding publicly traded securities as employer stock. Transition rules allow the new requirements to be phased in over three years. The bill also provides that S corporation ESOPs can use distributions on both allocated and unallocated stock to replay an ESOP loan. The effective date is retroactive to January 1, 1998. In addition, the law provides that in all defined contribution plans, vesting must be complete after not more than three years for cliff vesting and six years for graduated vesting (starting at 20% after the second year).

The bill now goes to the full Senate where further changes are possible. The House Ways and Means Committee previously passed H.R. 1776, the "Pension Preservation and Savings Expansion Act of 2003," which has a number of similar provisions, including on diversification (but does not have the S ESOP company provision). No action seems likely on that bill in the full House. Rep. John Boehner (R-OH) and Bill Thomas (R-CA, and Ways and Means Committee Chair) have now introduced much more modest pension reform legislation in the House, narrowly focused on defined benefit plans. This bill may pass the House, but observers are skeptical that the broader provisions of the Senate reform bill or H.R. 1776 will make it into law because the two bills differ too much on controversial provisions, particularly how to provide exemption from fiduciary liability for investment advice to employees.

Finance Committee Bill Also Makes Changes to Stock Options and ESPPs

As passed by the Senate Finance Committee, the "National Employee Savings and Trust Equity Guarantee Act" would prohibit employees from deferring taxation on stock options, restricted stock, or other equity arrangements by electing to defer any compensation until some point after the exercise of the award. Additionally, the bill would exclude from withholding taxes the income from exercising employee stock purchase plan options and the income from disqualifying exercises of incentive stock options. These exercises are not currently subject to such taxes, but only because the IRS has put an indefinite hold on a proposal to do so. The withholding proposal was passed by the House Ways and Means Committee as part of H.R. 1776, but no further action on that bill is planned in the House. The deferral of tax provision is not contained in House pension reform legislation.

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