April 2006
Vol. IX, No. 1
ERISA, EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION NEWSLETTER
This past year has been busy indeed with respect to tax and ERISA law changes affecting every type of tax-qualified, executive compensation and welfare benefit arrangement. This Newsletter highlights the salient issues of which you should be aware. This Newsletter also contains a table with new cost of living adjustments affecting tax-qualified plans.
The Newsletter is not intended as, and cannot be considered to constitute, specific legal advice, as each individual circumstance is unique. However, we are prepared to assist our clients and business associates in reviewing their employee benefit programs and in making any necessary or desirable revisions to take into account changes in the law.
Since our last Newsletter, Marcia S. Wagner has continued to lecture and write extensively, and has received recognition in "The Best Lawyers in America" and "Massachusetts Super Lawyers". She has also been quoted in several major news publications, and has provided numerous seminars for the American Bar Association, Department of Labor, Internal Revenue Service and others. Marcia has also co-authored a Quick Reference to HIPAA Compliance, for Aspen Publishers and two BNA Tax Management Portfolios entitled "ERISA Litigation, Procedure, Preemption and Other Title I Issues" and "EPCRS Plan Correction and Disqualification". Marcia has also received the prestigious AV Peer Review Rating by LexisNexis Martindale-Hubbell for very high to preeminent legal ability and integrity, and has received two Who's Who honors. Ari J. Sonneberg continues his work at the Tax Section Council of the Massachusetts Bar Association. Debra Dyleski-Najjar has received recognition in three Who's Who publications, was named by Boston Women's Business Journal as one of Boston's top-ten women attorneys, completed the prestigious "Leadership New Hampshire" program and was recognized in Chambers U.S. Guide to Leading Lawyers in America. Diane Goulder Cohen has received "The Best Lawyers in America" honor in the ERISA/Employee Benefits field. To learn more about our team and practice, please visit our web site at www.erisa-lawyers.com.
In the event you desire legal advice or consultation, please feel free to contact Marcia S. Wagner, Christopher J. Sowden, John R. Keegan, Diane Goulder Cohen, Stephen J. Migausky, Ari J. Sonneberg, Jon C. Schultze, Jaime A. Dansa or Virginia S. Peabody.
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TABLE OF CONTENTS
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I COST OF LIVING ADJUSTMENTS
II. DEFINED CONTRIBUTION PLANS
A. Roth 401(k) Plans
B. Final 401(k) Plan Regulations
C. New 403(b) Regulations
D. Temporary Rules Expand FICA Taxation of 403(b) Contributions under Salary Reduction Agreements
E. Deemed IRAs in Qualified Plans
F. S Corp/ESOP Abuses
G. Proposed Rules Finalized for Eliminating Forms of Distribution
H. EBSA Issues Guidance on Distributions to Missing Participants from Terminated DC Plans
I. EBSA Proposed Regulations Provide Termination Instructions for Service Providers of Abandoned Plans
III. DEFINED BENEFIT PLANS
A. Phased Retirement Distributions from Pension Plans
B. Cash Balance Plans
C. IRS Issued Proposed and Final Regulations on Anti-Cutback
Rules
D. Regulations on QJSAs and QPSAs Cover Information that Participants
Must Receive to Compare Distribution Forms
E. IRS Cracks Down on "Abusive" Life Insurance Policies in 412(i) Plans
F. Deficit Reduction Act
G. IRS Proposes Shift to New Mortality Tables for Computation of Employee Plan Liabilities
IV. ALL TAX-QUALIFIED PLANS
A. Fees for Plan Rulings Increase Sharply
B. Hurricane Katrina Statutory and Administrative Relief
C. IRS Overhauls Rules on Remedial Plan Amendments
D. Bankruptcy Issues
E. Labor Department Issues Safe Harbors for Automatic Rollovers of Plan Distributions
F. IRS Issues Comprehensive Guidance on Plan Limits on Benefits and Contributions
G. EBSA Overhauls Voluntary Fiduciary Correction Program and Proposes Amendment to Related Class Exemption
H. IRS Changes Policy on Part-Time Employees and Qualified Plans
V. WELFARE BENEFIT PLANS
A. Comparison of Health Savings Accounts, Health Reimbursement Arrangements and Flexible Spending Accounts
B. Definition of Dependent
C. Modification of the Application of the "Use-it-or-Lost-it" Rule
D. HIPAA Update
E. Medicare Prescription Drug Benefits Impact on Employer-Sponsored Plans
F. Final COBRA Regulations Require Major Overhaul to COBRA Notices and Procedures
G. Parking, T-Pass and Vanpool Fringe Benefits IRC Section 132(f)
VI. NEW NONQUALIFIED DEFERRED COMPENSATION RULES UNDER CODE SECTION 409A
A. IRS Guidance on New Nonqualified Deferred Compensation Rules Explains Key Terms and Exceptions
B. IRS Provides Deferred Compensation Relief for Stock Options and SARs
C. Elections as to Deferrals and Distributions
D. Restrictions on Distributions
E. Effective Dates and Reliance
VII. MISCELLANEOUS
A. IRS Circular 230 Rules Seek to Rein in Tax Shelter Activity
B. Proposed Regulations Tighten Private-Purpose Prohibition for Section 501(c)(3) Exempt Status
C. IRS Issues Guidance on Determining Automatic Excess Benefit Transactions
I. COST OF LIVING ADJUSTMENTS
| 2005 | 2006 | |
| Maximum annual payout from
a defined benefit plan at or after age 62 (Plan Year ending in stated Plan Year) |
$170,000* | $175,000* |
| Maximum annual contribution to an individual's defined contribution account (Plan Year beginning in stated year) | $42,000 ** | $44,000 ** |
| Maximum Section 401(k), 403(b) and 457(b) elective deferrals | $14,000 *** | $15,000 *** |
| Section 401(k) and Section 403(b) catch-up limit for individuals aged 50 and older | $4,000*** | $5,000*** |
| Maximum amount of annual compensation
that can be taken into account for determining benefits or contributions
under a qualified plan |
$210,000 | $220,000 |
| Test to identify highly compensated
employees, based on compensation in preceding year |
$95,000 | $100,000 |
| Wage Base: For Social Security Tax | $90,000 | $94,200 |
| For Medicare | No Limit | No Limit |
| Amount of compensation to be a key employee | $135,000 | $140,000 |
* There are late-retirement adjustments for benefits starting
after age 65.
** Plus "catch-up" contributions.
*** These are calendar year limitations.
**** For example, if looking back to 2005 to identify highly
compensated employees in 2006, use the $95,000 limit; if looking
back to 2006 to identify highly compensated employees in 2007,
use the $100,000 limit.
II. DEFINED CONTRIBUTION PLANS
A. Roth 401(k) Plans
The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") amended the Internal Revenue Code of 1986 (the "Code") to add Section 402A which permits Code Section 401(k) and 403(b) plans to allow participants to elect that a portion or all of their contributions to such plans be designated as Roth contributions for plan years beginning on or after January 1, 2006. Roth contributions are not tax deductible.
Roth contributions to Code Section 401(k) and 403(b) plans are likely to be attractive to many participants. The primary advantage of Roth contributions is that the earnings thereon are not taxed. This feature may be particularly advantageous to younger, lower-paid participants who have a longer time to retirement and for whom the benefit of a tax-free distribution at retirement will outweigh the current tax costs. Higher income employees have not had the right to use Roth IRAs because of the Roth IRA income limits. However, under Roth 401(k) and 403(b) plans, highly compensated employees will be able to save up to $15,000 after tax per year (in 2006, subject to an inflation adjustment in future years) without future income tax liability on the earnings on these Roth contributions. Further, there is a significant benefit to both lower income and higher income employees: contributions to a Roth 401(k) or 403(b), unlike Roth IRAs, may be matched by a participant's employer on a pre-tax basis, like matching contributions on non-Roth 401(k) or 403(b) elective deferrals.
Plan sponsors considering whether to implement Roth contributions in their 401(k) or 403(b) should tread carefully, as there are a number of legal and administrative issues that could add confusion, expense, or legal exposure for plan sponsors, their employees, and service providers.
1. Background
The general rule under Code Section 402A is that any contribution designated by a participant as a "designated Roth contribution" to a "qualified Roth contribution program" will be treated the same as an elective deferral. Except for rollover contributions from other Roth accounts, Roth contributions are aggregated with non-Roth elective deferrals and are subject to the elective deferral limits under Code Section 402(g) ($15,000 in 2006 for 401(k) or 403(b) plans; $20,000 for Code Section 414(v) catch-up eligible participants)).
A "qualified Roth contribution program" must satisfy two basic requirements. First, a participant must be able to designate that some or all of his or her elective deferrals will be Roth contributions. Second, Roth contributions must be recorded in a separate account with applicable earnings and losses allocated to the Roth account.
For a distribution from a designated Roth account to be tax-free, it must be a "qualified distribution." In general, a "qualified distribution" is a distribution (i) that is made after a participant reaches age 59-1/2, dies, or becomes disabled, and (ii) that is not made within five years of a participant's first Roth contribution to the applicable plan or a predecessor plan to which Roth contributions were also made. If Roth contributions result in excess deferrals under Code Section 402(g), the excess deferrals must be distributed by April 15 of the year following the year of contribution to avoid taxation even though the distribution is not a qualified distribution.
2. Proposed and Final Regulations
On March 2, 2005, the IRS issued proposed regulations providing guidance on Roth contributions, and recently, on January 3, 2006, the IRS issued final regulations. The regulations are written as additional language that is intended to supplement the recently effective comprehensive final regulations under Code Sections 401(k) and 401(m) (See Section II.B of this Newsletter).
a. Contribution Elections. An employee must irrevocably designate his or her contributions as Roth contributions at the time of his or her cash or deferred election and designate that the Roth contributions are being made in lieu of all or a portion of the pre-tax elective deferrals the participant is otherwise eligible to make, and Roth contributions must be included in income and subject to withholding at the time the employee contributes such amounts.
b. Separate Accounting. Roth contributions, earnings, and distributions must be tracked in a separate account. Gains, losses, and other credits or charges must be allocated to a Roth account and other plan accounts on a reasonable and consistent basis. Furthermore, forfeitures may not be allocated to a Roth account.
c. Compliance With Elective Deferral Requirements. Roth contributions must satisfy the requirements applicable to elective deferrals made under a cash or deferred arrangement or 401(k) plan. Therefore, Roth contributions must: (i) be nonforfeitable, (ii) follow the distribution-timing rules applicable to elective deferrals, and (iii) be treated as elective deferrals for most purposes (including nondiscrimination testing under Code Section 401(k) and (m)). Also, Roth accounts, unlike Roth IRAs, are subject to the minimum required distribution rules during a participant's lifetime (i.e., at the later of age 70-1/2 or retirement).
d. 401(k) and (m) Nondiscrimination Testing. A plan may permit an employee to designate whether excess contributions (as determined after ADP and ACP testing) are attributable to his pre-tax or Roth contributions.
e. Elective Deferral Requirement. In order to provide for designated Roth contributions, a qualified cash or deferred arrangement also must offer pre-tax elective deferrals.
f. Automatic Enrollment or Negative Elections. Plans can use automatic enrollment in conjunction with Roth contributions, but in doing so must set forth the extent to which default contributions are pre-tax elective contributions or designated Roth contributions. Wage laws of certain states may require that any deduction from wages be authorized by the employee in writing. Employers should check state law before using negative elections.
The IRS issued additional proposed regulations on the taxation of distributions from Roth contribution accounts under a 401(k) plan or 403(b) annuity on January 26, 2006. These regulations provide much-needed guidance and fill in gaps left from previous guidance.
a. Non-qualified Distributions. A "non-qualified distribution" will be subject to income taxation based on a pro-rata allocation of the income earned in the account to the contributions made to the account.
b. Partial Distributions. If a participant receives a partial distribution from a plan with both Roth and pre-tax accounts, either the participant or the plan can specify from which account the distribution is paid. A partial distribution from a Roth account must include a pro-rata distribution of income.
c. Rollovers. A participant can elect a direct plan-to-plan rollover of a Roth distribution from one 401(k) plan to another 401(k) plan, or from a Roth 403(b) plan to another Roth 403(b) plan. A participant also can elect a plan-to-plan or 60-day rollover of a distribution from a Roth plan to a Roth IRA (even if the participant would otherwise be barred from making a Roth IRA contribution). A participant cannot transfer any amount from a Roth IRA to a 401(k) or 403(b) plan even if the only amount in the IRA is a rollover distribution from a Roth 401(k) or 403(b) plan.
If a participant elects a direct plan-to-plan rollover of a Roth distribution, the five-year tracking period begins on the first day for which the employee first had Roth contributions made to the other plan, if earlier. In a plan-to-plan rollover from one Roth plan to another Roth plan, the distributing plan must inform the recipient plan, within 30 days, either: (1) that the distribution is a qualified distribution; or (2) the amount of the participant's basis and the year the participant's 5-year clock started to run. If a Roth plan distributes the amount to the participant, the participant can request a similar written statement.
d. Hardship distributions. The taxation of a hardship distribution to a participant from a 401(k) plan will depend on the portion of the participant's elective deferrals that is distributed from his Roth and pre-tax accounts (reduced by prior hardship distributions and excluding income on deferrals, QNECs, and QMACs).
e. Participant Loans. Loans may be paid from a participant's pre-tax account, Roth account, or both, and repayments must be allocated to each account, as applicable. If a participant defaults and a deemed distribution occurs, the Roth portion would be a nonqualified distribution, regardless of the 5-year clock or the participant's age.
f. Excess deferrals. Roth contributions that are excess
deferrals and that are not corrected before April 15th of the
following year are includible in gross income (with no exclusion
from income for amounts attributable to basis) and are not eligible
for rollover.
3. Open Issues
A number of questions remain to be addressed, including the following:
a. Automatic Rollover Rules. As discussed in Section IV. E of this Newsletter, effective March 28, 2005, mandatory cashouts of amounts between $1,000 and $5,000 became subject to the mandatory rollover rules. Because Roth contributions are treated as elective deferrals, Roth accounts may be subject to the mandatory rollover rules. As such, plans providing for mandatory cashouts of amounts between $1,000 and $5,000 may need to work with their service providers to provide default rollover Roth IRA accounts for Roth contributions.
b. Fiduciary Issues. There are certain unsolved fiduciary questions as well, for example: To what extent is the employer obliged to provide assistance to employees in deciding which type of contribution to make? Will general written materials suffice to meet any such obligation if these materials include a suggestion that the employee consult with a tax adviser, even though many employees may not have a tax adviser or are unwilling to hire one? If such assistance is provided by a person (including the employer) who is a fiduciary under the Employee Retirement Income Security Act of 1974 ("ERISA"), could this person be subject to claims of breach of fiduciary responsibility by plan participants asserting that such assistance was insufficient, misleading, or wrong?
Comment: Sunset After December 31, 2010. As is the case with many Code provisions added by EGTRRA, Roth contributions are due to sunset after December 31, 2010. It is expected that Roth contributions will result in a long-term reduction in revenue received by the Treasury due to the tax-free distribution of Roth accounts. As such, it is unclear whether there is sufficient political support for enacting legislation permitting Roth contributions after 2010. Employers should not shy away from offering Roth 401(k)s and 403(b)s because they might not be permanent. It is important to recognize that participants have a planning opportunity right now.
Comment: Plan Amendment. If you are considering adding a Roth contribution feature to your tax-qualified plan, please call us for assistance and advice; also, your plan document will need to be amended, and new summary plan descriptions or summaries of material modifications and enrollment forms will have to be distributed to your employees. Administratively, employers will need to ensure that new or upgraded recordkeeping systems are in place to maintain and track Roth contribution accounts. Additionally, changes to the payroll systems are needed to withhold taxes on Roth contributions and to include Roth contributions in income on an employee's Form W-2.
B. Final 401(k) Plan Regulations
The IRS has issued a huge set of comprehensive final regulations setting out the nondiscrimination and other requirements for Code Section 401(k) cash or deferred arrangements, and for matching contributions and employee contributions under Code Section 401(m). The 228 pages of regulations reflect the relevant tax law changes and IRS rulings that have come into effect since 1994, and modify and finalize the proposed regulations that were issued in 2003.
1. Prohibition of Pre-Funded Contributions
Contributions are treated as made pursuant to a cash or deferred election only if they are made after the employee's performance of services which relate to the compensation that would have been paid to the employee absent the election. Amounts contributed in anticipation of the future performance of services are not treated as elective contributions. Thus, employers may not pre-fund elective contributions in order to accelerate the deduction for elective contributions.
Employers are also prohibited from pre-funding matching contributions
to accelerate the deduction for contributions. Thus, a matching
contribution could not be made before the employee's performance
of services with respect to which the elective deferral was made
or before the employee's contribution.
2. Mandatory Disaggregation of ESOP and 401(k) Features of
Plan
An ESOP may be incorporated into a 401(k) plan if the applicable qualification requirements are satisfied. Under an earlier iteration of the regulations, the ESOP and 401(k) components of the plan had to be tested separately for purposes of compliance with the coverage and nondiscrimination rules. Thus, in applying the coverage test and the ADP and ACP tests, the ESOP and 401(k) features of the plan were tested separately.
Acknowledging both the expense and administrative burden imposed on plan sponsors by the requirement of applying two separate nondiscrimination tests and the increased use of ESOPs as the employer stock fund under 401(k) plans, the final rules eliminate the mandatory disaggregation of the ESOP and non-ESOP portion for ADP and ACP testing.
Comment: Mandatory disaggregation continues to apply
for purposes of the Code Section 410(b) coverage rules. Therefore,
the group of eligible employees under the ESOP and non-ESOP portions
of the plan would still be required to separately satisfy the
nondiscrimination tests of Code Section 401(a)(4) and the coverage
test of Code Section 410(b).
3. Distributions Upon Severance from Employment
401(k) plan participants may receive distributions in the event they continue on the same job for a different employer following a liquidation, merger, consolidation, or other corporate transaction. However, an employee will not be treated as having experienced a severance from employment, and therefore may not receive distributions, if the employee's new employer maintains the 401(k) plan in which the employee participates (e.g., by continuing to sponsor the plan or by accepting a transfer of plan assets and liabilities).
The final rules do not authorize a distribution to an individual
whose employment status has changed from that of common law employee
to leased employee, as that would not constitute a severance
from employment.
4. Hardship Distributions
The final rules clarify the changes to the hardship distribution rules implemented by EGTRRA, including a 6-month suspension of elective deferrals following a hardship distribution. In addition, the final rules permit an employer to rely on a written representation by an employee in support of a claim that a distribution is necessary to satisfy an immediate and heavy financial need (including funeral expenses and the cost of repairs to a principal residence) to establish that the need cannot reasonably be relieved by any available distribution or nontaxable plan loan. However, an employee would not be required to take a commercial loan if a loan sufficient to meet the employee's need would not be available on reasonable commercial terms. In order to qualify for a hardship distribution, a participant must obtain all distributions currently available under all qualified plans of the employer.
The final rules also add two additional deemed hardship reasons: (1) funeral expenses and (2) expenses related to the repair of damage to an employer's principal residence. The final rules also modify existing hardship reasons to disregard the meaning of the definition of "dependent" in Code Section 152 by the working families Tax Relief Act of 2004 (see Section V.B of this Newsletter) and to expand the class of children whose medical expenses can result in hardship distribution to include a non-custodial child.
5. Specify Nondiscrimination Method
The final rules require plans to specify the nondiscrimination
testing method and the optional choices being used under that
method. For example, a plan must specify whether the current
year or prior year ADP testing method is being used. A plan that
uses the safe harbor method must specify whether the safe harbor
contribution will be the nonelective safe harbor contribution
or the matching safe harbor contribution. Once elected, a plan
cannot switch from the safe harbor method to a non-safe harbor
method during the plan year.
6. Disregarding Early Participants in ADP Test
Nonhighly compensated employees ("NHCE") who do
not meet the Code Section 410(a) minimum age and service requirements
may be disregarded for purposes of the ADP test (and the ACP
test). This option is "permissive" and plans may continue
to use the testing option under which a plan that benefits otherwise
excludable employees is disaggregated and the ADP test (or ACP
test) is separately performed for eligible and excludable employees.
7. Calculating the ADR of HCEs in Multiple Plans
The actual deferral ratio ("ADR") of a highly compensated employee ("HCE") who is eligible to participate in two or more CODAs or 401(k) plans of the same employer is determined by treating all of the plans in which the employee is eligible to participate as one CODA or 401(k) plan. Prior final rules had required aggregation of the elective deferrals for the HCEs for all plan years that end with or within the calendar year. The rules, however, produced inappropriate results because more than 12 months of elective deferrals could be included in an employee's ADR. Accordingly, the final rules, effective beginning in 2006, require the ADR for each HCE participating in more than one CODA to be determined by aggregating the elective contributions of the HCE that are made within the plan year of the CODA being tested. The modification is designed to ensure that each of the employer's CODAs will use 12 months of elective contributions and 12 months of compensation in determining the ADR for an HCE who participates in multiple plans, even if the plans have different plan years.
Similar rules apply to the determination of the actual contribution
ratio under the ACP test for an HCE who receives matching contributions
on employee contributions under two or more plans.
8. Restrictions on "Bottom Up" QNECs
The final rules continue to allow plans, subject to specified conditions, to correct failures of the ADP test by making qualified nonelective contributions ("QNEC") or qualified matching contributions ("QMAC"). The final rules add a new condition that limits the use of the bottom-up leveling technique, pursuant to which employers attempt to pass the ADP test by targeting high percentage QNECs to a small number of part-time, terminated, or other short-service NHCEs with the lowest compensation during the year (raising that NHCEs' ADR), rather than providing contributions to a broad group of NHCEs. The bottom-up leveling method enables an employer to pass the ADP test by contributing a small amount of money to select NHCEs which, because the ADP test is based on the unweighted average of ADRs, has the effect of increasing the average contribution for NHCEs.
Generally, under the new rules, a plan would be treated as providing an impermissibly targeted QNEC if less than one-half of all NHCEs receive QNECs or if the QNEC exceeds 5% of the NHCE's compensation and is more than twice the QNEC that other NHCEs receive, when expressed as a percentage of compensation. Specifically, QNECs that exceed 5% of compensation could be taken into account for ADP testing purposes only if the contribution, when expressed as a percentage of compensation, does not exceed two times the plan's "representative contribution rate." The plan's representative contribution rate is the greater of: (1) the lowest contribution rate of any eligible NHCE among a group of eligible NHCEs that consists of one-half of all eligible NHCEs for the plan, or (2) the lowest contribution rate among all eligible NHCEs under the arrangement who are employed on the last day of the year. The applicable contribution rate for an eligible NHCE would be the sum of the QMACs taken into account under the ADP test for the eligible NHCE for the plan year and the QNECs made for that NHCE for the plan year, divided by the NHCE's compensation for the same period.
Parallel restrictions would apply to QNECs taken into account in ACP testing. However, the contribution percentage made in determining the lowest contribution percentage would be based on the sum of the QNECs and those matching contributions taken into account under the ACP test.
With respect to QNECs made in connection with an employer's obligation to pay a prevailing wage under the Davis-Bacon Act, the final rules allow a QNEC of up to 10% of compensation to be taken into account under the ADP test.
In order to prevent employers from using targeted matching contributions to avoid the restrictions on targeted QNECs, the final rules do not allow matching contributions to be taken into account under the ACP test if the matching rate for the contribution exceeds the greater of 100% or two times the representative matching rate.
9. Apportioning Corrective Distributions to HCEs in Multiple Plans
The final rules provide a special rule for correcting excess contributions for HCEs who participate in multiple 401(k) plans. Specifically, in determining the HCE who will be apportioned a share of the total excess contribution to be distributed for the plan, all contributions in CODAs in which the HCE participates are aggregated and the HCE with the highest dollar amount of contributions is apportioned excess contributions first. However, distributions would be limited to actual contributions under the plan undergoing correction, rather than all of the contributions considered in calculating the employee's ADR. If additional corrections are needed, the HCEs with the next highest dollar amount of contributions are apportioned the remaining excess contributions, until the excess contributions are completely apportioned.
The final rules further clarify that gap period income (i.e.,
income for the period after the plan year) needs to be included
only to the extent that the employee is or would be credited
with allocable gain or loss on those excess contributions for
that period, if the total account were to be distributed. In
addition, a distribution of excess contributions is not required
to include the income allocable to the excess contributions for
a period that is no more than 7 days before the distribution.
10. Safe Harbor 401(k) Plans
A 401(k) safe harbor plan, a design-based plan that meets
certain contribution and notice requirements, generally must
be adopted before the beginning of the plan year, and must be
maintained throughout a full 12-month plan year. The final regulations
adopt the exceptions to
this 12-month rule that were included in the proposed regulations.
Thus, a safe harbor plan generally can have a short plan year:
a. When a plan terminates, if the plan termination is in connection with a merger or acquisition involving the employer, or the employer incurs a substantial business hardship;
b. When a plan terminates, provided the employer makes safe harbor contributions for the short year, employees are provided notice of the change, and the plan passes the ADP test; or
c. Where a plan changes its plan year and, thus, has a short plan year, provided the plan was a safe harbor plan for the preceding plan year and the short plan year, and the short plan year is followed by a plan year (or 12-month period if the following plan year is a short plan year during which the plan is a safe harbor plan).
Comment: Although the regulations permit some provisions to be incorporated by reference, it is likely that most 401(k) plans will have to be amended to reflect the new regulations.
C. New 403(b) Regulations
1. Regulatory Background
The IRS has issued long awaited proposed regulations governing 403(b) plans. The proposed rules, which may not be relied upon until finalized, update final regulations issued in 1964, which predate ERISA. The proposed rules effectively consolidate legislative and regulatory developments released over the last 40 years that have significantly eroded the differences between 403(b) plans and other salary reduction arrangements, such as 401(k) plans and 457(b) plans. The new regulations generally codify existing rules and adopt standard administrative practices, but also impose documentation requirements that may subject employers to ERISA Title I coverage; eliminate good faith compliance with the nondiscrimination requirements applicable to nonelective deferrals; condition satisfaction of universal availability on an employee's effective opportunity to make deferrals; and clarify application of controlled group rules (including a new permissive aggregation option) to tax-exempt entities.
2. Statutory Background
Code Section 403(b) provides an exclusion from an employee's gross income for contributions made by an eligible employer to a Code Section 403(b) plan for the employee's benefit. A Code Section 403(b) plan may be funded in one of three ways:
a. Through annuity contracts, each of which is issued by an insurance company, and is purchased for an employee by his or her employer.
b. Through custodial accounts, each of which covers an employee, that meets the requirements of Code Section 401(f)(2), and is invested solely in mutual funds.
c. If the employer is a church, through retirement income accounts, each of which covers a church employee.
The exclusion from gross income generally will not apply unless
the plan satisfies: (i) a nonforfeitability requirement, (ii)
certain availability, nondiscrimination, and coverage requirements,
and (iii) certain limitations on any salary reduction contributions.
3. Fully Vested and Nonforfeitable Right to Benefits
An employee's right to elective deferrals under a 403(b) plan must be nonforfeitable, unless there has been a failure to pay premiums or any annuity contracts. Accordingly, an employee's rights to elective deferrals under the plan may not be conditioned upon a subsequent event, subsequent performance, or subsequent forbearance, which will cause a loss of the right. In addition, an employee's rights may not be conditioned upon a sufficiency of assets in the event of plan termination.
4. Taxation of Excess Annual Additions
Annual additions to a 403(b) plan may not exceed the limits specified under Code Section 415(c), treating contributions as annual additions. Under the proposed rules, only the excess annual additions to a 403(b) plan will be subject to tax (i.e., amounts in excess of $44,000 for 2006, as indexed). However, in order for this treatment to apply, the issuer of the contract must maintain separate accounts for the portion that includes the excess annual additions and the portion of the arrangement that includes the amount not in excess of the 415 limits.
5. Plan Document Required
The prerequisite conditions for the exclusion from an employee's gross income for 403(b) contributions must be satisfied in form and operation in the 403(b) contract. The proposed rules would require the 403(b) contract to be maintained pursuant to a written plan that must include all material provisions relating to eligibility, benefits, applicable limits, contracts available under the plan, and the time and form under which benefits could be distributed. For example, the 403(b) plan must expressly include the Code Section 402(g) deferral limit. The written document requirement would generally not apply to church plans or to defined benefit plans (in effect on the date the regulations are finalized) that have complied with the requirements of Code Section 403(b).
Comment: The requirement of a written plan document
is a significant change from current practice, in which, the
employer may act merely as a conduit for the payment of elective
deferrals to a custodian pursuant to a contract, but does not
maintain a plan document.
6. ERISA Title I Coverage
ERISA Regulations Section 2510.3-2(f) provides that a salary reduction 403(b) arrangement will not be considered an employee benefit pension plan subject to Title I if, among numerous factors, participation is voluntary for employees; all rights under the contract are enforceable only by the employee; the employer's involvement in the plan is limited to such matters as selecting an annuity provider and placing limits on the number of available annuity providers; and the employer receives no compensation other than reasonable compensation to cover expenses incurred in the performance of duties pursuant to the salary reduction agreement. Employer contributions (e.g., profit sharing and matching contributions) to the plans generally trigger ERISA Title I coverage. In addition, ERISA Title I will apply if the plan authorizes the employer to make determinations regarding an employee's eligibility for hardship, disability or in-service distributions even if the employer makes no contributions to the plan.
The requirement under the proposed rules that a 403(b) program
be maintained pursuant to a written plan, raises the issue of
whether all Tax Sheltered Annuities ("TSAs") will now
be subject to the requirements and standards of ERISA Title I
(e.g., the coverage, reporting and disclosure, summary plan description,
summary annual report, and joint and survivor annuity rules of
ERISA). Currently, not all TSAs are subject to ERISA Title I
as discussed below. Plans maintained by governmental employers
and non-electing church plans are currently, and remain, exempt
from ERISA Title I.
7. Distinguishing Between 403(b) and 401(k) Deferrals
The proposed regulations apply the rules governing cash or deferred elections under a 401(k) plan to elective deferrals under 403(b) plans. Therefore, elective deferrals would be limited to contributions made pursuant to a cash or deferred election and other benefits could not be contingent on an election to defer. However, the proposed rules would not eliminate all of the differences between 403(b) and 401(k) plans. Thus, among other differences: 403(b) plans may only be sponsored by specified tax-exempt employers; 403(b) contributions may only be made to an insurance annuity contract, a custodial account that is limited to mutual fund shares, or a church retirement account, and not to a trust or custodial account that fails to satisfy the custodial account rules of Code Section 403(b)(7) or the retirement income account rules of Code Section 403(b)(9) for churches; and 403(b) elective deferrals are subject to universal availability rules, rather than the ADP test and the 410(b) minimum coverage test applicable to 401(k) plans.
8. Coordination and Ordering of Catch-Up Contributions
A special catch-up election under Code Section 402(g)(7) allows employees who have completed 15 or more years of service with a qualified employer (e.g., an educational organization or hospital) to make a catch-up contribution to a 403(b) plan in excess of the generally applicable dollar limit. In addition, employees who will attain age 50 by the end of the tax year and for whom no other elective deferrals may otherwise be made to the plan for the year because of the deferral limits or any other comparable plan limits may, under Code Section 414(v), make additional catch-up contributions, up to a special limit ($5,000 for 2006), to the 403(b) plan.
Regulations issued under Code Section 414(v) have clarified
that a 403(b) plan participant who qualifies for the special
Code Section 402(g)(7) election may also make a catch-up contribution.
The proposed rules include a similar provision and specify an
ordering rule, under which any catch-up contribution for an employee
who is eligible for both an age 50 Code Section 414(v) catch-up
contribution and the special 403(b) catch-up under Code Section
402(g)(7) is treated first as a special 403(b) catch-up and then
as an amount contributed as an age 50 catch-up (to the extent
that an age 50 catch-up amount exceeds the maximum special 403(b)
catch-up).
9. Years of Service
An employee's number of years of service, for purposes of determining a participant's includible compensation and years of service (applicable in determining the special 403(b) catch-up contribution and employer contributions for former employees), includes each full year during which an individual is a full-time employee of the eligible employer, plus a fraction of a year for each part of a year during which the individual is a full-time or part-time employee of the eligible employer.
A year of service would be based on the employer's annual work period and not the employer's tax year. For example, in determining whether a university professor is employed full time, the annual work period would be the school's academic year. In addition, the determination of whether an individual is a full-time employee would be made by comparing the amount of work performed with the amount of work that is normally required of individuals performing similar services from which substantially all of their compensation is derived. The amount of work performed would generally be determined based on an individual's hours of service. However, a plan may measure the work of a university professor by the number of courses taught during an annual work period, if the individual's work assignment is generally based on a specified number of courses to be taught.
10. Nonelective Employer Contributions for Former Employees
Code Section 403(b)(3), as amended by the Job Creation and Worker Assistance Act of 2002, allows contributions to be made for an employee up to five years after retirement, based on includible compensation for the last year of service before retirement. A former employee is deemed to have monthly includible compensation for the period through the end of the tax year of the employee in which he or she ceases to be an employee and through the end of each of the next five years. Under the proposed regulations, the amount of the monthly includible compensation is 1/12 of the former employee's includible compensation during the former employee's most recent year of service. The proposed regulations specifically authorize a plan to continue nonelective employer contributions for a former employee for up to five years, in an amount up to the lesser of the Code Section 415(c) dollar limit or the former employee's annual includible compensation (based on the former employee's compensation during the most recent year of service).
11. "Good Faith" Would Not Satisfy Nondiscrimination Requirements for Nonelective Contributions
Employer contributions and employee after-tax contributions (but not pre-tax elective deferrals) under a 403(b) contract are subject to nondiscrimination rules, including restrictions on contributions, benefits, coverage and annual compensation. The IRS had provided in Notice 89-23 that the nondiscrimination requirements could be met through a reasonable good faith interpretation of the rules under Code Section 403(b)(12). In requiring adherence to specified nondiscrimination rules, including those under Code Section 401(a)(4) and (17) and 401(m), the IRS would officially abandon the good faith standard articulated in Notice 89-23.
12. Universal Availability Would Require "Effective Opportunity" to Make Deferral Election
Under the universal availability rule of Code Section 403(b)(12)(A)(ii), an eligible employer that authorizes any employee to make elective deferrals pursuant to a 403(b) plan must allow all employees to make a 403(b) deferral election. The proposed rules expressly require that the contribution be made pursuant to a plan, and the plan must permit elective deferrals (including catch-up contributions) that satisfy universal availability. Specifically, the plan must provide an employee with an "effective opportunity" to make or change a cash or deferred election at least once during each plan year.
Comment: In complying with the requirement to provide employees with an effective opportunity to make elective deferrals, employers will need to focus on affirmatively and effectively communicating the availability of election opportunities to employees.
A 403(b) plan may cover employees of more than one 501(c)(3) organization. Under the proposed rules, the universal availability requirement would be applied separately to each common law entity (i.e., 501(c)(3) organization). With respect to a 403(b) plan that covers the employees of more than one entity, universal availability would be applied separately to each entity that is not part of a common payroll. In addition, an employer may require an employee to make elective deferrals of more than $200 a year.
The proposed rules provide exceptions to the universal availability requirement that would allow a plan to exclude: employees eligible to participate (i.e., make elective deferrals) in a 457(b) plan or a 401(k) plan; non-resident aliens; students performing services for a school; and employees who normally work less than 20 hours per week (generally less than 1,000 hours of service for the 12-month period beginning on the anniversaries of the date the employee's employment began). Employers should be aware that, if an excludable employee is allowed under the plan to make elective deferrals, the proposed rules would prevent any other comparably situated employee from being excluded. For example, if one non-resident alien or one student performing services for a school is allowed to participate in the plan, then all non-resident aliens and all such students would have the right to make elective deferrals under the arrangement.
13. Distributions From the Plan
The proposed regulations contain guidance regarding the timing of distributions from, and the benefits that may be provided under, a 403(b) plan.
A 403(b) plan may not distribute benefits to an employee prior to the earlier of the employee's severance from employment or the occurrence of a specified event, such as the passage of a fixed number of years, the attainment of a stated age, disability, death, hardship or attainment of age 59-1/2.
Any amounts transferred out of a custodial account that funds a Code Section 403(b) plan to an annuity contract or retirement income account that funds a Code Section 403(b) plan, including earnings on such amounts, continue to be subject to the foregoing rules after the transfer.
For these purposes, a "severance from employment" occurs on any date on which an employee ceases to be an employee of the eligible employer maintaining the Code Section 403(b) plan. A severance from employment will occur, even though the employee may continue to work for another entity treated, under the controlled group rules, as the same employer as the one maintaining the plan, if either (i) that other entity is not an eligible employer (e.g., where the employer maintaining the plan is a Code Section 501(c)(3) organization and the new employer is a for-profit subsidiary of a Code Section 501(c)(3) organization), or (ii) the employee is working in a capacity that is not treated as employment with an eligible employer (e.g., the employee ceases to be an employee performing services for a public school but continues to work for the same state employer).
In addition, for these purposes, the definition of "hardship" (and the circumstances under which amounts attributable to salary reduction contributions may be distributed if a hardship occurs) are determined in accordance with Regulations Section 1.401(k)-1(d)(3) (including the rule under which the amount of the hardship distribution is limited to the amount necessary to satisfy the hardship). Also, the amount of a hardship distribution is limited to the aggregate dollar amount of the salary reduction contributions held by the Code Section 403(b) plan (excluding earnings).
The foregoing restrictions on distributions do not apply to amounts attributable to rollover contributions held in a separate account under the Code Section 403(b) plan.
Finally, the proposed rules confirm the application of QDRO
rules to 403(b) contracts, thereby authorizing distributions
to a participant's former spouse pursuant to a QDRO.
14. Required Minimum Distribution Rules
The proposed rules, with minor modifications, incorporate provisions under existing regulations applying the required minimum distribution requirements of Code Section 401(a)(9) to 403(b) plans. Under the proposed rules, 403(b) contracts are treated as IRAs. However, distributions from 403(b) contracts do not satisfy the minimum distribution requirements for IRAs nor do distributions from IRAs satisfy the minimum distribution requirements for 403(b) contracts.
15. Time Frame in which to Transfer Elective Deferrals to Annuity Contracts
The proposed rules would require that contributions to 403(b)
plans be transferred to the insurance company issuing the annuity
contract (or the entity holding assets of any custodial or retirement
income account that is treated as an annuity contract) within
a period that is no longer than reasonable for the proper administration
of the plan. The proposed rules would allow a plan to require
the transfer of elective deferrals to an annuity contract as
soon as reasonably practicable but in no event no later than
15 business days following the month in which the amounts would
have been paid to the participant.
16. Controlled Group Rules for Tax-Exempt Organizations
The employer for a plan maintained by a tax-exempt organization includes the organization whose employees participate in the plan and other organizations with which it is under common control. The common control rules, which must be considered when applying the nondiscrimination requirements, 415 limits and required minimum distribution rules, would generally not apply to church entities or public schools.
Common control would generally exist between exempt organizations if at least 80% of directors or trustees of one organization are representatives of, or directly controlled by, the other organization. However, in addition to such mandatory aggregation, the proposed rules would, for the first time, allow for permissive aggregation, under which exempt organizations that maintain a single plan covering one or more employees from each organization may treat themselves as under common control if the organizations regularly coordinate their day-to-day exempt activities. The proposed rules would further authorize permissive disaggregation, under which a church plan to which contributions are made by more than one common law entity, could disaggregate church controlled organizations from other non-church entities. Finally, the proposed rules would empower the IRS to treat a tax-exempt entity and a non tax-exempt entity as being under common control if the entities are structured to avoid or evade the common control rules or other requirements under Code Section 401(a), 403(b) or 457(b).
17. Distribution of Accumulated Benefits on Plan Termination
The proposed regulations provide rules under which an employer may amend a 403(b) plan to limit future contributions for existing participants or to limit participation to existing participants and employees. A plan would be allowed to authorize termination and the subsequent distribution of accumulated benefits. However, the distribution of accumulated benefits incident to plan termination would generally be allowed only if the employer (taking into account all the controlled group entities) did not make contributions to an alternative 403(b) contract during the 12-month period beginning on the date of plan termination and ending 12 months after the distribution of all assets from the terminated plan.
18. Exchanges and Transfers Among 403(b) Plans
The proposed regulations would allow a 403(b) contract to
be exchanged for another 403(b) contract held by the same 403(b)
plan if, among other conditions, the participant or beneficiary
has an accumulated benefit immediately after the exchange at
least equal to the benefit before the exchange. A 403(b) contract
also could be transferred to another 403(b) plan if, among other
conditions, the receiving plan provides for receipt of the transfer
and the accumulated benefit of the participant or beneficiary
whose assets are being transferred are, after the transfer, at
least equal to the benefit before the transfer.
19. Effective Date
The proposed rules may not be relied on until finalized. In addition, under transition relief, the rules would not apply to plans maintained under an existing collective bargaining agreement ("CBA") until the termination of the CBA. Although originally effective for tax years beginning in 2006, the proposed 403(b) regulations are expected to be made effective for tax years beginning on or after January 1, 2007.
D. Temporary Rules Expand FICA Taxation of 403(b) Contributions under Salary Reduction Agreements
The IRS has issued temporary regulations that, effective November 16, 2004, define salary reduction agreements in a manner that expands the FICA tax treatment of 403(b) contributions. By expanding the definition of 403(b) salary reduction agreements beyond the definition of elective deferrals that applies for income tax purposes, the temporary rules effectively subject a wider variety of 403(b) contributions to FICA tax.
The temporary rules define a salary reduction agreement as including a plan or arrangement whereby a payment will be made if the employee elects to reduce his compensation pursuant to a cash or deferred election. However, in going beyond the definition of an elective deferral, the temporary rules clarify that a salary reduction agreement also includes a plan or arrangement under which a payment will be made if the employee elects to reduce compensation pursuant to a one-time irrevocable election made at or before the time of initial eligibility to participate in the plan or arrangement. In addition, the temporary regulations provide that a salary reduction agreement will include a plan under which payments will be made if the employee agrees, as a condition of employment, to make a contribution that reduces the employee's compensation.
The temporary regulation is effective November 16, 2004. However,
the regulation is scheduled to expire on or before November 16,
2007.
E. Deemed IRAs in Qualified Plans
1. Background
The IRS has issued proposed temporary and final regulations relating to deemed individual retirement accounts for tax-qualified retirement plans under Code Section 408(q). The rules implement an EGTRRA provision that allows employees to contribute to an account or annuity within a qualified pension plan that is treated like an IRA.
Deemed IRAs allow an employer to offer employees the ability to keep their IRA assets in the employer's retirement plan as a separate IRA account within the plan.
For plan years beginning on or after January 1, 2003, an employer maintaining a qualified plan, qualified 403(a) annuity, tax-sheltered annuity plan or governmental eligible deferred compensation plan may allow employees to make voluntary employee contributions to a separate IRA or annuity established under the plan. Contributions to a deemed IRA are treated as contributions to the employee's deemed IRA, rather than to the employer plan.
2. Separate Trust Requirement
Under prior proposed regulations, a trust holding deemed IRA assets had to be separate from a trust holding assets of a qualified employer plan. The separate trust rule was intended to ensure better compliance with IRA requirements and limit confusion of assets. The IRS has eliminated the separate trust requirement for deemed IRA account assets, as long as a separate account is maintained for each deemed IRA and the employer plan. The final regulations also allow deemed Roth IRAs and deemed IRAs to be held in a single trust, as long as separate accounts are maintained and clearly designated.
3. Disqualification Clarified
Failure of either the employer plan or the deemed IRA portions of a program to satisfy the qualification rules will not automatically disqualify the other portion. This rule applies, however, only if the deemed IRA portion and employer plan portion are maintained as separate trusts (or separate annuity contracts).
F. S Corp/ESOP Abuses
Continuing its crackdown on tax evasion, the IRS recently issued proposed and temporary regulations to curb abuses involving employee stock ownership plans ("ESOP") holding stock in S corps.
1. Background
An ESOP is permitted to hold stock in an S corporation, provided that the ESOP benefits rank-and-file employees. However, accruals or allocations are prohibited if the S corp is used to pass corporate income to a tax-exempt ESOP and ESOP benefits are concentrated in a small number of persons, such as upper management or family members. In some abusive situations, the only participants in the ESOP are the owners of the business and rank-and-file employees are excluded.
2. New Terms
The regulations provide two new terms: "impermissible accrual" and "impermissible allocation." An impermissible accrual occurs if S corporation stock is owned and held by an ESOP for the benefit of a disqualified person during a nonallocation year. A "disqualified person" is a person deemed to own at least 10% of the ESOP's shares individually or least 20% of the ESOP's shares with family members. A "nonallocation year" is any plan year in which the ownership of the S corporation is concentrated among disqualified persons. An impermissible allocation is defined as any allocation for a disqualified person under any qualified plan or ESOP during a nonallocation year.
If an impermissible accrual or allocation occurs, the fair market value of the disqualified person's ESOP account is included in his gross income.
G. Proposed Rules Finalized for Eliminating Forms of Distribution
The IRS has issued final regulations that modify how certain forms of distributions in defined contribution plans can be eliminated without violating the anti-cutback rules under Code Section 411(d)(6).
The regulations contain amendments that were added as new Code Section 411(d)(6)(E) by EGTRRA and became effective January 25, 2005. As noted in the final rules, the new Code section provides that, generally, a defined contribution plan is not treated as reducing a plan participant's accrued benefit when a plan amendment eliminates a form of distribution that was previously available, as long as it is replaced with a lump sum distribution.
In a previous regulation, plan sponsors were allowed to change the available forms of distribution provided that each participant was given 90 days' advance notice; the final regulations do not require a 90-day advance notice period.
The final regulations clarify that amendments that terminate an annuity option can apply only to distributions with annuity starting dates after the amendment is adopted and, therefore, cannot apply to distributions that have already commenced. This change does not, however, allow for the elimination of annuity distributions with respect to that portion of plan attributable to transfer from a money purchase pension plan.
Comment: The reasoning behind the guidance is to simplify the choices offered to participants under the defined contribution plans without really reducing their options for distribution and because benefits can be rolled-over to IRAs offering a wide variety of distribution options. Money purchase plans remain subject to the qualified joint and survivor annuity requirements and thus cannot eliminate annuity options required to satisfy these rules.
H. EBSA Issues Guidance on Distributions to Missing Participants from Terminated DC Plans
In Field Assistance Bulletin 2004-02, the Department of Labor's Employee Benefits Security Administration ("EBSA") issued guidance for fiduciaries that wish to make final distributions from terminated defined contribution plans that have missing participants. To comply with the Code's requirements for termination of a qualified plan, a plan's assets must all be effectively distributed as soon as is administratively feasible following a plan termination. EBSA has issued this latest guidance in response to concerns of plan administrators that are unable to obtain a response from, or that cannot locate, defined contribution plan participants for instructions regarding the final distributions of their benefits.
The guidance details acceptable methods for distributing missing participants' benefits. These distribution methods may only be used, however, if plan fiduciaries have used specified search methods, in addition to using first class mail or electronic notification. The four search methods provided in the guidance are: (i) using certified mail, (ii) checking records of related plans through both the missing participant's employer and the related plans' administrators, (iii) contacting designated beneficiaries to see if they can provide updated information with regard to the missing participant's location, and (iv) using either the IRS's or the Social Security Administration's letter-forwarding service. EBSA states that plan fiduciaries may use additional search methods, but the cost of those additional methods should be taken into account if they will be charged to the missing participant's account balance.
1. Individual Retirement Plan is Preferred Distribution Option
If participants cannot be located after using the search methods described above, EBSA has advised that it prefers the transfer of the participants' benefits to individual retirement plans over all other distribution options. Specifically, EBSA has stated that "plan fiduciaries must always consider distributing missing participant benefits into individual retirement plans (i.e., an individual retirement account or annuity)." EBSA states that it prefers individual retirement plans because they preserve retirement assets. An eligible rollover distribution from a qualified plan, performed as a trustee-to-trustee transfer into an individual retirement plan, is not subject to immediate income tax, the 20% mandatory income tax withholding requirement, or the 10% additional tax for premature distributions.
EBSA cautions that the choice of an individual retirement plan trustee, custodian, or issuer, as well as the choice of an individual retirement plan to receive the missing participant's distribution raises fiduciary concerns. EBSA has referred plan fiduciaries to previously-issued regulations that provided a safe harbor for fiduciaries engaged in the automatic rollover of mandatory individual retirement plans (see Section IV. E of this Newsletter). EBSA states that defined contribution plan fiduciaries that comply with the relevant requirements of the automatic rollover safe harbor regulations (without regard to the amount involved in the distribution) and then choose investment products designed to preserve the missing participant's plan principal will be treated as satisfying their fiduciary duties in connection with distributions made from terminated plans on behalf of missing participants.
2. EBSA Addresses Other Distribution Options
EBSA has provided two alternative distribution methods that plan fiduciaries may use if they are unable to locate an individual plan provider that will accept a rollover distribution on behalf of a missing participant. Plan fiduciaries may use either an interest bearing federally insured bank account in the name of the missing participant, or may transfer a missing participant's account balance to a state unclaimed property fund in the state of the participant's last known residence or work location.
EBSA has warned that it would view plan fiduciaries that effectively transfer a missing participant's benefits to the IRS by imposing 100% income tax withholding as violating ERISA's fiduciary requirements. EBSA explains that the IRS has advised that the withheld amounts would not necessarily be matched or applied to the missing participant's income tax liabilities.
I. EBSA Proposed Regulations Provide Termination Instructions for Service Providers of Abandoned Plans
EBSA has issued for comment three proposed rules to facilitate the termination of individual account (i.e., defined contribution) plans, and the distribution of benefits where the plans have been abandoned by their sponsoring employers. EBSA has also issued notice of a proposed prohibited transaction class exemption that would permit a "qualified termination administrator" ("QTA") of an abandoned individual account plan to select and pay fees to itself or to an affiliate for performing termination-related services to the plan.
1. Determination of "Abandoned Plan" by QTA
Under the proposed regulations, an individual account plan would be considered abandoned when there have been neither contributions to nor distributions from the plan for a continuous 12-month period, or where such facts and circumstances as a plan sponsor's bankruptcy suggest that the plan may become abandoned. The QTA must make reasonable efforts to locate or communicate with the known plan sponsor, furnishing the sponsor with notice of the QTA's intent to terminate the individual account plan or plans and distribute benefits. An appendix to the proposed regulations contains a model notice which QTAs may use to comply with this notification requirement. For the plan to be considered abandoned, the QTA must, following the attempt at notification, determine that the plan sponsor either no longer exists, cannot be located, or is unable to maintain the plan.
Once a QTA finds that a plan has been abandoned, the plan would be deemed, under the proposed regulations, to be terminated on the 90th day following the date on which the QTA provides notice of its determination and its election to serve as a QTA to the EBSA. EBSA would have discretion to waive this 90-day waiting period if the facts of a particular case of abandonment are not complicated, and if it is apparent that the proposed termination would not put participants' assets at risk. A model notice for notifying EBSA of plan abandonment has also been included in an appendix to the proposed regulations.
2. Guidelines Given for Winding Up Plans
To both clarify and limit QTAs' responsibilities and liabilities in connection with terminating abandoned plans, EBSA has provided guidance in the proposed regulations for winding up a plan's affairs. EBSA states that QTAs should make reasonable and diligent efforts to locate and update plan records necessary to determine benefits payable under the plan. If a QTA determines that updating the records is either impossible or excessively costly to the plan in relation to the plan's total assets, EBSA explains that it would not consider the QTA to have acted in less than good faith if the QTA uses reasonable care in calculating benefits payable based on the plan records already assembled. The proposed regulations also provide that reasonable expenses may be incurred and paid from plan assets to engage service providers as necessary to terminate a plan and wind up its affairs. Expenses will be considered reasonable if they are consistent with industry rates for such services and are not in excess of rates charged by the QTA or its affiliates to other customers for the same services.
QTAs would be required to furnish a notice of the termination to the last known address of participants and beneficiaries. The proposed regulations also include a model notice that may be provided to participants and beneficiaries that allows for inclusion of plan-specified information, including the process for electing a form of distribution. If a participant or beneficiary fails to elect a form of benefit distribution, the QTA would be required to roll over that person's benefits into an individual retirement plan.
3. Safe Harbor Requirements
To alleviate apprehension on the part of QTAs about the fiduciary consequences of such a rollover, EBSA has included in the proposed regulations a fiduciary safe harbor, under which the QTA would be deemed to have satisfied the fiduciary requirements of ERISA Section 404(a). To obtain the safe harbor protection: (i) each distribution must be rolled over into an individual retirement plan; (ii) the QTA and the individual retirement plan provider must enter into a written agreement that provides that: (a) rolled-over funds must be invested in an investment product designed to preserve principal and provide a reasonable rate of return, whether or not such return is guaranteed, consistent with liquidity; (b) the investment product selected for the rolled-over funds seeks to maintain a stable dollar value equal to the amount invested in the product by the individual retirement plan; (c) fees and expenses attendant to the individual retirement plan, including investments of such plan, do not exceed certain limits; and (d) the participant or beneficiary on whose behalf the QTA makes a direct rollover should have the right to enforce the terms of the contractual agreement establishing the individual retirement plan, with regard to his or her rolled-over funds, against the individual retirement plan or other account provider; and (iii) the self-designation of the QTA as the transferee of rollover proceeds is exempt from the restriction imposed by ERISA Section 406 (see the next section for an explanation of this restriction).
4. EBSA Proposes Exemption Relief for QTAs of Abandoned Plans
EBSA has issued a proposed class exemption in conjunction with the proposed regulations that would permit the QTA of an abandoned individual account plan to select itself or one of its affiliates to provide plan termination services to the plan and to pay itself or the affiliates for those services. ERISA Section 406 generally prohibits a plan fiduciary from, among other acts, causing a plan to engage in a transaction that constitutes the furnishing of goods, services, or facilities between the plan and a party in interest, or a transfer to, or use by or for the benefit of, a party in interest of any plan assets. ERISA also prohibits a plan fiduciary from dealing with the plan's assets in his own interest and from acting in any capacity in any transaction involving the plan on behalf of a party whose interests are adverse to the plan's interests, or to that of the plan's participants or beneficiaries.
Therefore, a QTA that determines to pay itself for services rendered to an abandoned plan from the plan's assets, that designates itself as the provider of an individual retirement plan established on behalf of an abandoned plan's participants who fail to elect a form of benefit distribution, or that invests a rollover distribution in the QTA's own proprietary investment product may commit a prohibited transaction. The proposed class exemption would provide conditional relief, so that a QTA of an abandoned individual account plan could select itself to provide termination services and pay itself for services rendered, subject to certain conditions.
The QTA would only be able to obtain the exemption if its fees and expenses are consistent with industry rates for similar services and the fees and expenses are not in excess of rates charged by the QTA for the same or similar services provided to customers that are not individual account plans terminated pursuant to the proposed regulations, if the QTA provides such services to other customers. The QTA would also be required to notify participants and beneficiaries of the abandoned plan that, absent the participant's or beneficiary's election within 30 days from receipt of the notice, the QTA will roll over the participant's or beneficiary's account balance to an individual retirement plan or other account offered by the QTA or one of the QTA's affiliates. The QTA would further be required to notify participants and beneficiaries that the account balance may be invested in the QTA's own proprietary investment product. The QTA's investment product would need to preserve principal and provide a reasonable rate of return and liquidity.
Furthermore, the QTA must maintain sufficient records to permit persons (e.g., IRS, EBSA, or the account holder) to determine if the QTA has met the conditions of the class exemption.
III. DEFINED BENEFIT PLANS
A. Phased Retirement Distributions from Pension Plans
1. Background
The IRS has issued proposed regulations that would permit distributions to be made from a pension plan under a phased retirement program, if the program meets specific requirements. Under this approach, a plan could allow employees who phase in their retirement by working fewer hours to receive a portion of their pension benefits while still working.
Some employers offer employees who are eligible to retire the opportunity for a reduced schedule or workload. Such a phased retirement provides the employee with a smoother transition from full-time employment to retirement, and allows the employer to retain the services of an experienced employee.
2. Phased Retirement Distributions
The proposed regulations would permit a pro rata share of an employee's accrued benefit to be paid under a bona fide phased retirement program. The pro rata share would be based on the extent to which the employee reduced his working hours.
A bona fide phased retirement program would be a written, employer-adopted program under which employees could reduce the number of hours they customarily work beginning on or after a retirement date specified in the program (but not before age 59-1/2), and a phased retirement benefit would be permitted only if the program met certain conditions. For example, employee participation would have to be voluntary and there would have to be an expectation that the employee would reduce, by 20% or more, the number of hours worked during the phased retirement period.
The maximum payment would be limited to the portion of the employee's accrued benefit equal to the product of his total accrued benefit on the date he commences phased retirement and his reduction in work. All early retirement benefits, retirement-type subsidies, and optional forms of benefit that would be available upon full retirement would have to be available with respect to the phased retirement accrued benefit. However, in order to prevent the premature distribution of retirement benefits, a plan could not permit payment in the form of a single-sum distribution (or other eligible rollover distribution).
3. Accruals During Phased Retirement
During the phased retirement period, in addition to being entitled to the phased retirement benefit, the employee generally would have to be entitled to: (i) participate in the plan in the same manner as if he were still maintaining a full-time work schedule (including calculation of average earnings), and (ii) to the same benefits (including early retirement benefits, retirement-type subsidies, and optional forms of benefits) upon full retirement as a similarly situated employee who has not elected phased retirement. However, the years of service for any plan year during the phased retirement period would be multiplied by the ratio of the employee's actual hours of service during the year to the employee's full-time work schedule, or by the ratio of his compensation to the compensation that would be paid for full-time work. Thus, for example, under a plan with an 1,000 hours of service requirement to accrue a benefit, an employee participating in a phased retirement program would accrue proportionate additional benefits, even if the employee worked fewer than 1,000 hours.
An employee who was a highly compensated employee before commencing phased retirement would have to be treated as a highly compensated employee during phased retirement.
The employee's final retirement benefit would be comprised of the phased retirement benefit and the balance of the employee's accrued benefit under the plan (i.e., the excess of the total plan formula benefit over the portion of the accrued benefit paid as a phased retirement benefit).
4. Application of Phased Retirement Rules
The new rules for phased retirement distributions would apply to pension plans, i.e., defined benefit plans and money purchase plans. The proposed regulations would apply for plan years beginning on or after the date the regulations are finalized.
B. Cash Balance Plans
The Treasury Department announced the withdrawal of controversial proposed regulations that provided conditions under which cash balance pension plans could meet age discrimination requirements. In Announcement 2004-57, the Internal Revenue Service said the move would "provide Congress an opportunity to review and consider the Administration's legislative proposal and to address cash balance and other hybrid plan issues through legislation."
Cash balance plans are defined benefit plans that mimic defined contribution plans like 401(k) plans, generally defining a participant's benefit in terms of a hypothetical account balance, credited each year with a pay credit and interest credit, and including an annuity conversion factor. They generally result from conversions from traditional defined benefit plans, which guarantee a promised amount at retirement.
The announcement said Treasury and IRS will not publish new age discrimination guidance for cash balance plans or other hybrid plans while these issues are under consideration by Congress. The IRS also does not intend to process determination letter requests for cash balance plan conversions while cash balance plans and cash balance conversion issues are under consideration by Congress. Hundreds of requests have been on hold since a 1999 moratorium on determination letters for cash balance plan conversions.
C. IRS Issues Proposed and Final Regulations on Anti-Cutback Rules
1. Background
The IRS has issued proposed and final regulations that provide guidance on amendments under Code Sections 411(a)(3) and 411(d)(6) dealing with protected benefits under qualified retirement plans, and also take into account recent judicial decisions.
These regulations allow defined benefit plan sponsors to streamline administration by reducing the number of distribution and early retirement benefit offerings under certain circumstances. The rules generally permit plans to eliminate optional forms of benefit that are not "core" options and are "redundant" to retained forms of benefit within certain designated "families." Plans also may eliminate "noncore" optional forms of benefit if "core" benefit options are provided. The regulations do not permit the elimination of a lump-sum payment option.
The U.S. Supreme Court case Central Laborers' Pension Fund v. Heinz (541 U.S. 739 (2004)) and EGTRRA prompted the guidance. In its decision, the Supreme Court ruled that plan sponsors are prohibited from expanding postretirement categories of jobs in ways that would result in the suspension of payments of early retirement benefits that retirees already had accrued. The final rules are intended to reflect the holding in Heinz by providing a utilization test under which a plan amendment is permitted in certain circumstances to eliminate or reduce an early retirement benefit, a retirement-type subsidy, or an optional form of benefit that is not widely utilized.
2. Conditions Allowing Reduced Benefits
The new regulations replace provisions in former Treasury Regulation Section 1.411(d)-3 by setting forth conditions under which a plan amendment is permitted to eliminate an optional form of benefit and to eliminate or reduce an early retirement benefit or a retirement-type subsidy that creates significant burdens or complexities for the plan and its participants.
The final regulations provide two permitted methods for eliminating or reducing protected benefits: (i) elimination of redundant optional forms of benefit, and (ii) elimination of noncore optional forms of benefits where core benefits are offered.
Under the regulations, a plan amendment may eliminate one or more optional forms of benefit if each eliminated optional form satisfies the redundancy and/or the core option rule:
a. Redundancy. Plans may eliminate an optional benefit form that is not "core" (as described below) and is redundant to another retained form of benefit within one of six designated "families" of optional forms (i.e., the 50% or more joint and contingent family; the below 50% joint and contingent family; the 10 years or less term certain and life annuity family; the greater than 10 years term certain and life annuity family; the 10 years or less level installment family; and the greater than 10 years level installment family). The plan amendment must not apply to any optional form of benefit with an annuity starting date less than 90 days after the adoption of the amendment, and the annuity starting date of the retained option must be within six months of the eliminated option. The actuarial present value of the eliminated option must not exceed that of the retained option by more than a de minimis amount.
b. Provision of Core Options. A noncore optional form of benefit may be eliminated if the plan, after amendment, offers "core" options ( i.e., straight life annuity; a 75% joint and contingent annuity; a 10-year certain and life annuity; and the most valuable option for a participant with a short life expectancy). The plan amendment must not apply to any optional form of benefit with an annuity starting date not more than 90 days after the adoption of the amendment, and the annuity starting date and the actuarial present value of the retained option must be the same as those of the eliminated optional form of benefit.
c. Special Rule. Where the retained option has a different annuity starting date or is of a lesser actuarial value than the option being eliminated:
(i) the eliminated option must be "burdensome"; and
(ii) the elimination must not effect participants in more
than a
de minimis manner.
If these requirements are satisfied, the plan may eliminate an optional form of benefit even if it has the effect of eliminating an early retirement benefit or reducing a retirement-type subsidy.
3. Issues Addressed in Proposed Form
Under the proposed regulations, a plan may be amended to eliminate optional forms of benefit that comprise a "generalized optional form" for a participant with respect to benefits accrued before the applicable amendment date if certain requirements relating to the use, or rather non-use, of the generalized optional form are satisfied. Generalized optional forms of benefit are all optional forms in the plan that are the same form of benefit, with the exception of their actuarial factors and annuity starting dates. For example, benefits in the form of lump-sum distributions, but which use different actuarial factors for converting from an annuity, may be a generalized optional form.
The utilization test used to determine whether a plan has a sufficient number of eligible participants to eliminate an optional form is based on the forms of benefit that are not chosen within a specified period. To pass the utilization test, a generalized optional form of benefit must have been made available to at least 100 eligible participants in the last two years without having been chosen.
The utilization test cannot be used to eliminate core benefits, nor can it be applied to an annuity commencement date within 90 days of the adoption of the amendment eliminating the optional form.
If the optional forms are offered to fewer than 100 participants in two years, the plan then can go back three, four, or at the most, five years. The use of the longer lookback period may prove useful for smaller employers that may have too few employees eligible to take the benefit, usually through termination, or to employers that only offer the optional benefits to a limited group of eligible participants.
Certain participants do not count toward the pool of eligibility for purposes of the utilization test. Eligible participants who would be excluded from the utilization test include those who, in the two to five-year lookback period: (i) did not elect any optional form of benefit with an annuity commencement date during the relevant period, (ii) elected a lump-sum distribution in lieu of an annuity for at least 25% of the distribution that was due to them, (iii) elected an enhanced benefit that was available during a limited time period, and (iv) elected to start receiving their benefit with an annuity commencement date of more than 10 years before their normal retirement age.
The utilization test is proposed to become effective for plan years beginning in 2007.
D. Regulations on QJSAs and QPSAs Cover Information That Participants Must Receive to Compare Distribution Forms
In 2003, the IRS issued final regulations that: (i) consolidate the content requirements applicable to explanations of qualified joint and survivor annuities ("QJSAs") and qualified preretirement survivor annuities ("QPSAs") payable under certain retirement plans, and (ii) specify requirements for disclosing the relative values of optional forms of benefit that are payable from certain retirement plans in lieu of a QJSA.
In 2005, the IRS issued proposed regulations (on which taxpayers may rely) that revise final regulations that set forth the information required to be explained to pension plan participants regarding optional forms of benefit offered. The changes relate to the final regulations' effective date, notice requirements, and valuation of a QJSA.
The proposed regulations modify the 2003 regulations to provide that the 2003 regulations are generally effective for QJSA explanations provided with respect to annuity starting dates beginning on or after February 1, 2006.
1. Background
A defined benefit or money purchase pension plan must pay a participant's retirement benefit under the plan in the form of a QJSA. A QJSA for a married participant generally must be the actuarial equivalent of the single life annuity benefit payable for the life of the participant. However, a plan is permitted to subsidize the QJSA for a married participant. If a plan fully subsidizes the QJSA for a married participant, so that failure to waive the QJSA would not result in reduced payments over the life of the participant compared to the single life annuity benefit, then the plan need not provide an election to waive the QJSA (Code Section 417(a)(5)).
If a plan provides a subsidy for one optional form of benefit (i.e., the payments under an optional form of benefit have an actuarial present value that is greater than the actuarial present value of the accrued benefit), there is no requirement to extend a similar subsidy (or any subsidy) to every other optional form of benefit. Thus, for example, a participant might be entitled to receive a single-sum distribution on early retirement that does not reflect any early retirement subsidy in lieu of a QJSA that reflects a substantial early retirement subsidy.
A plan must provide to each participant, within a reasonable period before the annuity starting date: (i) a written explanation of the terms and conditions of the QJSA, (ii) the participant's right to make, and the effect of, an election to waive the QJSA form of benefit, (iii) the rights of the participant's spouse, and (iv) the right to revoke (and the effect of the revocation of) an election to waive the QJSA form of benefit.
The regulations provide rules for satisfying the Code Section 417(a)(3) written explanation requirement. For example, under one rule, sufficient information must be provided to explain the relative values of the optional forms of benefit available under a plan (e.g., the extent to which optional forms are subsidized relative to the normal form of benefit, or the interest rates used to calculate the optional forms). Under another rule, a written explanation must contain a general explanation of the relative financial effect of a participant's election on the participant's annuity.
2. Uniform Explanation for Both Married and Unmarried Individuals Permitted Where the Benefit Options are the Same
The final regulations require that the description of the relative value of an optional form of benefit compared to the value of the QJSA be expressed in a manner that provides a meaningful comparison of the relative economic values of the two forms of benefit, without the participant having to make calculations using interest or mortality assumptions.
Under the final regulations, the disclosure method may be either: (i) "participant-specific," or (ii) a "generalized notice." Under the participant-specific method, a plan must provide information on the relative value and financial effect of each optional form of benefit, and the plan is permitted to use reasonable estimates for this purpose.
Under the generalized notice method, a plan discloses the amount of the participant's benefit payable in the normal form of benefit and provides additional information that is not participant-specific. The additional information may be disclosed in the form of a chart based on computations for hypothetical participants that shows the financial effect of generally available optional forms of benefit, and the relative values of those optional forms.
The final regulations permit a plan to use a uniform basis of comparison of relative value for both married and unmarried participants, if the benefit options are the same for the married and unmarried participants. Thus, in a plan in which the applicable QJSA form for unmarried participants is a straight life annuity and the applicable QJSA form for married participants is a 50% joint and contingent annuity (and each of these forms of distribution is available to all participants on the same terms), the plan may choose to: (i) compare the relative values of the plan's optional forms of benefit to the value of the straight life annuity with respect to the required disclosure for all participants, or (ii) compare the relative values of the plan's optional forms of benefit to the value of the 50% joint and contingent annuity with respect to the required disclosure for all participants (Regulations Section 1.417(a)(3)-1(c)(2)(ii)).
3. Grouping Optional Forms of Benefit to Provide Simplified
Disclosure of Relative Value
The final regulations provide for certain simplifications in the disclosure to plan participants. The final regulations permit a plan that is comparing the relative value of each optional form to the value of the QJSA for a married participant to treat each presently available optional form of benefit that has an actuarial present value of at least 95% of the actuarial present value of the QJSA as having approximately the same value as the QJSA.
In addition, for a plan that is comparing the relative value of each optional form to the value of the single life annuity, if all of the optional forms of benefit presently available have actuarial present values that are at least 95%, but not greater than 102.5%, of the actuarial present value of the presently available single life annuity, the plan is permitted to treat all the presently available forms of distribution as approximately equal in value.
4. Offer to Provide Actuarial Assumptions
The final regulations require that information be made available upon request about what actuarial assumptions were used when the plan estimated relative value, if this information is not already provided in the notice to participants.
E. IRS Cracks Down on "Abusive" Life Insurance Policies in 412(i) Plans
The IRS issued regulations that constitute a broad-based attack aimed at shutting down "abusive" transactions involving specially designed life insurance policies in Code Section 412(i) plans. The regulations generally provide that life insurance contracts transferred to an employee must be taxed at their full fair market value ("FMV"), and a revenue procedure provides a temporary safe harbor for determining FMV. A new ruling concludes that an employer cannot buy excessive life insurance in order to claim large tax deductions and generally categorizes these arrangements as listed transactions. Finally, another ruling states that a Code Section 412(i) plan cannot use differences in life insurance contracts to discriminate in favor of highly paid employees.
1. Background
An individual insurance contract plan is exempt from the Code Section 412 minimum funding requirements for a plan year if the plan satisfies the following six requirements:
a. The plan is funded exclusively by the purchase from a licensed life insurance company of individual annuity or individual insurance contracts, or a combination of such contracts. The purchase may be made either directly by the employer or through the use of a custodial account or trust.
b. The contracts provide for level annual, or more frequent, premium payments.
c. Benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by a licensed insurance carrier to the extent premiums have been paid.
d. Premiums payable for the plan year and all earlier plan years under the contracts have been paid before lapse or there is reinstatement of the policy. If a lapse has occurred during the plan year, the requirement is met if reinstatement of the insurance policy under which the individual insurance contracts are issued occurs during the year of lapse and before distribution is made or benefits commence to any participant whose benefits are reduced because of the lapse.
e. No rights under the contracts have been subject to a security interest at any time during the plan year.
f. No policy loans are outstanding at any time during the plan year.
The employer may claim tax deductions for contributions that are used by the plan to pay premiums on the insurance contract covering an employee, but not in excess of the Code Section 404(a)(1) deduction limit. Contributions exceeding that limit may be carried over to future years and deducted in those years to the extent the deduction ceiling for a later year is not exhausted by contributions for that later year. The plan may hold the contract until the employee dies, or it may distribute or sell the contract to the employee at a specific point, such as when the employee retires.
IRS's regulations contain two differing provisions that describe the amount includible in income under (Code Section 72 annuity rules) when a qualified plan distributes a life insurance contract. Under Regulations Section 1.402(a)-1(a)(1)(iii), the "fair market value" of the property distributed is includible, while under Regulations Section 1.402(a)-1(a)(2) the "entire cash value" of the life insurance contract distributed is includible. The IRS said that its regulations do not conclusively define "fair market value" or "entire cash value" or indicate which applies in determining the income consequences of a distribution. Cash surrender value and the value of a contract's reserves have been used as the value of a life insurance contract for purposes of determining the amount includible in income when the contract is distributed.
2. Reason for Crackdown
The IRS has become aware of abusive arrangements that purportedly enable businesses to generate large tax-deductible contributions to plans and tax-free retirement distributions and death benefits. For example, special policies are made available only to highly compensated employees. The insurance contract is designed so that the cash surrender value is temporarily depressed, making it significantly below the premiums paid. The contract is distributed or sold to the employee for the amount of the current cash surrender value during the period the cash surrender value is depressed. However, the contract is structured so that the cash surrender value increases significantly after it is transferred to the employee. Use of this "springing cash value" life insurance gives employers tax deductions that far exceed what the employee recognizes in income.
3. Proposed Reliance Regulations
New proposed regulations aim to prevent taxpayers from using artificial devices to understate the value of the life insurance contract. They provide that where a qualified plan distributes a life insurance, retirement income, endowment, or other contact providing life insurance protection, the FMV of the contract (i.e., value of all rights under the contract, including any supplemental agreements, and whether or not guaranteed) is generally included in the distributee's income, and not merely the entire cash value of the contracts. The proposed regulations also provide that, if a qualified plan transfers property to a plan participant or beneficiary for consideration that is less than the FMV of the property, the transfer will be treated as a distribution by the plan to the participant or beneficiary to the extent the FMV of the distributed property exceeds the amount received in exchange.
4. Fair Market Value Defined
Revenue Procedure 2004-16 provides interim rules under which the cash value (without reduction for surrender charges) of a life insurance contract distributed from a qualified plan may be treated as the FMV of that contract. These interim rules also apply for purposes of determining the value of insurance contracts under Code Section 79 and Code Section 83. Cash value (without reduction for surrender charges) may be treated as the FMV of a contract, as of a determination date, provided the cash value is at least as large as the aggregate of:
a. premiums paid from the date of issue through the date of determination, plus
b. any amounts credited (or otherwise made available) to the policyholder with respect to those premiums, including interest, dividends, and similar income items (whether under the contract or otherwise), minus
c. reasonable mortality charges and reasonable charges, but only if those charges are actually charged on or before the date of determination and are expected to be paid.
5. Plan Qualification Issues
Under the proposed regulations, the amount of a plan's distribution of a life insurance contract must be taken into account in determining the plan's qualified status. For example, the FMV of a distributed life insurance contract must be considered in determining whether the insured participant has received benefits in excess of the Code Section 415 limits.
6. Excess Life Coverage Not Deductible
Revenue Ruling 2004-20 holds that a qualified pension plan cannot be a Code Section 412(i) plan if it holds life insurance contracts and annuity contracts for the benefit of a participant that provide for benefits at normal retirement age in excess of his benefits at normal retirement age under the plan's terms. Employer contributions under a qualified defined benefit plan used to buy life insurance coverage for a participant in excess of the death benefit provided under the plan are not fully deductible when contributed. Rather, they must be carried over as contributions in future years and deducted in future years when other plan contributions that are taken into account for the tax year are less than the maximum amount deductible under Code Section 404.
Revenue Ruling 2004-20 provides that the purchase of excessive life insurance (i.e., insurance contracts where the death benefits exceed the death benefits provided to the employee's beneficiaries under the terms of the plan, with the balance of the proceeds reverting to the plan as a return on investment) to claim large tax deductions is a listed transaction for tax-shelter reporting purposes. However, the listed transaction label applies only if the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that exceeds the participant's death benefit under the plan by more than $100,000.
7. Nondiscrimination
In Revenue Ruling 2004-21, the IRS notes that Code Section 401(a)(4) provides that a qualified plan cannot discriminate in favor of highly compensated employees concerning contributions to or benefits accrued under the plan. Further, all benefits, rights and features provided under a qualified plan must be made available to participants in a nondiscriminatory manner. The ability of a plan participant to purchase a life insurance policy from a qualified plan before distribution of retirement benefits is a right that must be made available on a nondiscriminatory basis.
In the ruling, IRS described a plan where the features of the life insurance contracts covering the lives of highly compensated employees are different from the features of the contracts covering nonhighly compensated employees. Because of this difference, the purchase rights of nonhighly compensated are not of inherently equal or greater value than the purchase rights of the highly compensated. Thus, a plan that is funded partially or completely with life insurance contracts does not satisfy the Code Section 401(a)(4) nondiscrimination rules if: (i) it allows highly compensated employees to buy those life insurance contracts before distribution of retirement benefits; and (ii) rights under the plan for nonhighly compensated employees to buy life insurance contracts from the plan before distribution of retirement benefits are not of inherently equal or greater value than the purchase rights of highly compensated employees.
F. Deficit Reduction Act
On February 8, 2006, President Bush signed the Deficit Reduction Act of 2005 which increases Pension Benefit Guaranty Corporation ("PBGC") premiums for both single employer and multiemployer defined benefit plans, starting with the 2006 plan year.
1. Flat-Rate Premiums
Effective for plan years beginning in 2006, the annual flat-rate premium payable by all PBGC-covered single employer plans increases from $19 to $30, and the annual flat-rate premium for multiemployer plans increases from $2.60 to $8.00. For 2007 and subsequent years, it will be indexed for inflation, using the same wage-based index that is currently used for Social Security indexing. According to a statement issued by the PBGC, large plans that have already filed their estimated premiums using the old rate will have to submit an amended filing with the new rate. The amended filing must be submitted by the estimated premium due date.
2. Bankruptcy Exit Premium
A special premium will be assessed in the case of a distress termination of an underfunded single employer plan, unless the employer is liquidated. This special assessment applies to plan terminations in bankruptcy proceedings filed on or after October 18, 2005. The charge is $1,250 per participant (as of the day before the termination). To avoid a direct conflict with the bankruptcy laws, if the employer is in a bankruptcy reorganization, the special premium does not become payable until the bankruptcy proceeding is concluded. The premium is payable annually for each of the three years following the termination date or, if later, the employer's exit from bankruptcy. This special assessment will not apply to terminations that take place after December 31, 2010, unless Congress extends this provision.
G. IRS Proposes Shift to New Mortality Tables for Computation
of Employee
Plan Liabilities
The IRS has issued proposed regulations that would provide guidance for updating mortality tables used in determining current liability for participants and beneficiaries of employee plans.
The proposal would update the methodology for generating mortality tables used under Code Section 412(l)(7)(C)(ii) and ERISA Section 302(d)(7)(C)(ii). The proposed rules would apply to plan years beginning on or after January 1, 2007.
The regulations would change the mortality tables used to determine current liability from tables based on the 1983 Group Annuity Mortality Table to updated tables based on the RP-2000 mortality tables, which were created by the Society of Actuaries.
The Service believes the 1983 GAM is no longer appropriate for determining current liability. By way of example, it said that:
a. Comparing the RP-2000 Combined Healthy Mortality Table for males projected to 2007 with the 1983 GAM shows that a current mortality table reflects a 52 percent decrease in the number of expected deaths at age 50, a 26 percent decrease at 65, and an 19 percent decrease at age 80.
b. Comparing annuity values derived under the RP-2000 Combined Healthy Mortality Table for males with annuity values determined under the 1983 GAM shows an increase in present value of 12% for a 35-year-old male with a deferred annuity payable at age 65, a 5% increase for a 55-year-old male with an immediate annuity, and a 7% increase for a 75-year-old male with an immediate annuity, when calculated at a 6% interest rate.
c. For females, the number of expected deaths decreased by 10% at age 50, but increased by 33% at age 65 and increased by 2% at age 80.
d. Comparing annuity values derived under the RP-2000 mortality rates with annuity values determined under the 1983 GAM shows a decrease in present value of 3% for a 35-year-old female with a deferred annuity payable at age 65, a 2% decrease for a 55-year-old female with an immediate annuity, and a 2% decrease for a 75-year-old female with an immediate annuity.
IV. ALL TAX-QUALFIED PLANS
A. Fees for Plan Rulings Increase Sharply
The IRS is implementing a new user fee schedule for 2006, including some sharply increased fees for employee plans private letter rulings and determination letters. New letter ruling fees increased from $95 - $5,415 to $200 - $14,500, effective February 1, 2006. New fees under the revised and centralized determination letter program take effect July 1, 2006.
In many instances, the fees jump to more than double the amount under the former fee structure. Compliance fees and compliance correction fees under the Employee Plans Compliance Resolution System ("EPCRS") remain at current levels.
According to the IRS, the increased user fees are a response to an Office of Management and Budget directive to charge user fees reflecting the full cost of providing goods or services when the benefits to the recipient otherwise exceed those received by the general public. The new fee structure is designed to more accurately reflect the resources that the IRS expends in processing the ruling request.
B. Hurricane Katrina Statutory and Administrative Relief
In response to the devastation caused in the Gulf Coast region by Hurricane Katrina, Congress, the Department of the Treasury (the IRS) and the Department of Labor (EBSA) took swift action to provide various measures of relief to affected individuals and entities with respect to their employee benefit plans.
1. Statutory Relief
On September 23, 2005, President Bush signed into law the Katrina Emergency Tax Relief Act of 2005 ("KETRA"). KETRA provides relief to Hurricane Katrina victims in the form of relaxed rules related to plan distributions and loans as follows:
a. KETRA provides for exemption from the 10% penalty tax under Section 72(t) of the Code for any distribution (up to $100,000) from an eligible retirement plan (i.e., 401(a), 403(a), 403(b) and 457(b) plans, and IRAs) made on or after August 25, 2005, and before January 1, 2007, to an individual whose principal abode on August 28, 2005, was located in an area declared a disaster area by the President before September 14, 2005, as a result of Hurricane Katrina and who has suffered economic loss as a result of the hurricane (a "Qualified Individual").
b. KETRA permits repayment of a distribution described above (a "Qualified Hurricane Katrina Distribution"), not to exceed the aggregate amount of such distribution, to any eligible retirement plan to which a rollover can be made at any time during the three-year period beginning on the day after the date on which the distribution was received. The repayment will be deemed an eligible rollover distribution.
c. Any amount that would be required to be included in a Qualified Individual's gross income for a taxable year as a result of a Qualified Hurricane Katrina Distribution, unless otherwise elected by the taxpayer, may be included on a prorated basis over the period of three taxable years beginning with such taxable year.
d. KETRA exempts Qualified Hurricane Katrina Distributions from the rollover rules under Section 401(a)(31) of the Code, from the rule concerning the special tax notice regarding plan payments under Section 402(f) of the Code, and from the mandatory 20% withholding under Section 3405 of the Code.
e. A Qualified Hurricane Katrina Distribution will be deemed to have met all plan distribution requirements.
f. The loan amount that a Qualified Individual may take from a plan pursuant to Section 72(p)(2) of the Code is raised to the lesser of $100,000 (reduced by the excess of outstanding loans) or 100% of the nonforfeitable accrued benefit of the employee under the plan.
g. KETRA provides for a one-year delay for plan loan repayment due dates occurring during the period from August 25, 2005, to December 31, 2006, for any loan made to a Qualified Individual who had an outstanding plan loan on or after August 25, 2005. Any subsequent repayment will be adjusted to reflect the delayed repayment due date and any interest accruing during the delay. The one-year delay period will be disregarded for purposes of the five-year repayment rule under Section 72(p)(2) of the Code.
h. A plan may be amended, no later than January 1, 2007 (or a later date if the IRS so permits), to include KETRA's provisions if the plan operates as if the amendment were in effect during the period from the amendment's effective date until the amendment is adopted.
2. Administrative Relief
On September 15, 2005, the IRS published Announcement 2005-70 (the "Announcement") which provides relief to Hurricane Katrina victims with respect to loans and hardship distributions, as follows:
a. A plan may make a loan or hardship distribution for a need resulting from Hurricane Katrina to an employee or former employee whose principal residence on August 29, 2005, was located in one of the areas in Louisiana, Mississippi or Alabama that have been or are later designated a disaster area eligible for individual assistance by FEMA as a result of Hurricane Katrina, or whose place of employment was located in one of those areas.
b. Plan administrators may rely on representations made by the individual with respect to the need for and amount of a hardship distribution unless they have actual knowledge to the contrary.
c. Hardship distributions may be made from profit sharing or stock bonus plans that currently do not provide for hardship distributions, except such distributions may not be made from qualified nonelective contributions ("QNECs") and qualified matching contributions ("QMACs") or from earnings on elective contributions.
d. Defined benefit plans and money purchase pension plans may only permit hardship distributions from any employee contributions or rollover contributions.
e. Hardships for which distributions are available under the Announcement are not limited to the hardships enumerated in the 401(k) plan regulations.
f. No post-hardship distribution contribution restrictions are required for hardship distributions made pursuant to the Announcement.
g. A plan that does not provide for hardship distributions or loans, but does permit such distributions pursuant to the Announcement, must be amended to so provide no later than the end of the first plan year beginning after December 31, 2005.
h. Plan loans made pursuant to the Announcement must satisfy the requirements under Section 72(p) of the Code (i.e., dollar amount limitations, timing limitations and level amortization requirement).
i. Any hardship distributions made under the Announcement must be made on or after August 29, 2005, and no later than March 31, 2006.
j. A plan's failure to comply with its procedural requirements with respect to loans and distributions made during the period beginning on August 29, 2005, and ending on March 31, 2006, to individuals eligible under the Announcement will be excused as long as the plan administrator makes a good faith effort under the circumstances to comply with those requirements. The plan administrator must make a reasonable effort to assemble any foregone documentation (e.g., spousal consent) as soon as practicable.
The Department of Labor issued a news release stating that it will not treat anyone as having violated the provisions of Title I of ERISA (e.g. reporting and disclosure and fiduciary obligations) as a result of complying with the Announcement.
On September 21, 2005, the Department of the Treasury and the Department of Labor jointly issued the Extension of Certain Time Frames for Employee Benefit Plans Affected by Hurricane Katrina; Final Rule, which extends time frames related to the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA"), the Health Insurance Portability and Accountability Act of 1996 ("HIPAA") and employee benefit plan claims procedure deadlines, as follows:
a. Relief applies to participants, beneficiaries, qualified beneficiaries and claimants who resided, lived or worked in, at the time of Hurricane Katrina, one of the areas designated a disaster area eligible for Individual Assistance by FEMA as a result of Hurricane Katrina. The rules also apply to any employee benefit plan that: (i) is maintained by an employer having a principal place of business in an area described above at the time of the Hurricane, or (ii) has its office or the office of the plan administrator or primary recordkeeper in an area described above at the time of the Hurricane.
b. The period from August 29, 2005, through January 3, 2006, must be disregarded when determining certain time periods under COBRA and HIPAA and for filing claims under a plan covered by ERISA.
c. The 60-day period to elect COBRA coverage is extended so that a qualified beneficiary who receives a COBRA election notice during the period from August 29, 2005, through January 3, 2006, will have until March 4, 2006, to elect COBRA continuation coverage.
d. The period from August 29, 2005, through January 3, 2006, is disregarded for a qualified beneficiary who received a COBRA election notice less than 60 days prior to August 29, 2005. For example, an individual who was given a COBRA notice on August 14, 2005 (having 45 days remaining in their COBRA election period on August 29, 2005), must be allowed to make the election until February 18, 2006.
e. COBRA premium payment deadlines are extended. A qualified beneficiary who was receiving COBRA coverage and who made a timely payment for August 2005 must have until February 2, 2006, to make COBRA premium payments for September, October, November and December 2005 and January 2006. If the individual only makes the equivalent of two monthly premium payments by February 2, 2006, then such amounts will be applied to the first two eligible months (i.e., September and October).
f. The period for a qualified beneficiary to inform the plan administrator of a qualifying event (e.g., divorce, adoption, loss of dependent status) that occurred in the period from August 29, 2005, through January 3, 2006, is extended until March 4, 2006. The period from August 29, 2005, through January 3, 2006, is disregarded for a qualified beneficiary whose 60-day notice obligation arose before August 29, 2005, but extended beyond such date.
g. A group health plan participant whose last day of coverage was August 29, 2005, will not be considered to have had a 63-day break in creditable coverage until 63 days after January 3, 2006, which was March 7, 2006.
h. The last day for requesting special enrollment under HIPAA as a result of a loss in eligibility for health care coverage due to Hurricane Katrina was February 2, 2006 (30 days after January 3, 2006). This also applies to an individual who acquired a new dependent during the period from August 29, 2005, through January 3, 2006. If the event qualifying an individual for special enrollment occurred less than 30 days before August 29, 2005, the period from August 29, 2005, through January 3, 2006, is disregarded in determining the individual's eligibility period for special enrollment.
i. The period from August 29, 2005, through January 3, 2006, is disregarded with respect to the deadline by which an affected individual has to file a benefit claim under any employee benefit plan.
j. The period from August 29, 2005, through January 3, 2006, is disregarded with respect to the deadline for an affected individual to file an appeal of an adverse benefit determination.
k. An affected employer required to provide notice to an individual of COBRA eligibility during the period from August 29, 2005, through January 3, 2006, will had until February 16, 2006 (44 days) to issue such COBRA notice. An employer that would have been required to issue a COBRA election notice to an individual during the 44-day period that extended beyond August 29, 2005, may disregard the period from August 29, 2005, to January 3, 2006, with respect to the required COBRA notice period. This same rule is applied for notices of creditable coverage required under HIPAA.
3. Conclusion
Congress, the IRS and EBSA have provided much needed relief for victims of the devastation caused in the Gulf Coast region by Hurricane Katrina with respect to their employee benefit plans. This relief will provide affected individuals with the flexibility that is needed so that they may use retirement plan funds to begin rebuilding their homes and their lives without adverse tax consequences, as well as to maintain their health coverage and claims. Although victims of future disasters or outside of the specified areas affected by Hurricane Katrina will not automatically receive similar relief, general guidelines have now been established that may provide a foundation should the need again arise.
C. IRS Overhauls Rules on Remedial Plan Amendments
1. Introduction
The IRS has issued Revenue Procedure 2005-66, a sweeping revenue procedure that creates fixed, regular cycles for the adoption of remedial plan amendments, and the submission of determination, opinion, and advisory letter applications. The procedure establishes a system of staggered five-year remedial amendment cycles for individually-designed plans, and a system of six-year amendment/approval cycles for pre-approved plans (M&P and volume submitter plans), while extending a plan's remedial amendment period to reflect the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA").
2. Remedial Amendment Periods
The IRS established remedial amendment periods to provide an extended period of time for plan sponsors to amend their plans to comply with legislative changes. Plans must be amended within the applicable remedial amendment period in a timely manner in order to reflect the new qualification requirements. Failure to amend a plan within the remedial amendment period can disqualify a plan for those plan years.
Example: GUST Remedial Amendment Period. GUST amendments are a series of required amendments that qualified plans were required to adopt in order to maintain their qualified status. For individually-designed plans, the GUST remedial amendment period ended on the later of February 28, 2002, or the end of the 2001 plan year. If a plan sponsor failed to amend its plan within the GUST remedial amendment period, the plan is disqualified.
Comment: Even though a plan does not need to be amended or restated until the end of a remedial amendment period, it must operate in compliance with any applicable legislative changes.
3. Cyclical Remedial Amendment Periods
Using a single remedial amendment period that applied to all qualified plans resulted in significant backlogs in the IRS opinion and determination letter programs. As a result, the IRS recently announced cyclical remedial amendment periods. Under this system, individually-designed plans have a regular five year remedial amendment cycle. The cycles are staggered over five year periods (i.e., different plans have different remedial amendment period cycles depending on the last digit of the plan sponsor's employer identification number ("EIN")). Pre-approved plans (i.e., VS and M&P plans) generally have a regular six-year remedial amendment cycle. As a result, prototype sponsors, practitioners, and adopters of pre-approved plans generally need to apply for new opinion, advisory or determination letters once every six years. Pre-approved defined contribution plans and defined benefit plans have dif