Qualifying Employer Securities: Limits, Diversification, and NUA

Qualifying employer securities are the narrow set of company-issued investments that ERISA lets a retirement plan hold: stock of the employer or an affiliate, certain marketable debt obligations, and interests in a small class of pre-1988 publicly traded partnerships.¹ Whether a plan can hold these securities, how much it can hold, when participants can sell them, and how the plan must price transactions all depend on rules scattered across ERISA and the Internal Revenue Code.

What Qualifies

Under 29 U.S.C. § 1107(d)(5), a qualifying employer security is one of three things. The first and most common is stock of the sponsoring employer or an affiliate, whether common or preferred. The second is a marketable obligation, essentially a bond or note that meets specific market and concentration tests. The third is an interest in certain publicly traded partnerships that existed before 1988, which rarely comes up in practice.¹

Traditional defined benefit pensions and other plans that are not individual account plans face a further test. Since December 17, 1987, stock only qualifies for these plans if it satisfies ownership-percentage tests in the statute, which effectively keeps pension funds out of thinly traded employer shares.¹

Marketable Obligation Tests

If the plan holds employer debt rather than stock, several conditions apply at once. The obligation must be bought on a national securities exchange, from an independent underwriter at the public offering price, or directly from the issuer at a price no worse than what independent buyers are paying. Right after the purchase, the plan cannot hold more than 25 percent of the total outstanding issue, independent parties must hold at least 50 percent of that issue, and the plan cannot have more than 25 percent of its total assets in employer obligations.²

How Much a Plan Can Hold

The default rule is a hard cap. A plan cannot acquire employer securities or employer real property if the purchase would push those holdings above 10 percent of the plan’s total fair market value.¹ Defined benefit pensions live under this ceiling because they promise a fixed benefit no matter how the investments do.

Eligible individual account plans are the big exception. This category includes 401(k) plans, profit-sharing plans, stock bonus plans, and ESOPs, and it is exempt from the 10 percent limit.¹ The exemption only applies if the plan document actually authorizes the higher concentration; when the governing documents are silent, the 10 percent default controls, and fiduciaries who exceed it face personal liability for resulting losses and possible removal by the Department of Labor.³

Participant Diversification Rights

The Pension Protection Act of 2006 gave workers the right to move out of employer stock in a defined contribution plan, and the rules split by the source of the contribution.

For your own money, meaning elective deferrals, after-tax employee contributions, and rollovers, you can diversify immediately. If any of your account is in employer securities, the plan has to let you sell and reinvest in other options. The plan can restrict how often you switch, but it must give you the chance at least quarterly.⁴

For employer contributions, including matching and other nonelective amounts, the right kicks in after three years of service. The same three-year threshold applies to alternate payees under a qualified domestic relations order and to beneficiaries of deceased participants.⁵

When you exercise these rights, the plan has to offer at least three investment alternatives besides employer securities, each with meaningfully different risk and return characteristics. The plan also cannot impose restrictions on employer stock that don’t apply to other investments. A waiting period that locks you out of buying back into employer stock after you have diversified out is a prohibited restriction.⁵

Plans must also send periodic notices explaining these rights and the risks of concentration in a single stock. Failure to provide the notices exposes the plan administrator to per-participant penalties under ERISA § 502(c)(7), and the penalty adjusts annually for inflation.

Buying and Selling Stock Between the Plan and the Employer

Any transaction between a plan and its sponsoring employer is a prohibited transaction by default because of the built-in conflict of interest. ERISA carves out a specific exemption for trades in qualifying employer securities, but only when two conditions are met: the plan pays or receives adequate consideration, and no commission is charged.⁶

For publicly traded stock, adequate consideration is the market price on a recognized exchange at the time of the trade. For privately held stock, the plan needs an independent appraisal establishing fair market value. The appraiser cannot have a financial relationship with the employer that would bias the valuation and must produce a written report analyzing value, financial viability, and debt-service capacity.

If a transaction misses the exemption, IRC § 4975 imposes an initial excise tax of 15 percent of the amount involved for each year, or partial year, in the taxable period. If the transaction still isn’t corrected by the end of that period, an additional tax of 100 percent of the amount involved applies.⁷ The disqualified person who took part in the transaction owes the tax, not the plan.

Fiduciary Duty When the Plan Holds Company Stock

Courts once applied a “presumption of prudence” to ESOP fiduciaries who bought or held employer stock. The Supreme Court eliminated that presumption in Fifth Third Bancorp v. Dudenhoeffer, holding that ESOP fiduciaries are subject to the same duty of prudence as other ERISA fiduciaries, with one carve-out: they are not required to diversify the fund’s assets.⁸

The harder question is what to do with nonpublic negative information. The Court set a demanding standard: a plaintiff must show that a prudent fiduciary in the same position could not have reasonably concluded that disclosing the bad news or halting purchases would cause more harm to the fund than good.⁸ Courts weigh whether selling the stock or going public with bad information would itself crash the price and hurt participants who already own shares.

Net Unrealized Appreciation on Distribution

When you leave the employer or hit another qualifying event, IRC § 402(e)(4)(B) offers a tax option that can beat a plain rollover for people with appreciated company stock in the plan. If you take a lump-sum distribution that includes employer securities, the net unrealized appreciation on those shares is excluded from gross income at the time of distribution.⁹ You pay ordinary income tax only on the plan’s cost basis in the stock. When you later sell the shares, the NUA portion is taxed at long-term capital gains rates regardless of how long you held the shares after distribution.¹⁰

Say the plan bought your shares at an average cost of $20 and they are worth $100 at distribution. You owe ordinary income tax on the $20 basis in the year of distribution. The $80 of NUA is taxed at long-term capital gains rates whenever you decide to sell.

The rules for qualifying are strict. You must take a lump-sum distribution of your entire account balance, though non-stock assets can be rolled to an IRA. The distribution must be triggered by separation from service, reaching age 59½, disability, or death. The stock has to be distributed in kind, meaning the actual shares move to a taxable brokerage account rather than being sold inside the plan first. Rolling the stock into an IRA permanently forfeits NUA treatment.⁹

Appreciation after the distribution date follows normal capital gains rules. Hold the shares more than 12 months after distribution and the additional gain is long-term; sell sooner and the post-distribution gain is short-term. The NUA portion itself is always long-term.

Voting and Tender Offers

Holding employer stock through a defined contribution plan doesn’t strip you of shareholder influence. The Internal Revenue Code requires certain voting rights to pass through to participants on major corporate decisions like mergers, recapitalizations, or liquidations, so you vote the shares allocated to your account.¹¹ On a tender offer, the plan fiduciary must give you the information needed to decide and then let you choose whether to tender your allocated shares. Your decision is generally confidential. If you give no instructions, the trustee follows the default procedures in the trust agreement.

S-Corporation ESOP Anti-Abuse Rules

S-corporation ESOPs get special tax treatment because the ESOP’s share of company income passes through tax-free. IRC § 409(p) exists to keep these plans from becoming shelters that benefit owners and highly compensated employees rather than rank-and-file workers.¹²

The key trigger is a “nonallocation year,” which happens when disqualified persons collectively own or are deemed to own at least 50 percent of the ESOP shares. A person becomes disqualified by owning at least 10 percent of the shares individually, or 20 percent when combined with family members. Triggering a nonallocation year brings excise taxes on the employer, deemed distributions to disqualified persons, potential loss of plan qualification, and even loss of S-corporation status. The plan document must explicitly define both terms and must prohibit allocating employer stock to disqualified persons during a nonallocation year; incorporation by reference is not enough.¹²

Blackout Period Notices

When a plan temporarily suspends trading in employer stock or other investments, the administrator must notify affected participants at least 30 days but no more than 60 days before the blackout starts. Blackouts usually happen during recordkeeper changes or plan mergers, and they block trades and distributions during the transition. The 30-day rule has narrow exceptions: a fiduciary determining in writing that the delay would breach the duty of prudence, unforeseeable events that make advance notice impossible, or a blackout caused by a corporate merger or acquisition. Even then, notice has to go out as soon as reasonably possible.¹³ Missing the deadline exposes the administrator to per-participant penalties under ERISA § 502(c)(7).

1
Office of the Law Revision Counsel. 29 USC 1107 – Limitation With Respect to Acquisition and Holding of Employer Securities and Employer Real Property by Certain Plans
2
eCFR. 29 CFR 2550.407d-5 – Definition of the Term Qualifying Employer Security
3
U.S. Department of Labor. Fiduciary Responsibilities
4
eCFR. 26 CFR 1.401(a)(35)-1 – Diversification Requirements for Certain Defined Contribution Plans
5
Internal Revenue Service. Notice 2006-107 – Diversification Requirements for Qualified Defined Contribution Plans Holding Publicly Traded Employer Securities
6
Office of the Law Revision Counsel. 29 USC 1108 – Exemptions From Prohibited Transactions – Section: (e)
7
Office of the Law Revision Counsel. 26 USC 4975 – Tax on Prohibited Transactions
8
Justia. Fifth Third Bancorp v Dudenhoeffer, 573 US 409 (2014)
9
Office of the Law Revision Counsel. 26 USC 402 – Taxability of Beneficiary of Employees Trust
10
Internal Revenue Service. Notice 98-24
11
Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
12
Internal Revenue Service. Preventing the Occurrence of a Nonallocation Year Under Section 409(p)
13
eCFR. 29 CFR 2520.101-3 – Notice of Blackout Periods Under Individual Account Plans